Monday DeLong Smackdown: Alan Kirman on Self-Fulfilling Financial Crises


Alan Kirman is wise. Listen to him: Monday DeLong Smackdown: Alan Kirman: Self-Fulfilling Financial Crises: For the first time I feel moved to disagree with your assessment here Brad. The behavioral approach proposed by the authors suffers from the same disease as many that have been proposed earlier. It is the idea that one particular "bias" will help to understand and explain the causes and consequences of economic crises. This seems to me to be at odds with what really goes on. Already in 1900 Poincaré criticised Bachelier because he ignored the fact that people tend to behave like sheep. People do not simply receive their information independently and then act on it and in so doing reveal that information. Herd behaviour would suggest that people's beliefs change and are strongly influenced by those with whom they interact...

...Thus different biases will predominate periodically, think of chartists and fundamentalists.

What is more, in order for the market to be active at all there must be people on both sides so the idea that everybody shares a common bias cannot be completely true. What in fact would seem to be a reasonable explanation is that people have different biases and histories and form their expectations partly on the basis of these and partly on what they see to be the current trend. Lastly, one still has to explain why there was such a long lag between the downturn in house prices in the U.S and the collapse of the price of MBS. One possible explanation is that the information contained in the MBS was difficult to extract and people kept happily trading them believing that someone would buy them without checking, and finally this bubble burst when a few people broke away from the herd and started checking, and initiated a collapse.

None of this suggests that there was a single simple basic psychological bias which was the key. I will spare you Krugman's quote from Mencken on that point...