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.