Lectures on Macroeconomics, No. 12
By Arnold Kling
This lecture speculates on some possible behavioral economics of booms and recessions. The idea is that herd behavior (buying at the top, selling at the bottom) is a form of procrastination.As I write this, on January 1st, 2009, the U.S. economy is in recession. There is evidence that consumers have cut back on their purchases of automobiles and other durable goods. They have cut back on their purchases of jewelry and other discretionary purchases. As a result, prices on these goods have been marked down.
One might think that it would be rational for consumers to shift some of their purchases to times like this. That is, it would be rational at the margin to buy more during a recession and to buy less during a boom. Yet we know that the opposite is what happens. It appears that:
–consumers cut back especially on durable goods purchases during a recession, when such goods are cheap
–the typical investor buys more stock near the peak than near the trough
–the typical firm hires more labor near the peak of a cycle, when labor is expensive, than near the trough of the cycle, when labor is cheap
Let us call this phenomenon herding, because people behave as a herd in a way that is contrary to their interests as individuals. A rational economic agent tries to buy low and sell high. The herd does it the other way around.
There are two reasons for economists to be interested in herding. One reason is that it poses a puzzle about behavior, since herding seems inconsistent with rational decision-making. Second, herding accentuates business cycles. If instead people behaved more countercyclically, the cycles would be dampened.
As a specific example, consider the real estate boom and bust. In 2005 and 2006, fewer people should have been trying to buy real estate and more people should have been trying to sell. Today, we seem to have the opposite, with many people foregoing opportunities to buy and many people anxious to sell, even though prices are low.
As of January 1st, 2009, is it a good time to buy real estate? To most people, the answer is, “No. Wait until prices decline further.” This reasoning may prove correct, in the sense that prices may very well decline further. However, I predict that the average person who reasons this way will end up buying real estate at prices that are considerably higher than they are today. Instead of buying at the bottom, they will miss the bottom and instead buy at some point well into the next upswing.
People confuse perfect market timing with feasible market timing. When prices are high, they think to themselves, “If I get out now, I may miss out on more profits. I’ll keep putting money in.” Implicitly, they are assuming that they will be able to time the market better by waiting. They are afraid that if they sell now, they will have failed to time the market perfectly. They do not take account of the fact that perfect market timing is not really feasible.
Similarly, when prices are low, they think to themselves, “If I get in now, prices may fall further. I’ll wait until they go lower.” Again, they are acting as if they can time the market perfectly.
In a famous lecture, Procrastination and Obedience, George Akerlof argued that a lot of irrational behavior could be explained by procrastination. You don’t quit smoking today, because you know you can quit smoking tomorrow. What you fail to account for is the fact that tomorrow you will once again think that postponing quitting smoking by another day is a good idea.
I think that herding behavior takes place for the same reason. People realize that prices are too high, but they put off selling until tomorrow. Or, people realize that prices are too low, but they put off buying until tomorrow.
The problem is that nobody can predict when the herd will turn, and when it does it turns so quickly that the procrastinators lose. For example, a retailer’s executives may worry that they have expanded too quickly, but they put off closing marginal stores until too late. Instead, the firm waits, the boom ends, and the firm finds itself selling excess inventory and stores in the midst of a recession, just as everyone else is trying to do the same thing.
At some point, the herd will once again buy U.S. stocks. When that happens, more people will be late than early.
What the foregoing assumes is a model in which asset prices fluctuate wildly relative to a “true mean.” It suggests that if you as an investor have a reasonable estimate of the true mean and sufficient patience, you can do well. Invest more in the stock market when prices are below their long-run mean and invest less when prices are above their long-run mean. Ex post, this model always works. That is, if you take some model of average stock prices, estimate it on historical data, and then use that model to determine buy and sell decisions, you can go back and show that you would have done very well. The challenge is coming up with the right model of the true mean ex ante. Your model of the true mean that fits past data really well (think of Shiller’s model that looks at the ratio of stock prices to the past ten years of earnings) could end up not being the right model in the future.
From a macroeconomic perspective, the key decisions that may be subject to herding are labor demand by firms and spending on durable goods by consumers. (Investment by firms could also be subject to herding.)
On the margin, it is smarter for a firm to hire during a recession, when good workers are readily available, than to hire during a boom, when the quality of available workers is lower. Similarly, during a boom, it would be smart to be reluctant to hire workers and eager to shed workers, because at the margin worker quality is likely to be low. However, what we get is herding behavior–firms tend to hire too much at the peak, and they all tend to lay workers off at the same time.
Similarly, consumers–even those who are safely employed–do not buy durable goods in a recession, when they are cheap. Instead, they procrastinate, and they make more of their purchases during a boom, when durables are expensive.
To the extent that procrastination and herding are important, there is a theoretical justification for countercyclical government policy. However, there is an even stronger justification for ordinary individuals to behave countercyclically.
Do not assume that just because government might behave countercyclically that it in fact will behave that way. It would not surprise me if it turns out that most of the spending in the soon-to-be-enacted stimulus package ends up taking place after the recession has bottomed out.
Previous lectures in this series:
11. Leijonhufvud and the corridor