## On ‘Coherence’ in Asset Markets: Everything is Going According to Plan

The author of the Philosophical Economics blog has a post up that caught my attention on the supply and demand dynamics of asset markets. It caught my attention because it looked, at first, very similar to my own dissertation that was published in working paper form last year by the Levy Institute. At first glance the author’s approach looks very similar to my own: what he/she appears to be doing is trying to put together what I referred to in the paper as a ‘stock-flow’ approach to asset pricing. But as I read on I realised that the author was not doing this and what they were instead doing was reintroducing the old textbook supply and demand fables.

The key point at which this begins to happen is about halfway through the post. You can see it crystal clearly when he/she writes:

For buyers, let’s suppose that this price range begins at \$0 and ends at \$500,000.  At \$0, the average probability that a generic potential buyer–any individual living in an apartment–will submit a buy order in a given one year time frame is 100%, meaning that every individual in an apartment will submit one buy order, on average, per year, if that price is being offered (to change the number from per year to per second, just divide by the number of seconds in a year).  As the price rises from \$0 to \$500,000, the average probability falls to 0%, meaning that no one in the population will submit a buy order at that price, ever.

I am unsure why the author uses the language of probability here. The same result can be derived by simply saying, for example, “as the price rises from \$0 to \$500,000 no one will buy a house”. This is the standard textbook exposition and it makes far more sense than using the language of probability. In reality there is no need to use the language of probability here. All the author needs to discuss is the number of people willing to buy at a given price; he/she does not need to discuss the probability that someone will buy at that price. That is a level of abstraction that is simply unnecessary and only obscures the underlying argument.

Anyway, whether deploying the language of probability or simply saying that at a higher price less people will buy an asset the author comes to the same conclusion. Namely, the downward sloping demand curve that we see in textbooks. The author then supplements this with the upward sloping supply curve by assuming that at higher prices sellers will offload more of the asset. The author then goes on to explain why they make this assumption:

Over time, buyers and sellers become anchored to the price ranges that they are used to seeing.  As the price move out of these ranges, they become more averse, more likely to interpret the price as an unusually good deal that should be immediately taken advantage of or as an unfair rip-off that should be refused and avoided.

Um, I don’t think so. In fact, as I discuss at length in my dissertation, prices in asset markets can very often call forth more demand. This is known as ‘speculation’ and is a key feature in financial markets. During the housing bubble in the mid to late-2000s, for example, people bought houses precisely because the prices were rising. They did this because they thought that they might be able to lock in capital gains as prices rise. Similar phenomenon can often be seen in the stock market and in many other asset markets. As I discuss in my dissertation (pp13-17) this completely overturns the market equilibrium framework that attempts to use as its base model the familiar Supply-Demand (S-D) cross diagram.

The author begins to realise this when he/she writes:

Anchoring is often seen as something bad, a “mental error” of sorts, but it is actually a crucially important feature of human psychology.  Without it, price stability in markets would be virtually impossible.  Imagine if every individual entering a market had to use “theory” to determine what an “appropriate” price for a good or service was.  Every individual would then end up with a totally different conception of “appropriateness”, a conception that would shift wildly with each new tenuous calculation.  Prices would end up all over the place.

Yes, in such a situation prices would end up “all over the place”… which is precisely what we see in financial markets! But what the author seems to imply is that this would be completely chaotic and any semblance of orderliness would break down. So, prices would go from \$0.01 to \$100 and back again in moments. Why is this not the case? Well, there are other somewhat stabilising forces in the market. They are stabilising forces that we see across society and they were well articulated by Keynes in his famous 1937 article ‘The General Theory of Employment‘. There he wrote:

(1) We assume that the present is a much more serviceable guide to the future than a candid examination of past experience would show it to have been hitherto. In other words we largely ignore the prospect of future changes about the actual character of which we know nothing.

(2) We assume that the existing state of opinion as expressed in prices and the character of existing output is based on a correct summing up of future prospects, so that we can accept it as such unless and until something new and relevant comes into the picture.

(3) Knowing that our own individual judgment is worthless, we endeavor to fall back on the judgment of the rest of the world which is perhaps better informed. That is, we endeavor to conform with the behavior of the majority or the average. The psychology of a society of individuals each of whom is endeavoring to copy the others leads to what we may strictly term a conventional judgment.

It is the third of these that is key — indeed, the other two are really just derived from the third. And it is this that ties back into the famous ‘beauty contest’ theory of asset prices that Keynes put forth in the General Theory when he wrote:

Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.

Such behavior is known as imitation in anthropology, psychology and sociology. In psychoanalytical psychology it is known as identification. Whatever one chooses to call it basically everyone is in agreement that it is a key part of the socialisation process. Whenever we, as human beings, find ourselves in a new social environment we begin to imitate the behaviors of those around us by assuming — somewhat unconsciously — that they are somehow more ‘proper’ than ones that we might either create ourselves or arrive at by using our critical faculties.

This is what gives asset prices the modicum of stability that they display. It also accounts for the fact that bubbles can occur; after all, if the herd moves in a certain direction most people are simply going to imitate. It is this view of financial markets that I tried to get a grip on in my dissertation and I think it is a far better representation of actual asset markets than anything that incorporates the old S-D cross diagram. Indeed, using the latter leads to bizarre conclusions. The author of the post, for example, writes:

Housing markets represent an instance where these two phenomena–anchoring and disposition effect–are particularly powerful, especially for sellers.  The phenomena is part of what makes housing such a stable asset class relative to other asset classes.

He/she then produces a graph of nominal home prices that he/she claims shows stability in this market. Stability? In the market for homes? Really? The only reason that the author’s graph displays anything remotely resembling stability is because it is measured in nominal dollars and is thus pretty much constantly rising (as will be most graphs produced in nominal dollars). Here is a more realistic portrayal of the supposed stability of house prices (it is a largely stationary time-series which is the type that we typically use in statistics; the author’s own is non-stationary which is well-known to have misleading statistical properties):

That sure doesn’t look like a ‘stable asset class’ to me. It looks like prices bounce all over the place. They sometimes boom, rising up to almost 20% year-on-year, and they sometimes crash, falling nearly 10% year-on-year. Do we even need a chart to show this? Is this not intuitively obvious in a post-2008 world wracked by the consequences of property bubbles in multiple countries?

In order to get away from the type of thinking that is ingrained in us by learning the old S-D cross diagram by rote we need a different way of thinking about asset prices. While the approach I put forward in my dissertation was by no means perfect it at least pointed in the right direction. Thinking about prices in this way will ensure that we are not blindsided by bubbles in the markets. Because what the old S-D cross diagram and its derivatives really sell to the public is the vague notion that Markets ‘work’ and that whatever is going on in them at any given moment in time is sustainable (see Keynes’ points (1) and (2)). This, as I never tire of pointing out, is pretty much akin to a theological argument about a benign God that ensures coherence and justice in the world. Since what we are ultimately dealing with in both cases is belief there is no real logical cleavage between both types of ideas.

Rather than realising that prices rely on the beliefs that people hold about prices and, beyond this, that one’s own understanding of prices relies on the beliefs that one holds about the beliefs that others hold — scary thoughts that inject elements of arbitrariness into the way we organise our economies and our markets — people tend to fall back on some ‘fundamentalist’ vision that relies on the old Market metaphor. The Market provides coherence in a world the true structure of which is one of intertwined and interdependent beliefs. It is an easy way out and it stops reflection in its tracks by providing us with vague metaphors. But pretty as it is, it ain’t true.

Recent work by David Tuckett, a psychologist studying financial markets at UCL, and his team of economists and computer scientists has provided evidence that what people in the financial markets actually do when they think about problems is provide themselves with ‘conviction narratives’. These allow them to be confident about what they believe. Tuckett writes:

Our argument is that financial actors act by constantly and actively managing to modify in their mind s the threat uncertainty poses to their operations and ontological security. They do this by creating, proclaiming and maintaining what we call conviction narratives. Such narratives relate past and present to the future in an emotionally believable way and so manage day-to-day the cognitive and emotional elements necessarily and irreducibly created by decision-making under uncertainty. Constantly, but always tenuously, such actors have to create a sense of conviction as to their expertise, capacity to act and skill. They do it through developing stories told to themselves and others which combine (a) to exploit the opportunity element in uncertainty while (b), at the same time, to hold any doubts at bay. (p4)

If Tuckett is correct, and I think that he is, then the hoary old S-D cross diagram metaphor is what might be called the ‘master conviction narrative’. It is a key that turns any lock. Unfortunately, it does not open any door worth entering. Because what it really does it sell us the most simplistic of myths; precisely the ones that Keynes outlined in his 1937 paper. Everything is okay, everything will be alright, all will go according to plan. Or, as a Russian dissident poet once put it:

And the Perestroika is still going and going according to plan.
And the mud has turned into bare ice.

And everything is going according to plan.
And everything is going according to plan.

Philip Pilkington is a macroeconomist and investment professional. Writing about all things macro and investment. Views my own.You can follow him on Twitter at @philippilk.
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### 16 Responses to On ‘Coherence’ in Asset Markets: Everything is Going According to Plan

1. I’ve never really understood the whole ‘supply’ idea in asset markets. Assets just get transferred from one party to another. That other party can also supply them back to the market. There is no change in the whole supply, because the asset doesn’t get used up.

One of my favourite economists also gets caught up in this trap when discussing land as a durable good. Apparently one person owns all the land, and they price discriminate to sell it all off and maximise their revenue. But hang on. Now someone else owns all the land and can do the whole thing again!

Nice post.

• Well, some assets are limited in their supply. But some are not. A company, for example, can always issue more shares. This does not, however, necessarily mean that the price of these shares will go down. It could well go up.

The old S-D framework is simply useless for these questions.

2. LK says:

“In fact, as I discuss at length in my dissertation, prices in asset markets can very often call forth more demand. This is known as ‘speculation’ and is a key feature in financial markets. … As I discuss in my dissertation (pp13-17) this completely overturns the market equilibrium framework that attempts to use as its base model the familiar Supply-Demand (S-D) cross diagram.”

Not disagreeing with your analysis, but isn’t the neoclassical response to this always: “but with the “ceteris paribus” condition there is no violation of the law of demand?”

• ivansml says:

Of course it would be the usual response. The fact is that nobody models demand for assets as downward-sloping function of current price *only*, so that’s just a straw-man. At least since the times of Markowitz, the usual way to describe portfolio choice is in terms of expected returns, which of course depend on both current and future price. If you want to have demand function in terms of prices, you get something like

q = a + b*p + c*efp

with q – demand, p – current price, efp – expected future price, b 0.

• ivansml says:

(typo) … where b is negative, c is positive.

• And how do you get that expected future price? That is where the old stuff comes in through the backdoor.

• LK, yes, in a sense. I deal with this in the Levy paper where I discuss expectations in an S-D diagram.

3. LK says:

A quick off-topic question. In the GT, Keynes assumes that consumption is a “fairly stable function” mainly depending on income, and investment is the “driving force” or “prime mover”, right? So does this mean that Keynes thinks the investment function leads the business cycle?

I’ve been looking at FRED data for both US personal consumption and gross private domestic investment expenditures during recessions.

In a lot of them, it does seem that investment is leading the cycle in the sense that it is the first to fall before recessions, with consumption falling later.

But in a lot of the recoveries, to looks like consumption is rising first with investment rising later.

Is there any problem here? Is this what a Post Keynesian theory of business cycles would predict? After all, given the evidence that demand or expected demand for output is what drives a lot of investment decisions, is that what we could expect in recoveries?

• Investment always leads the downswing in the cycle and that is Keynes’ theory.

If there were no government sector we would likely expect that investment would have to lead the upswing too. But since we have a government sector with automatic stabilisers it is likely these that will lead the upswing. Consumption will follow suit. Then investment.

You might find investment leading both the downswing and the upswing in the 19th century when there were no automatic stabilisers in place. I’m not sure. But you might.

With regards to whether Keynes really thought the consumption function was stable, this was actually a rather big controversy that Friedman and others picked up on. I don’t think that he did. Here is a quote from your own comment yesterday:

Colin, for example, has recently persuaded himself that the propensity to consume in terms of money is constant at all phases of the credit cycle. He works out a figure for it and proposes to predict by using the result, regardless of the fact that his own investigations clearly show that it is not constant, in addition to the strong a priori reasons for regarding it as most unlikely that it can be so.

All of Keynes’ theorising is non-ergodic. All of it. To read it in the mechanistic way that the neo-Keynesians (and their critics) did is to do it an injustice.

• LK says:

Thank you very much, this is an excellent clarification.

So if I construct FRED graphs to research this, I should be selecting in an index the following:
(1) personal consumption expenditures
(2) Gross private domestic investment

But for government expenditures what is the right metric:
(1) federal government current expenditures or
(2) federal government total expenditures? or something else?

• For federal government expenditures I think you should be looking at the deficit. And then I suppose you’re best looking at private investment minus savings. But doing that on FRED will be tricky. To be honest the whole thing will get messy very fast.

• You might be able to dig into the national accounts to get some causal explanations going on. But it is a terrible trek.

4. Michael Robinson says:

“Whenever we, as human beings, find ourselves in a new social environment we begin to imitate the behaviors of those around us by assuming — somewhat unconsciously — that they are somehow more ‘proper’ than ones that we might either create ourselves or arrive at by using our critical faculties.”

I suppose we can infer the type of comments sections you hung out in, growing up.

• I’m not sure I follow. But as is well studied by psychologists people act entirely different online than they do in the real world.

5. KP says:

Nice commentary on the issues. A couple of basic questions that arise in my mind given your perspective that I am reading after 10 years of saving my company from the consequences of a 2008 FASB decision that I spent half of 2007 proposing alternatives.

1. Do you believe that cash is different from a bond?

2. Have you heard of FAS 157 — an accounting rule adopted in early 2008, before which a bunch of us said would cause an extended financial crisis? We proposed mandating disclosure on the structure and performance of complex credit pool structures rather than forcing mark to market on securities that were so complex that they had no liquid market and perhaps 3 or 4 traders wordwide that knew what they were. The correlation between adoption of FAS 157 and the crash (e.g. Lehman being forced to mark to an “imaginary market” the value of a security) is 100% (1.00).

-KP

• 1. They are similar instruments. But differently dated. That is all.

2. I’ve honestly never heard of it.