self-interest and the financial meltdown, part II

As discussed in part I of this series, there has lately been a lot of talk that paradoxically suggests that markets sometimes suffer from a lack of self-interested behavior rather than the surfeit of self-interestedness that is often attributed to capitalism.  And especially since I argued that such an attribution is reasonable (due to the fact that competition induces self-interestedness, and capitalism fosters competition), the question of why we sometimes suffer from self-defeating market behavior on a large-scale is a critical question.  Furthermore, while I cited an attribution of “irrational exuberance” on the upside (the case of investment banks exploiting the loosening of capital controls to take on unwise risks), it is now becoming increasingly common to hear attributions of irrational panic (e.g.), during this meltdown.  If markets produce self-interestedness, why does the pursuit of self-interest so often turn out to be self-defeating?  In particular, how could banks have misvalued their risks so badly?

As I mentioned in a follow-up comment to my last post, I think the foundations for an approach to this question can be found in chapter 12 of Keynes’s General Theory, which basically is an overview of how the stock market works, and which can be applied (mutatis mutandis) to other financial markets.  (This is not to say that one cannot find such foundations in more recent work; but I think Keynes is quite eloquent on these points).  Unfortunately, my sense is that insofar as people have heard of Keynes’s analysis in this chapter, it is that he likens the stock market to a “beauty contest” and especially that it is ruled by “animal spirits.”  I say this is unfortunate because the latter metaphor is more of an aferthought to the thrust of his analysis, and it is easy to miss the deep point behind the “beauty contest” metaphor.  So, in this post,  let me summarize why I think his analysis is so good and how it can help us understand why we self-defeating behavior in financial markets.

Basically, Keynes makes two key points.  The first is that the securitization of equity and its trading on large, liquid markets, fundamentally transforms the orientation of the equity-owner towards ownership, such that one can no longer expect the investment decision to be based on what he calls “enterprise” and he defines as “the activity of forecasting the prospective yield of assets over their whole life (p.158).”  Rather, he argues that the orientation of many investors (with that number increasing as “the orgainsation of investment markets improves” [ibid]) can be described as “speculation [ibid],” which he defines (in a few related ways, but most succinctly) as “foreseeing changes in the conventional basis of valuation a short time ahead of the general public (p.154).”  Why does this tranformation happen?  He stresses that:

… it is not the outcome of a wrong-headed propensity.  It is an inevitable result of an investment market described along the lines described (I.e., it is structural, not behavioral– EZ).   For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30 if you also believe that the market will value it at 20 three months hence (p.157).

The key point, as I have written elsewhere (Zuckerman 2004, p.414), is that


to the extent that most participants in contemporary markets care about capital gains and losses within a relatively short time-horizon, they are effectively engaged in speculation. And the proximate determinant of the return that a speculator receives from the purchase (or short-sale) of a stock is the change in the marginal valuation that takes place (Zuckerman 1999:1411).  As such, it may often be quite rational for a speculator to place more weight on the prevailing interpretation than on her “private” valuation (e.g., Arthur et al. 1997; Froot and Obstfeld 1991; Romer 1993).

In sum, securities markets provide two standards for the rational pursuit of (material!) self-interest– a focus on what Graham famously called “intrinsic value,” which involves forecasting the yield of the investment and comparing it to current price; or a focus on forecasting what Keynes called the “conventional valuation.”  But while it may be individually rational for any individual investor to focus on anticipating the conventional valuation, such efforts in the aggregate serve to drive price away from intrinsic value (because, at the limit, information about value does not enter into prices), and this can have bad consequences for the investment community as a whole as well as the individual investor, once the gap between price and value is eliminated.


It is important to note that the “efficient markets” perspective, which dominated academic finance for the last third of the twentieth century and is now very much on the wane, predicted that gaps between price and value will not persist due to the enormous profits that are available to anyone who can find such gaps.  But Keynes also pointed out a key problem with this line of thinking (see also the recent literature on the limits to arbitrage; e.g.).  In particular, whereas one would think these gaps would be closed by “the skilled individual who, unperturbed by the prevailing pastime, continues to purchase investments based on the best genuine long-term expectations he can frame (p.156);” in practice,

… it is the long-term investor, he who most promotes the public interest, who will in practice come in for (the) most criticism, wherever investment funds are managed by committees or boards or banks.  If he is successful, he will only confirm the general belief in his rashness; and if in the short run, he is unsuccessful, he will not receive much mercy.  Worldly wisdom teaches that it is better to fail conventionally than to succeed unconventionally

The last line, which I bolded, is a great one, even if is exaggerated.  By definition, it is always better to succeed.  But the point still holds.  Insofar as the investor is actually an agent rather than a principal, the basis for evaluating self-interest is again transformed.  Agents are evaluated based on how an alternative/substitute agent would have performed.  This means that: (a) if all other agents are doing x and it works out, I will have a lot of explaining to do if I do y, and it doesn’t work out; and (b) if all other agents are doing x and I do it too, even if it fails I will have relatively little to explain.   Of course, if I do y and it works out while everyone else fails with x, I am on top of the world (contrary to that last line).  But: (a) that requires cojones; and (b) insofar as speculative success is based on the conventional valuation, I can be right (in an intrinsic value sense) but still be wrong (in a speculative sense).  So, the two mechanisms interact in a way to make it that much harder to deviate from the herd.

Insofar as these two factors– (a) the fact that returns are driven by market price changes rather than income; and (b) that the typical investor is an agent rather than principal– are salient, they make it more and more likely that gaps between price and value will persist, and may even become yawning canyons for a time.  At the very least, these factors mean that even if the market disciplines participants to try and maximize their material self-interest, they may do so in a way that defeats them in the long-term.

And of course, each of these two factors were at work in a big way in creating our current mess.  In this case, it was debt rather than equity that was newly securitized.  But the key transformation was the same– from what the yield on the asset would be to the prices at which I can buy and sell it.  And Keynes’s points on the importance of agency relationships were clearly at work in magnifying this.  See, e.g., this very insightful article on what happened at the credit ratings agencies.  This was hardly an environment where the most straightforward path towards following one’s self-interest was about figuring out the right price based on fundamentals.

But then, why did it all come crashing down?  And more generally, why do prices ever have to fall back to earth (after such speculative bubbles).  This is a question that is particularly vexing for someone who might want to take the fact that prices can become unmoored from fundamentals and use it to develop a radical constructionist view of markets.  I’ll try to address that question in an upcoming post.

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Written by ezrazuckerman

October 13, 2008 at 6:50 am

Posted in uncategorized

12 Responses

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  1. I don’t find it hard to believe that much investment behavior is speculative and that, because of the limits of arbitrage, even those who might make a lot of money short-selling are willing to take the safer route of siding with speculators. My impression from this last week was that much of the market downturn is the result of similar processes, although in this case it’s caused by investor fear rather than exuberance.

    But don’t most bubbles take place in markets where there is very little good information about fundamentals? The internet stock boom wouldn’t have happened had there been good criteria by which to assess the value of these new companies. The miscalculation of value of the telecom companies was caused by a similar lack of good evaluative standards. Although telephones had been around for a long time, the combination of new technology and a new competitive environment with fewer regulatory constraints undermined former means of value assessment. When analysts and investors lack reliable (i.e., tested) standards of assessment, other investors’ behavior becomes a more salient signal. Hey, during the 90s stock bubble, even analysts were taking cues from the herd. Analysts’ ratings were endogenous to the fluctuation of the market.

    The implication of this is that when investors have evaluative criteria that have been tested and shown to be reliable in a particular competitive environment, speculative investing is somewhat constrained and market prices will more closely approximate inherent value.


    October 14, 2008 at 2:51 am

  2. I am still digesting this post a bit, but I think you are hanging your hat quite a bit on a distinction between price and value.

    In your estimation, rationality breaks from arbitrage at the point where ‘intrinsic value’ and ‘price’ diverge. So, in the interests of trying to make money on price changes in the market, otherwise rational people – ideally principals, though as you mention, increasingly agents – jettison value. Which has the potential to drive price further from value rather than towards it. Is this a fair assessment of your argument?

    Further, price may be driven by many things assumedly, including intrinsic value, arbitrage, panic, joy, whether hedge funds need to liquidate to accommodate cash withdrawals, etc. And value is driven by some underlying fundamental value (‘conventional valuation’ as you put it), assumedly earnings, costs, profits, market share, etc.

    Given all this, I want to critically question the idea of inherent value. Or rather, I am curious why you cede so much to this concept, assuming that there is a kind of reality to value that there isn’t to price. It has the effect of underestimating the realness of price, and overestimating the realness of value. As you know, earnings, costs, market share, these are tremendously constructed things, the more so the closer you get to nitty-gritty actuarial and forecasting elements (and I’m not making a postmodern ‘nature of reality’ argument here).

    There are always going to be people who talk about market prices as not reflecting the ‘true’ value of the underlying object. My favorite is an art specialist who talked about a painting that was brought in (unsold) had not yet ‘matured’ into its appropriate value.


    October 14, 2008 at 4:33 pm

  3. Peter – I’ll only speak for myself in saying that I do think there is a reality to value that is somewhat distinct from price. At least this is the case in the stock market; I’m not sure if you could say the same thing for art or some commodities. The inherent value of a corporate asset is its net present value, which is reducible to cash flows and debt. The ups and downs of a stock price are supposed to reflect the perceptions that investors have of that asset’s net worth. Sometimes they get it somewhat right and other times they’re way off. This was the problem with the stock market bubble of the 90s. A lot of the assets were thought to produce lots of future cash flow but this revenue never materialized like they hoped. The two – price and value – had become disjointed.


    October 14, 2008 at 5:04 pm

  4. As I am teaching Watts Ch 7 tomorrow in my freshman seminar- the top is the madness of crowds and how externalities can explain social decision making, it was nice to tune in here on lunch break and get a jolt of deeper thinking about the financial mess. Now I will go back and read first part…


    October 14, 2008 at 5:32 pm

  5. Brayden – cash flow and debt are themselves contested concepts in the accounting literature, and particularly so in an era of financialization (and h/t to Greta Krippner’s work on this front).

    There may have been a time when we could add up the cash in the drawer against the costs in the books, but that time is long gone. Much of the cash flow literature is about how to measure the net present value of derivatives; and Krippner’s work demonstrates that manufacturing firms by the end of 2001 were achieving almost a 1:1 ratio of portfolio income to cash flow. So how do you, even theoretically, separate out value from perceptions that investors have of an asset’s net worth?


    October 14, 2008 at 5:47 pm

  6. I’m not saying that there aren’t measurement issues when trying to estimate value. Clearly, there are. If we had a straightforward measure of net present value (NPV) there would be a lot less market volatility, wouldn’t there? It’s our inability to precisely detect the inherent value of a company that makes it attractive to look to stock prices and futures.

    Stock prices are supposed to be a nice shorthand for NPV, which is why strategy scholars and financial economists have often abused event studies and treated them as if they were direct indicators of how much value is created in a company when X event happens. Economics sociologists and OT folks are, of course, more skeptical that stock price really gives you a direct indicator of value because, as Ezra points out, we’re deeply aware of the problems with the efficient markets hypothesis. But that doesn’t mean we can’t assume that stock prices are in some way anchored to real fundamentals, no matter how difficult those fundamentals are to measure.


    October 15, 2008 at 2:52 am

  7. Hi folks.

    As I hinted in the last paragraph of my post, I kind of expected that it would lead to a debate between a more (Peter) and a less (Brayden) constructionist position. That is why I planned to address this divide in my next post. Should be sometime before Monday.

    For now, I’ll just say that while I largely agree with Brayden, I would note that it’s a little glib to say that in bubbles such as the internet stock bubble of the 90s, that investors were ignoring the fundamentals more than usual. Yes, that’s true, in the sense that there were no cash flows to look at. But even in more mature markets, the investment community looks at leading-indicators of cash-flows (e.g., same-store sales in retailing). (See p.409 of Zuckerman 2004 on this, and its implications). Moreover, Huggy Rao and I show( that, as indicated by how they moved together, the pricing of internet stocks actually looks like it was as much driven by the fundamentals as other stocks were. So the problem was less with ignoring fundamentals than with how those fundamentals were translated into price. As is the case with all stocks, prices were governed by a prevailing theory of value (what Keynes calls a “convention”) that maps fundamentals into price. The problem, however, was that the theory was wrong.


    October 16, 2008 at 1:11 am

  8. Dang, to be lumped in with the constructionists. And I am always going on about how economic sociology needs to go beyond ‘markets are socially constructed.’ And yet. You want to say that there is an underlying, fundamental value to market instruments, but that these underlying values are somehow translated poorly into market prices – either through perception and/or bubbles, by which we mean a kind of irrational exuberance (Brayden), or through a ‘wrong’ theory of value mapping fundamentals to price (Zuckerman).

    I say that this is like arguments about the ‘missing link’ in anthropology (though I may be getting the specifics of this wrong, conceptually it was deeply meaningful to me as a grad student. But it’s been a while). Susan Gal has written about ‘Langurs with Lipstick’, a way to say that the prevailing notion of patriarchy is found in humans but not apes, and so there must be some missing link that gets us from there to here. That missing link serves to justify a belief (that patriarchy is natural); and it’s great because no evidence can refute it. If you can’t find patriarchal langurs, we just haven’t found the missing link yet. Keep looking. Matriarchal bonobos? Keep looking, there must be patriarchy someplace.

    Similarly, fundamental value serves as an axiom of markets, unrefutable because whatever evidence you find of prices doing whatever crazy they do, it’s just because people are irrational, our current convention/theory of value is wrong, fundamentals are hard to measure, etc. But there. Still there. What’s the use of a concept that acts more as religious station than tractable concept?


    October 16, 2008 at 11:07 am

  9. Peter: I’ll address this in my next post. For now, I would say: if someone offered you ownership of GE for $100, would you take it?


    October 16, 2008 at 12:19 pm

  10. Of course I would. I’m something of a constructionist, but I’m not a postmodernist. But having said that, and looking a bit at what I can puzzle in a few minutes looking at their balance sheet presentation, it seems to me that the finance arm of their operations, GE Capital Finance, has been providing a larger and larger proportion of their revenues; and things like the $350M ‘investment impairment’ w.r.t. their WaMu investments and others are problematic.

    But not problematic in the ‘I wouldn’t take ownership for $100′ sense. Of course, there is revenue that comes from stuff they make and do. It is problematic in the notion of fundamental value that operates outside of sentiments or ‘perceptions of value’ – what you I think are calling price.

    This said, I think the idea of returning to securitized assets rather than debt is interesting and completely useful. And I think it may be worth thinking about different kinds of assets (per Brayden’s useful analytic distinction between stock and come other kinds of commodities that don’t generate revenue – like art), and for me at least to stop making more sweeping statements about fundamental value always and everywhere. But I await the next post..


    October 16, 2008 at 3:20 pm

  11. [...] prices depends on what other investors will come to beleive– it is a speculative maneuver, as defined by Keynes.  And speculation is always risky– what if the optimistic herd keeps on growing?  Oy veh.  [...]

  12. Hello, very interesting reading, thank you for this.
    I wanted to add one important element, peer pressure, in the behaviour of agents (and maybe of principals too, as they are struggling to stay in the top-dog group):
    (a) LOSE: if all other agents are doing x and it works out, I will have a lot of explaining to do if I do y, and it doesn’t work out;
    (b) WIN/EVEN: if all other agents are doing x and I do it too, even if it fails I will have relatively little to explain
    >>(c) LOSE: if all other agents are doing x and it does not work out and I do y, every peer will try to drag me down before executives notice that I did y and succeeded. Quite often they manage to do it. Even if they don’t I will suffer isolation and contempt from my peer. Far from being king of the realm, usually.

    I would say choosing (b) is very rational. The only case in which doing domething different makes sense is when the company culture is expecially designed to foster originality and innovation (so all the peers are doing it).


    September 28, 2009 at 8:53 am

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