This Mimic is Different
By Arnold Kling
Eric Falkenstein offers a theory of financial manias.
Sometimes, the investors (dupes) think a certain set of key characteristics are sufficient statistics of a quality investment because historically they were. Mimic investors seize upon these key characteristics that will allow them to garner funds from the duped investors. The mimic entrepreneurs then have a classic option value, which however low in expected value to the investor, has positive value to the entrepreneur. The mimicry itself may involve conscious fraud, or it may be more benign…The mimicking entrepreneurs are really symptomatic of investing based on insufficient information that is thought sufficient.
It is my view that it is characteristic of financial intermediation to be non-transparent. If you knew everything that the intermediary knew, you would not need the intermediary. Instead, you rely on signals. The signals might include accounting statements, or stately buildings, or evocative words (“Internet play in the pets space”) or historical claims (“house prices have never fallen nationwide”).
Falkenstein’s point is that the signaling is endogenous. When a particular signal works well for good intermediaries (ones that make a legitimate profit by choosing investments wisely), there is an incentive for bad intermediaries (who choose investments less wisely) to mimic the signals provided by good intermediaries.
Falkenstein claims that there is no equilibrium in which good intermediaries are well received and bad intermediaries are not. When times are good, the incentives are great for bad intermediaries to develop the ability to mimic good intermediaries. Only when there is a crash do the bad intermediaries get exposed and wiped out. Right after a crash, people distrust all sorts of signals, including those that had been used by good intermediaries. So after a crash, even good intermediaries have difficulty establishing credibility. By the time they come up with credible signals, bad intermediaries are ready to mimic those signals.