The Bitcoin bubble in context

Over the course of recent months I have done a lot of work looking at Bitcoin and have watched its recent sharp ascent with a mixture of bemusement and concern. I do not intend here to go into a detailed description of how the currency operates and refer the interested reader to the website Bitcoin.org  for an overview. Instead I want to focus on the sharp surge in the price of Bitcoin which has seen its value against the dollar increase by a factor of almost six since the start of 2017.

The puzzling question is why its value should have risen so sharply this year – after all, it has been around for seven years and we have already been through one boom and bust episode. In 2013 Bitcoin’s value against the dollar surged by a factor of 83, only for it to fall back by 85% over the next 14 months. What is rather more of a concern today is that the market value of all Bitcoin in circulation stands at $99 billion versus $9 billion in late-2013, and one of the questions which has been posed to me in recent days is whether an implosion of the Bitcoin bubble represents a threat to financial stability in a way which it did not in 2013.

As to the first of these questions, I believe that the rally in Bitcoin this year represents a different sort of bubble to that of four years ago. In 2013 there was genuine interest in Bitcoin as an alternative currency. Much of this optimism was misplaced, however, as the disadvantages of digital cryptocurrencies became evident. For example, the huge variability in the price of Bitcoin means that it does not represent a stable store of value. Together with security issues – the collapse of the Mt. Gox Bitcoin exchange in 2014 being a case in point – investors began to rethink their Bitcoin strategy.

But the currency is underpinned by the blockchain – a distributed ledger which potentially has a huge range of applications outside the realms of the currency world. One of the fastest growing digital currencies this year is Ether which is created as a by-product of the Ethereum network – a blockchain technology with wider applications than that used for Bitcoin. But as investors have jumped on the blockchain bandwagon so they have forced up the value of the digital currencies which these systems churn out.

In many ways, the digital currency revolution is reminiscent of the dot-com bubble of the late 1990s: There are many new and interesting applications of the blockchain technology but they have yet to be fully realised. Accordingly, investors are paying for their potential rather than their realised value, and because it is almost impossible to put a price on potential value, they are overpaying. It is thus hard to avoid the conclusion that current Bitcoin valuations represent a bubble which is set to burst at some point. As a historical guide, I have compared data for the 14 months prior to the Bitcoin peak versus the late-1990s Nasdaq rally and the Tulipmania bubble of 1636-37. As is clear from the chart, the surge in Bitcoin outstrips the surge in equity valuations in 1999-2000 but would appear not to match up to events in the Netherlands almost 400 years ago. But given the poor quality of the data for tulip prices in the 1630s and the fact that we may not be comparing like with like (different types of tulip bulb sold for different prices), we should be careful in making comparisons. But the fact that the Bitcoin boom far outstrips the Nasdaq rally of the late-1990s demonstrates that this is a boom to be taken seriously.

On its own, the bursting of the Bitcoin bubble should not in theory impact most investors. Indeed, the market cap of all digital currencies represents only around 0.3% of global GDP. Moreover, China is increasingly the dominant player in the Bitcoin market, accounting for the vast majority of coins created. It is thus likely that much of the Bitcoin wealth is held by domestic Chinese investors who will bear the brunt of any price collapse (for a fascinating overview of the impact of the digital currency in the Middle Kingdom, this article from Quartz is worth a read).

However, there are residual concerns that a collapse in Bitcoin could be a canary in the coalmine for a more widespread asset price correction, following years of easy money which has pumped up equities and real estate prices. My guess is that this is unlikely and that the spillover effects will be limited, precisely because of the narrow base upon which Bitcoin ownership rests. But as IMF Managing Director Christine Lagard once said, “I'm of those who believe that excesses in all matters are not a good idea … whether it's excess in the financial market, whether it's excess of inequality, it has to be watched, it has to be measured, and it has to be anticipated in terms of consequences.” We should thus not be complacent if the Bitcoin bubble bursts. It might have a deeper meaning than we can currently ascertain.

Get a grip

In recent days I have come across a couple of insightful articles which expose the lack of new thinking at the heart of the Conservative Party which goes a long way towards explaining why the Brexit vote happened and why the negotiations are not going as hoped. In an article at the weekend, Will Hutton argued very forcibly that the party’s inability to consign the Thatcher years to history is preventing it from moving forward (here). We have to allow for the fact that Hutton has a particular political bent, with his Wikipedia page describing him as being “widely known for his advocacy of centre-left policies.” That said, his article did hit many issues on the nail.

Hutton was particularly critical of former chancellor Nigel Lawson who “in any league table of national figures who have been consistently wrong on almost every major judgment … must rank close to number one … Yet, extraordinarily, he is the ringleader of a group of Thatcherite ultras who now crowd on to our airwaves, exploiting the mythology of Thatcherite greatness to insist Britain must make a complete break with the EU.” In 2016, Lawson wrote an article for the FT in which he claimed “Brexit gives us a chance to finish the Thatcher revolution.” But Hutton points out that many of the supply-side reforms of which Lawson is so proud are now beginning to unravel. The tide of opinion has turned against privatisation as society increasingly questions who has reaped the benefits. The financial deregulation over which Lawson presided was one of the contributory factors to the UK banking collapse in 2008, and also helped to widen regional imbalances as London benefited whilst other parts of the country lagged behind. Finally, the labour market reforms of the 1980s, which emasculated the trade unions, are increasingly being seen as one of the reasons why workers are being squeezed despite unemployment at 40-year lows.

It also raises a question of why a politician who left front-line politics almost 30 years ago should still be invited to opine on economic matters. Is the party really so devoid of new thinking? Indeed, I still find it odd that a man who was aged 84 at the time of the EU referendum should have had such a prominent role in the Leave campaign, when he is unlikely to be around to see the long-term effects. Moreover, I do not recall that in the 1980s any of Nigel Lawson’s predecessors from 30 years previously enjoyed such a prominent media profile as he does today (still less calling for the sacking of the incumbent, as Lawson recently demanded of Philip Hammond). Lawson was a bold, self-confident reformer in his day but his time has passed. Unfortunately, many members of his party appear not to have realised that time has moved on and that the solutions of the 1980s may not be appropriate today.

This is indeed a point I have made on this blog in recent months (here, for example). But the blogger Pete North offered an impassioned critique of the problems facing the Conservatives (here – it’s a fine post which deserves a read). More to the point, it explains very eloquently how the current iteration of Conservative economic policy differs from what went before, and gets to the heart of an issue that I have spent much time trying to explain to foreign friends and family. North notes that whilst aspiration was at the centre of Conservative policy during the Thatcher era “there was also something about Mrs Thatcher's values that made her version of conservatism the definitive one. There was something more than just the slash and burn free market instinct. There was still an underlying obligation to observe that, as citizens, we are custodians of a particularly British order where enterprise sits comfortably alongside the institutions of state.” He goes on to state (admittedly in a less than temperate fashion) that “I don't see that in the modern Conservative Party. For the most part I see the dregs of Thatcherism and the second generation Toryboys wedded to extreme free market dogma - which is no respecter of anything … It is this corrosive trend that is ultimately shredding the social contract.”

You can argue about the nature of the language he uses, but his point about the shredding of the social contract is a valid one. The recent experience of having to wait almost four weeks for an appointment with my local GP is an indication that there is something badly wrong with local health provision. Indeed, North argues, as I have done, that if this were consistent with the operation of a free market policy “we should at least be seeing some sort of corresponding tax cuts” as compensation for the reduction in service.

But the wider point is this: A large swathe of the Conservative party has been captured by the ultras who see Brexit as an end in itself. This in turn has divided the party which is scared that the diametrically opposing economic solutions offered by the Labour Party are increasingly finding electoral favour. As a result, the whole government appears to have turned in on itself in a bout of vicious in-fighting and has less time (or perhaps just the stomach) to tackle the mounting economic problems caused by failed welfare reforms such as the botched rollout of Universal Credit (here and here).

We may not yet be quite at the McCarthyism stage here in the UK but as Robert Peston tweeted today, the current state of public discourse “is redolent of a country suffering a Brexit-induced nervous breakdown.” Given the magnitude of the economic challenges ahead (Brexit, flatlining productivity, overly-indebted households, the lack of adequate pension savings for many people), the UK really needs a government that can get a grip – and fast.

Regulate but don't suffocate

Some time ago I was sitting in a meeting in which the discussion turned to administrative and procedural matters, none of which affected me. I realised that if I left the room I would not be missed and I could use the time to do something more productive. This is, of course, an experience familiar to many millions of people. Once we add up the amount of person hours wasted in processing apparently trifling administrative matters, we begin to understand the magnitude of the economic costs imposed by red tape.

Like many people, I tend to think of this problem as one which others should deal with. After all, I am not paid to be a bureaucrat – surely there must be someone else to take care of this. But so long as we are operating on the company's time, our employer has a right to ask us to deal with processes which make the company's life easier. In any case a lot of regulation is necessary. We cannot hope to operate in a complex economic system without a set of detailed rules governing the underlying processes. Indeed, without a lot of these rules, we would experience market failures far more frequently than we do. But that does not mean we should accept all regulation as good, or even necessary.

An example of "good" legislation is that designed to tackle the problem of environmental damage. It has a transparent aim of reducing the wider social costs associated with pollution, which yields obvious benefits to society. Of course producers have to adapt their production methods which can act as a spur to innovation but it also raises costs which are ultimately passed on to the consumer. Society thus has to carefully weigh the costs and benefits of regulation. One of the problems we are now beginning to understand is that as circumstances change, much of the regulation that sits on the statute book becomes outdated.

To this end, President Obama signed executive orders requiring federal agencies to review existing legislation to “determine whether any such regulations should be modified, streamlined, expanded, or repealed” with the purpose of making the “regulatory program more effective or less burdensome in achieving the regulatory objectives.” Consider the situation we are in today in which governments are increasingly concerned about the nitrous oxide emissions caused by diesel engines – the very same technology which was once seen as the solution to the problem of CO₂ emissions. That solution is increasingly being seen as a problem and regulation is being amended accordingly, with the likes of the UK and France planning to ban the sale of new cars powered by the internal combustion engine within the next 25 years.

Financial regulation is another case in point. Much of the legislation implemented in the past decade is designed to reduce the risks to society from the socialisation of a private sector problem (i.e. governments do not have to bail out banks) by preventing the emergence of banks which are too big to fail. Globally, banks now have to hold bigger capital buffers and are subject to much greater regulatory oversight. We will only see how effective the legislation has been over the longer term if it reduces the frequency of banking crises. What we do know is that the short-term adjustment costs are high, as banks increase the size of their compliance budget whilst getting out of, or being forced to turn down, business which was once extremely lucrative. In effect, a tax is being imposed on banking activity whose incidence falls mainly on the banks themselves: The wider social costs of this legislation are minimal and it satisfies society's demand for justice in the wake of the crash of 2008 by clamping down on banks’ activity.

But is it all good or necessary? The US Dodd-Frank Act, for example, comprises almost 14,000 pages and 15 million words. Nobody can possibly know the full complexities of the Dodd-Frank Act – it is simply too big. Ironically the US Constitution, upon which a nation was built, contains just 4,543 words. Consider also the EU’s MiFID II legislation due to come into effect next year which is designed to offer greater protection for investors and inject more transparency across the financial services industry. EU financial instruments which fall within its scope will have to comply with the new regulations, irrespective of where they are traded. One of the other aspects of the regulation is that it forces sell-side institutions to charge money managers for their research, rather than bundling it in with transaction fees, in order that money managers’ clients have greater transparency over the fees they are charged (a topic I will deal with another time).

Suffice to say this is a big deal for the European financial services industry and has cost a lot of time and effort as banks and asset managers gear up for it. But according to a recent Bloomberg report (here), a lot of countries are struggling to be ready to implement the law in January. It will potentially change the nature of the industry – never mind Brexit – and before anyone suggests that the UK will benefit by leaving the EU, may I remind you that the UK was instrumental in driving through large parts of the MiFID II legislation.

I confess that I have a vested interest in this area so my view may not be unbiased. But with Brexit likely to change the shape of the European industry anyway, it reinforces my view that large elements of the non-EU financial services industry may simply expand their businesses in less heavily regulated areas. Frankfurt may grab a piece of the London pie but in the longer term it may well turn out only to be crumbs compared with what eventually relocates to Singapore and Shanghai

They still don't get it

It has been pretty evident to anyone with even a passing interest in the subject that the Brexit negotiations are not going as planned. The closeness of the referendum result in June 2016 reflected a country that was split down the middle on the issue of EU membership, and in the subsequent 16 months the Conservative Party has all but torn itself apart. Theresa May’s attempts to placate the hard Brexit faction within her own party has resulted in a series of clumsy soundbites (“Brexit means Brexit” and “no deal is better than a bad deal”) which fail to cover up the fact that the government does not have a plan – or at least not one that is acceptable to the EU27 and the two factions within the Conservative Party.

This has been compounded by an election which robbed the PM of whatever authority she had, and as a result the EU27 is loath to accommodate any demands the UK might make for fear that she will not be able to deliver at home. With more than a quarter of the negotiation period mandated under the Article 50 process having ebbed away, the UK is no further forward than in March. If a scriptwriter had come up a parody of all that is wrong with modern politics, they would have struggled to come up with a story as bizarre as the one which is unfolding before us.

There are those who continue to believe that the EU needs the UK more than vice versa. Indeed, a group of Brexit supporters has written an open letter to Theresa May demanding that she commit the UK to trading under WTO rules in the event that no deal with the EU27 is forthcoming because “no deal on trade is better than a deal which locks the UK into the European regulatory system and takes opportunities off the table.” Moreover, “it has become increasingly clear that the European Commission is deliberately deferring discussions on the UK’s future trading relationship with the EU27 post-Brexit. The EU is taking this approach because they do not believe that the UK would be prepared to go to WTO rules for our trading relationship with them.”

Owen Paterson MP argued in a radio interview this morning (here starting at 1:09:10) that the EU27 has “simply not taken up [Theresa May’s] generosity to discuss a future trading relationship” following her Florence speech and it is time to take an alternative approach. In Paterson’s view, this would give business “certainty” as to the post-Article 50 trading arrangements. He also repeated the canard that it is “massively” in the EU27 interests to do a deal on trade because “they run a huge surplus” with the UK. Paterson argued that a fallback to WTO rules would allow the UK (and I emphasise that I am quoting verbatim from the interview) to “immediately be able to grab the advantages of leaving the single market, leaving the customs union and doing trade deals around the world [and] sorting out our own regulation.” Yes, you did read correctly that leaving the single market is somehow an advantage.

I am not sure which alternative reality Paterson (and other signatories to the letter, including former Chancellor Nigel Lawson) are inhabiting but it is not one that most economists recognise. When 47% of UK exports go to the EU whilst 16% of EU27 exports go to the UK, it should be pretty obvious where the balance of power lies – and the EU27 knows it. As for giving clarity about future trading relationships by committing to WTO rules, it would effectively give business the green light to think about alternatives to investing in the UK. Moreover, on the assumption that the UK imposes most-favoured-nation tariffs on imports from the EU, the Resolution Foundation reckons that the basket of goods which makes up 40% of consumption would rise in price by 2.7% which will hit the poorest households most hard. And of course the WTO approach has little to say about how to deal with services where non-tariff barriers are more important. Such an approach would clearly signal to banks that the government is not serious about trying to arrange a transition deal, which would hasten efforts to move business to other parts of the EU – a process which is already underway.

Of course, none of this is new. These arguments were made in the run-up to the referendum by Brexiteers who believe in the primacy of free trade without acknowledging that the EU has other objectives and no incentive to play ball. It is a sad indictment of the whole debate that the Leavers continue to make the same hollow arguments. However, the evidence is mounting that there is an economic cost. Why, for example, don’t our incomes stretch as far as they once did? It’s mainly because the currency markets have taken a negative view of the UK’s post-Brexit economic prospects and have forced down the value of the pound, resulting in higher inflation and a real income squeeze. It may not have been the economic disaster that was feared in summer 2016, but whilst we may not have dropped the frog in a pan of boiling water it is in the pot and the heat is being turned up.

Those people who want Brexit at any price are blind to the consequences of their actions. But equally, they fear that the UK will not leave the EU as planned because they underestimated the complexities of doing so and will be trapped in the exit lounge for longer than they desire. But even if a transitional period is eventually granted which will give the UK an extra two years to finalise a deal, it will not be long enough. As Joachim Lang, managing director of the BDI, Germany’s chief business group told the FT, “it’s unrealistic to expect that we could renegotiate rules within two years that evolved over the 40 years of Britain’s EU membership.”

Theresa May will be told at today’s summit in Brussels that “insufficient progress” has been made during the first phase of Brexit negotiations and that the UK will not be rewarded with the start of any discussions on trade. Brexit supporters are fearful because if no such deal is forthcoming, their lies during the campaign will be found out. Many of us would be only too happy to see them drive off the much-feared cliff edge – we just don’t want to go down with them.

Conditional credibility

With interest rates trapped at the lower bound central banks have in recent years adopted a policy of forward guidance to help markets interpret what they were likely to do in the face of the incoming data flow. Its success has been mixed. Recall the bond market “taper tantrum” in 2013 when the Federal Reserve announced that it was about to slow down the pace of asset purchases - though in fairness, this was more the result of a market which panicked rather than the fault of the central bank. But so far this year the Fed has more or less adhered to the message contained in the dot plot (see p3 here) despite the market’s initial scepticism.

Arguably, the Bank of England’s efforts at forward guidance have not been quite as successful, and in a week of important UK data releases which may determine whether the BoE will soon raise rates, it is important to understand the nature of the forward guidance message. In August 2013 the BoE pledged “not to raise Bank Rate from its current level of 0.5% at least until … the unemployment rate has fallen to a threshold of 7%.” The BoE was clear that this was a conditional target, subject to (i) CPI inflation 18 to 24 months ahead no more than 0.5 percentage points above the 2% target; (ii) medium-term inflation expectations no longer remaining sufficiently well anchored and (iii) the stance of monetary policy posing a significant threat to financial stability. Even though unemployment fell more rapidly than the BoE – and indeed, most other forecasters – anticipated, none of the knockouts were ever triggered. Thus although policy was conditional, it was never fully clear why the BoE did not raise rates once the unemployment rate fell below 7%. Good arguments could be made for leaving rates on hold but it rather defeated the purpose of the forward guidance framework.

By February 2014 the BoE abandoned the simple mechanistic link between monetary policy and unemployment in favour of a less easily defined policy based on the nebulous concept of spare capacity. Since the measure of spare capacity was determined by the BoE, this meant that outside observers became increasingly reliant on the information feed from the MPC to determine the future policy stance. The clarity of rule-based forward guidance policy was lost. Later in 2014, at his Mansion House speech, Governor Carney suggested that the first rise in interest rates “could happen sooner than markets currently expect.” It didn’t. And to this day it is difficult to explain why the rate hike did not happen other than the fact that the BoE simply did not want to act before the Fed.

Last month “a majority of MPC members judged that, if the economy continued to follow a path consistent with the prospect of a continued erosion of slack and a gradual rise in underlying inflationary pressure then, with the further lessening in the trade-off that this would imply, some withdrawal of monetary stimulus was likely to be appropriate over the coming months.” We know from this morning’s parliamentary testimony that two Committee members (Dave Ramsden and Silvana Tenreyro) are not part of that majority. We also know that four other members appear to be edging towards an earlier rate increase whilst the view of the other three is unknown.

Arguably, given the clarity of the message given in recent weeks, the MPC needs to deliver sooner rather than later after having left markets hanging in the past. Of course, “coming months” does not necessarily refer to November (the next month in which an Inflation Report is released) – it could just as easily be February (the following Inflation Report month). But the fact that little has been done to dissuade the market of this view suggests that November would be a good time to act. Leaving the door open until February runs the risk that events could transpire which change the Bank’s priorities, and despite the conditional nature of the policy decision, markets will see this as another occasion on which it has cried wolf.

Policy credibility remains important to policymakers. An absence of such credibility defeats the purpose of forward guidance. Whilst the BoE can justifiably argue that forward guidance is conditional on economic circumstances, it cannot continue to hide behind the Augustinian clause forever (allow us to raise interest rates, but not just yet). Whether or not it is the right time to consider a rate increase is almost irrelevant – my own view is that the recent surge which has taken CPI inflation to 3% is not a good justification for a policy tightening, driven as it is by a one-off sterling depreciation. However, what matters is the consistency of the message. The markets are hearing a very clear message: It would require a lot of explanation on the BoE’s part if it were to pass up on a rate hiking opportunity.

Holding the centre

In his poem The Second Coming, WB Yeats wrote “Things fall apart; the centre cannot hold; Mere anarchy is loosed upon the world.” It was written in 1919 as an allegorical description of the state of European politics in the wake of World War I. It is an apt description of where we are today. Over recent years I have consistently made the point that the failure of western governments to be honest with their electorate about the scale of the economic challenges they face will ultimately be to their detriment. We have seen this writ large in the form of the Brexit referendum and the election of Donald Trump but it has also been seen in the strong performance of populist parties in Dutch, French and German elections this year. It is thus interesting to look at the vote shares of populist parties over recent years to assess the scale of the problem.

The Swedish think tank Timbro notes that the share of the European populist vote, whether to the left or right of the political spectrum, rose from around 8% in 2004 to 20% today (chart). As the authors of the study point out “in the 33 countries included in this index, there are a total of 7843 seats in national parliaments …  representatives of illiberal and/or anti-democratic parties today hold 17.5% of all seats within European national parliaments.” It is popularly believed that populist parties advocate right-wing solutions – low taxes, smaller government and opposition to immigration – but as Timbro points out, there has been a resurgence of so-called radical left parties, particularly in those southern European countries so badly affected by the euro zone crisis.

The flip side of the rise of radicalism, of course, is that centrist ideas are squeezed out. To the extent that this has proven to be the bedrock upon which the economic successes of the past 70 years have been based, this has to be a cause for concern. Moreover, political extremists do not have to hold office in order to wield influence. In Germany, for example, votes gained by the AfD ate into the SPD’s vote share and prompted it to stand aside from the coalition government, raising the likelihood that the FDP will form part of the government. To the extent that the FDP does not necessarily share Angela Merkel’s future vision of the EU this could have a major bearing on whether Emmanuel Macron’s ideas on European reform will find acceptance in Germany.

We see the same forces at work in the UK. UKIP has had very little success in securing parliamentary representation yet it was one of the prime grass roots motivators behind the Brexit referendum. The wider consequences of the Brexit vote have yet to be realised but as Simon Nixon pointed out in the Wall Street Journal last week, whilst the Brits may have voted to leave the EU, they did not vote for a revolution. But in effect, that is precisely what they have got. In his words “what makes Brexit so destabilizing is that it shares two features common to revolutions. First, it has created a parallel legitimacy, pitching the supposed ‘will of the people’ expressed in the referendum against the traditional sovereignty of Parliament … Second, it has created a power vacuum … [Brexiters] shook the economic order but without a coherent plan as to what to put in its place.”

This resultant power vacuum at the heart of the UK government is a major problem, for it is diverting energy away from the most pressing issue of the day – how to ensure that Brexit does not tip the economy over the cliff. Instead, we hear a constant stream of press stories suggesting that ministers are fighting amongst themselves. Such is the apparent disarray that the prime minister, who would like to see some form of transitional agreement with the EU, cannot get her colleagues to fall in line. David Davis, the UK’s chief negotiator, has thus been allowed to hold to his hard line in the negotiating chamber with the result that at next week’s summit, the EU27 will almost certainly decide that “insufficient progress” has been made during phase 1 of negotiations to allow discussions on a trade deal to begin.

Most people in business are increasingly worried about the implications of where the Brexit negotiations are headed as pessimism mounts. There is also some evidence to suggest that voter preferences have changed, with the share of those believing that voting to leave the EU was the wrong choice now sharply higher than in the spring (chart). This may have something to do with the fact that Brexit is not the easy option which voters were promised. It is also a warning to those who are seduced by the simple policy prescriptions of populists. If something were that easy, it would have been done already. Now, Mr Trump, about that wall …

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