It is not irrational to be concerned

If we thought that Brexit was a major economic challenge it pales into insignificance compared to the threat posed by COVID-19. As the days unfold, the spread of the disease is following the normal pattern associated with infections, which in the early stages follows an exponential curve until it begins to level off. It is quite obvious that things are going to get worse before they get better which is going to result in a lot of human misery, never mind the economic consequences.

If we can take a step back, however, it provides a fascinating test bed for many of the theories put forward by behavioural economics, which applies psychological insights to the economic actions that we take, and which is in stark contrast to the assumption of rationality which underpins much of conventional thinking. I was reminded of this by the signs which began to appear reminding us all to wash our hands in a bid to spread the disease. This is a classic application of nudge theory which attempts to provide positive reinforcements to encourage a particular course of action. Supermarkets have known for years that prominently displaying a particular type of item encourages sales and it has also been used by various health campaigns (recall the famous 1980s campaign designed to combat AIDS “Don’t die of ignorance”). Nudge theory works up to a point, in as much as it does have an impact on short-term behaviour although its usefulness as a determinant of long-term behaviour is open to debate. However, as this study noted just a month ago, the case for hand washing as a first step to control the spread of epidemics appears indisputable.

Perhaps one of the most contentious issues in the early stages of the outbreak is the extent to which people are stocking up on provisions in case they will be needed. This led to the bizarre situation last weekend whereby shops were completely sold out of toilet rolls and other forms of sanitary wipes, whilst hand sanitizers are virtually impossible to get hold of. The government’s advice is that people should not panic buy. But can we really describe the current situation as panic buying?

Panic can best be described as taking irrational actions in the face of extreme stress. However, as an economist, the notion of taking preventive action strikes me as a perfectly rational forward-looking response. Whilst I am less sure about the need for such huge quantities of toilet rolls, there is a case for having some emergency food provisions. Indeed, the Swiss government has long recommended that each household should have a stock of drinks and food for a period of seven days in the event of a disaster (not that they all do). If you believe that a major problem is about to be visited upon you, which in the worst case will prevent you from leaving your home, a sensible forward-looking economic actor will make some sort of contingency rather than trust to luck. You certainly do not have to be some hardline survivalist (or prepper, if you prefer) believing in the imminent collapse of society to anticipate that the information given by governments today will change in future in response to changed circumstances. However, there is also an element of herd instinct driving some of the recent actions by individuals. We may not in the end need the huge quantities of toilet roll that have been purchased, but in the event we do, you certainly do not want to be the individual who has ignored the actions of the rest of the herd.

Human history is littered with examples of catastrophe, from plagues to harvest failures which once upon a time were a regular occurrence.  These required societies to set aside a store of food to tide them through the hard times, but modern societies which rely heavily on just-in-time inventory management are unable to cope with shocks of this magnitude. Many western societies are unused to making such provisions and it feels very alien to our way of living to have to think in such terms. It ought to act as a wakeup call on so many levels. Our supply chains are long and easily broken and should force us to think more carefully about the limits to globalisation. As I noted in this post in 2016, my views on weighing the costs and benefits of globalisation have changed over the years. The current episode has also made people realise the benefits of international cooperation. Admittedly the rapid spread of COVID-19 has been made possible by the extent to which borders have opened up but equally the solution to what is now a global problem will also have to be global.

As for recent market moves, investors’ actions of late have not been entirely irrational. Financial investors always have to deal with decision making under uncertainty, but today the uncertainty levels have risen to unprecedented levels. I have long extolled the virtues of the distinction between risk and uncertainty which was made by the economist Frank Knight in his magnum opus Risk, Uncertainty and Profit  a century ago. In his words, “risk means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character.” A known risk “is easily converted into an effective certainty” while “true uncertainty … is not susceptible to measurement.” Accordingly it makes perfect sense for markets to sell off in what is the biggest shock to markets since 2008. The unknowable economic consequences are such that we cannot predict what will happen to corporate earnings other than to say there is no near-term upside, and it is impossible to call the bottom of the current slide. However, most investors believe things will get worse before they get better.

And they have certainly been bad of late. On the basis of UK data going back to 1709, the performance of the FTSE All Shares so far this month has been worse than at any time since the collapse of 1720 following the bursting of the South Sea Bubble when prices declined by 38% in September and a further 25% in October of that year. The 1720 episode was the response to a good old-fashioned bubble. The collapse of 1987 (which was bad enough) was attributable to global monetary tensions and exacerbated by automatic trading systems which contained no circuit breakers. Today, it is attributable to genuine concerns about life and death and in the grand scheme of things, market moves can often seem somewhat trivial.

A Nobel cause

Economics is a social science and although many economists do not like to admit it, it is bracketed alongside disciplines such as anthropology and psychology. Indeed, in the second half of the eighteenth century, when Adam Smith was setting out the principles of the invisible hand so beloved in market analysis, psychology did not exist as a separate discipline. The work of many of the early economists such as Smith and Jeremy Bentham, was closely intertwined with issues which are now the preserve of academic psychologists. Economics thus has deep roots in the field of psychology.

Despite the best efforts of the profession to move away from the imprecision of psychological concepts, many of the paradigms explaining economic behaviour failed to stand up to rigorous testing. Whilst these were initially explained away as anomalies which did not negate the underlying assumptions, developments in cognitive psychology from the 1960s began to be seen in some quarters as better explanations of certain forms of economic behaviour. Over the last 20-30 years, a number of these insights, derived from experimental psychology, have been applied to economic and financial decision making as better explanations of behaviour than the standard model. The new field of behavioural economics, for which Richard Thaler this week won the 2017 Nobel Prize for economics, examines what happens when we relax the assumptions of rationality and perfect information which underpin much of modern macroeconomics.

Amongst the range of judgement and decision biases which clearly violate the principle of rationality, behavioural economists have focused on factors such as overconfidence, wishful thinking, conservatism, belief perseverance, availability biases and anchoring (estimates based on an initial, often random, value). Using a combination of empirical evidence and thought experiments, academic researchers have demonstrated that some of these characteristics are at work in driving the expectations formation process. For example, evidence for the overconfidence hypothesis suggests that the confidence intervals assigned to outcomes tend to be too narrow. In a famous 1974 paper, Kahneman and Tversky[1] find evidence that whilst individuals often start off with an initial value in making estimates of future values, they are often reluctant to make big adjustments to this estimate when revising their assessment (the anchoring problem). This might go some way towards explaining why economists are reluctant to radically change their forecasts on a regular basis.

We could go on, but the point is made that there is enough empirical evidence to challenge the rational expectations assumption and thereby the idea that markets are efficient. This is a problem for many economists to deal with, for they have often spent years learning to deal with the sophisticated mathematics underpinning their stochastic models, which use rational expectations as a convenient simplifying assumption. It is an even bigger problem for the finance industry which spent many decades convincing itself that prices adequately reflect all available information.

One of the great ironies of a trading environment is that if rationality is common knowledge, there ought to be relatively little trading since a rational investor should be reluctant to buy if another investor is willing to sell. But the converse is true since the trading volume on world exchanges continues to rise. Indeed, much of the empirical evidence suggests that traders would make higher returns if they trade less frequently. Moreover, the same body of research indicates that investors are unwilling to sell assets which trade at a loss relative to the price at which they were purchased – behaviour which may well reflect an irrational belief in mean-reversion.

There are also clear patterns in purchasing decisions where there is evidence to suggest that investors buy stocks which have previously been big winners (in the hope that this performance will be repeated) or big losers (in the expectation of mean reverting performance). Neither of these is consistent with rational behaviour, but one reason why investors may follow such strategies is that they do not have time to systematically analyse the whole range of stocks. The choice of which to sell is limited to the range of stocks currently owned, but the range of stocks from which investors can choose to buy is enormous, and they are attracted to the outliers in what is known as the attention effect.

Clearly, markets display characteristics at odds with efficiency and expectations are not always formed rationally. The world thus owes a debt to Thaler and his colleagues for pointing out some of the absurdities in conventional economic thinking. Behavioural economic does not have all the answers. In the minds of many people it is just a collection of theories which can only ever be tested on small samples and thus its wider applicability is limited. But to the extent that it makes us think about some of the reasons why economics has not always come up with the right answers, Thaler’s award is well deserved.

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[1] Kahneman, D. and Tversky, A. (1974) 'Judgement Under Uncertainty: Heuristics and Biases,' Science, 185, 1124-1131