Thursday, 9 July 2009

The animal spirit of the market

There are some articles an educated man cannot just miss out on, like the one which I found in yesterday’s “Highbrow’s guide” (Niezbędnik inteligenta) insert to Polish weekly “Polityka”. On the first few pages of the insert Jacek Żakowski (incidentally probably the only journalist in Polityka’s makeup who has an excellent command of English – I infer it as he’s the only person who carries out interviews with native English speakers) conducts an interview with Robert Shiller – American psycho-economist. The whole article can be found here (in Polish) – recommendable for everyone who knows Polish.
This time I think there’s no point in summarising the whole content, instead of this, I’ll translate some of the most crucial parts of professor Shiller’s theses. Just after reading it, today in the morning, I e-mailed the weekly’s editors, asking them to provide me with the original version of the interview. My request has met the response of Jacek Żakowski in the flesh, who wrote back he had taken it down it Polish right away. That’s a pity, you’ll have to fall back on the product of my translations skills ;)

I know I have some problems with translating complex sentences, mostly with the word order, hope you’ll forgive me…

The illusion of money
J.Z.: The mortgage bubble which brought about the current crisis has not have as spectacular legend [as the collapse and insolvency of Mexican economy in the early 80’s]. No oil deposits have been discovered, no cartel has caught the mortgage market in its clutches.
R.S.: On the contrary, the pattern was very similar. The mirage of invariably low interest rates, built by FED, governed by Alan Greenspan, thanks to which even the poor families were able to serve huge debts, was the equivalent of giant deposits’ mirage. (…) The crisis which broke out in 2000 posed a threat to the swelling illusion that everyone could get richer by investing on the stock exchange. When the stock exchange failed to turn the quick profits, social hopes were pined on real estate market.
The very legend of mortgage boom consisted, roughly speaking, in the assumption that the house prices would always rise, what was a palpable absurdity. (…) As the bubble was swelling, many economists warned that neither can the prices rise forever, nor the interest rates will be kept down forever. Nobody heard those warnings. After crisis of 2000 all the reflexes of “animal spirit” of America centred on the housing market. The legend of cheap house for everyone fitted the social needs too well too be undermined by any rational argument. No one even bated an eyelid, when in 2008 the Association of Real Estate Owners, intending to fuel the bubble, placed an ad in the media, the ad stated that the real estates are the best long-term investments, cause their value doubles each ten years. People believed it. There was no way of persuading them that there was no profit in it, that it was just another example of “animal spirit”, which is “the illusion of money”.
J.Z.: That is…?
R.S.: That is the perception of prices, costs and investment which omits changing wages and inflation. Everybody remembers they bought the house for let’s say one hundred thousand dollars and is happy cause today its value rose to two hundred thousand, so they took the profit of one hundred per cent. But no one paid attention to the fact the wages also rose by one hundred per cent. (…)
The phenomenon of “the illusion of money” was very well visible during the deflation which accompanied the great depression in the United States. The American economy would have endured it much better if the employees had freed themselves from that illusion in the deflation phase. When the prices were dropping, wages remained nominally unchanged, consequently they rose substantially, what drive many companies to the wall. (…) As far as I know, none of the employers made any attempt to explain it to the trade unions that as the wages are increased along with the inflation, they should be cut along with the deflation. (…)

The herd instinct drives us to work within a group, but our mistrust makes us join it gradually, with reserve. That’s the reason why many bubbles fade. But when the legend is credible enough to reach an enormous size, the acceleration mechanism switches on.
J.Z.: Is this a symptom of the “animal spirit”?
R.S.: Huge (…) As long as an ordinary man finds out speculators from the Wall Street made millions on the speculations on houses, he looks at it with envy or with condemnation, however he does not join it. But when it transpires that his neighbours, colleagues, even brother-in-law made money on house price surge, it gets on the nerves of even those people with the most conservative approach to money. One day, during the supper spouse starts a conversation: Honey, our neighbours moved to a better borough, my workmate bought a new yacht, the property of my brother has tripled. Why don’t you take this opportunity? Why shouldn’t we transfer more of our savings into the stock exchange, why shouldn’t we buy a house to sell it at much higher price in a few years?
Thus the bubble is blown up by new people joining with new money. One day virtually everyone is engaged in it – that is the moment it bursts.
J.Z.: So financial conservatism does not pay off, the later someone joins, the less they can win, the more they can lose.
R.S.: For sure it does not pay off to be an inconsistent conservative. The more because the later someone joins the bull run, the more probable it is they would fall victim to the deception, for a few reasons. Firstly, the longer and the more sustainable the bubble is, the more excessive is its credibility. Secondly, the bigger the bubble is and the higher profits it turns, the stronger is the temptation to raise them even more. Thirdly, the profits cannot rise endlessly only faster. (…) An excellent example was the bubble – then the well-educated and intelligent experts devised a theory of a new economy based on the assumption of ceaseless growth in share prices, totally separated from work efficiency and profits of enterprises. People believed it, cause they had wanted to believe it. What can be more pleasant than the perception that if you buy some stocks you can sit on your hands and get richer thanks to the spurts on the stock exchange.

J.Z.: Is there any fix for it [helplessness of market participants against growing unmanageable risk]?
R.S.: Primarily the economic awareness should be disseminated just as it was in case of health awareness. (…) Today an ordinary man, who cannot afford to pay for the services of expensive advisory offices, takes the advice of advisors who are paid by banks, mutual funds or insurance companies. Those advisors mostly mind the business of the ones who pay them. Consequently millions of customers and small investors follow the advice of advisors, who are in fact salespeople and take irrational decisions – take out loans they will not afford to pay off, buy houses the cannot afford or invest all their savings in securities which soon will be worth as much as the paper they’re printed on. There are two sources of crises that can be distinguished – firstly people lack competencies which are essential to perform in a market economy, secondly the ones who cannot afford to make mistakes cannot also afford to pay for advice provided by impartial and competent advisors.
J.Z.: What should those impartial advisors tell them?
R.S.: Most of all they should inhibit the behaviours which arise from their animal spirits, that could be done only through giving them objective knowledge. They also ought to offer investments in special products, overseen by the government, destined for the people who cannot take the risk. The poorer people are, the more they pay for the mistakes made when they were driven by irrational reasoning.

The commendation of non-conformism
R.S.: I have a wife. She’s a psychologist. That’s why I found it harder to believe people take rational decisions. And I have never yielded to the quite common belief that complex processes which take place in the markets can be described with simple equations. (…) Even the teacher who expelled me from Sunday school accused me of my propensity for challenging everything my friends had taken for granted, stating my behaviour had been unacceptable. Roughly the same I have heard from Tim Geithner, who as a governor of FED ousted me from the board of advisors. All they wanted a simple, mathematical answer to the question of the sources of rising mortgage bubble and I have been returning to the unpredictable animal spirit of the market. There is always a group of people who do not put stock in the commonly recognised truth, instead of this they start wondering where is the catch…

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