Each day many investors anxiously watch the stock market to see if their shares have gone up or down. They may also speculate: buying if they think share prices are likely to go up; selling if they think their shares will fall. But what drives these expectations?
To some extent, people will look at real factors, such as company sales and profits or macroeconomic indicators, such as the rate of economic growth or changes in public-sector borrowing. But to a large extent people are trying to predict what other people will do: how other people will react to changes in various indicators.
John Maynard Keynes observed this phenomenon in Chapter 12 of his General Theory of Employment, Interest and Money of 1936. He likened this process of anticipating what other people will do to a newspaper beauty contest, popular at the time. In fact, behaviour of this kind has become known as a Keynesian beauty contest (see also).
Keynes wrote that:
professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgement, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.
When investors focus on people’s likely reactions, it can make markets very unstable. A relatively minor piece of news can cause people to buy or sell in anticipation that others will do the same and that others will realise this and do the same themselves. Markets can overshoot, until, when prices have got out of line with fundamentals, buying can turn into selling, or vice versa. Prices can then move rapidly in the other direction, again driven by what people think other people will do. Sometimes, markets can react to very trivial news indeed. As the New York Times article below states:
On days without much news, the market is simply reacting to itself. And because anxiety is running high, investors make quick, sometimes impulsive, responses to relatively minor events.
The rise of the machine
In recent years there is a new factor to account for growing stock market volatility. The Keynesian beauty contest is increasingly being played by computers. They are programmed to buy and sell when certain conditions are met. The hundreds of human traders of the past who packed trading floors of stock markets, have been largely replaced by just a few programmers, trained to adjust the algorithms of the computers their finance companies use as trading conditions change.
And these computers react in milliseconds to what other computers are doing, which in turn react to what others are doing. Markets can, as a result, suddenly soar or plummet, until the algorithms kick the market into reverse as computers sell over-priced stock or buy under-priced stock, which triggers other computers to do the same.
Robot trading is here to stay. The articles and podcast consider the implications of the ‘games’ they are playing – for savers, companies and the economy.
Articles
Questions
- Give some other examples of human behaviour which is in the form of a Keynesian beauty contest.
- Why may playing a Keynesian beauty contest lead to an undesirable Nash equilibrium?
- Does robot trading do anything other than simply increase the speed at which markets adjust?
- Can destabilising speculation continue indefinitely? Explain.
- Explain what is meant by ‘overshooting’? Why is overshooting likely to occur in stock markets and foreign exchange markets?
- In what ways does robot trading (a) benefit and (b) damage the interests of savers?
With many countries struggling to recover from the depression of the past few years, central banks are considering more and more doveish moves to kick-start lending. But with short-term interest rates in the USA, the UK and Japan close to zero, the scope for further cuts are limited. So what can central banks do?
The first thing that can be done is to adopt a higher inflation target or to accept inflation above target – at least for the time being. This could be accompanied by explicitly targeting GDP growth (real or nominal) or unemployment (see the blog from last December, Rethinking central bank targets).
The second option is to increase quantitative easing. Although in a minority at the last MPC meeting, Mervyn King, the current Bank of England Governor, argued for a further £25 billion of asset purchases (bringing the total to £400bn) (see MPC minutes paragraph 39). It is highly likely that the MPC will agree to further QE at its next meeting in March. In Japan, the new governor of the Bank of Japan is expected to include asset purchases as part of the policy of monetary easing.
The third option is for the central bank to provide finance at below-market rates of interest directly to the banking sector specifically for lending: e.g. to small businesses or for house purchase. The Bank of England’s Funding for Lending Scheme is an example and the Bank is considering extending it to other financial institutions.
One other approach, mooted by the Bank of England’s Deputy Governor before the House of Commons Treasury Select Committee, is for negative interest rates paid on Banks’ reserves in the Bank of England. This would, in effect, be a fee levied on banks for keeping money on deposit. The idea would be to encourage banks to lend the money and not to keep excessive liquidity. As you can see from the chart, three rounds of quantitative easing have led to a huge increase in bank’s reserves at the Bank of England. (Click here for a PowerPoint of the chart.)
The following articles consider these various proposals and whether they will work to stimulate lending and thereby aggregate demand and economic recovery.
Central banks: Brave new words The Economist (23/2/13)
Phoney currency wars The Economist (16/2/13)
Analysis: Global central banks will keep taking it easy Reuters, Alan Wheatley (22/2/13)
Quantitative easing: the markets are struggling with a serious drug habi The Guardian, Larry Elliott (24/2/13)
Negative interest rates idea floated by Bank’s Paul Tucker BBC News (26/2/13)
Bank of England mulls negative interest rates Independent, Ben Chu (26/2/13)
BoE floats extending Funding for Lending to non-banks Mortgage Solutions, Adam Williams (26/2/13)
Funding for Lending Scheme failing to get banks lending Left Foot Forward, James Bloodworth (26/2/13)
Mortgage market boosted by lending schemes, says Redrow BBC News (26/2/13)
Widespread quantitative easing risks ‘QE wars’ and stagnation The Guardian, Nouriel Roubini (28/2/13)
Questions
- Consider each of the methods outlined above and their chances of success in stimulating aggregate demand.
- Go through each of the methods and consider the problems they are likely to create/have created.
- How important is it that monetary policy measures affect people’s expectations?
- What effects do the measures have on the distribution of income between borrowers and savers?
- What are annuities? How are these affected by policies of monetary easing?
- How has actual and anticipated Japanese monetary policy affected the exchange rate of the Japanese yen? How is this likely to affect the Japanese economy?
- Explain the sub-heading of the final article above, “When several major central banks pursue QE at the same time, it becomes a zero-sum game”. Do you agree?
According to Brad DeLong, professor of economics at the University of California at Berkeley, if we are to get a full understanding of the financial crisis and recession of the past two years, we need to take a historical perspective. In the following article from The Economic Times of India, he argues that modern macroeconomists need to learn from history if their assumptions and models are to be relevant and predictive.
The anti-history boys The Economic Times (India) (1/10/09)
A fuller version of the above article, along with comments from readers, can be found on Brad deLong’s blog site, a Semi-Daily Journal of an Economist at:
Economic History and Modern Macro: What Happened? (30/9/09)
Questions
- According to Narayana Kocherlakota, most macroeconomic models “rely on some form of large quarterly movements in the technological frontier. Some have collective shocks to the marginal utility of leisure. Other models have large quarterly shocks to the depreciation rate in the capital stock (in order to generate high asset price volatilities)…”. How could these models explain business cycles? Would you classify them as ‘real business cycle theories’: i.e. as ‘supply-side’ explanations?
- How does Brad deLong explain recessions?
- Why does a change in the velocity of circulation of money contribute to a crash?
- What are the strengths and limitation of using economic history to understand the current crisis?
During his lifetime Galbraith warned extensively of the problems likely to be associated with financial excesses, and if alive today would almost certainly allow himself a ‘told you so’ moment. He was a lifelong liberal who argued that capitalism was inherently a fragile and unstable system. So what relevance does his work have to the current financial crash?
Galbraith saw this coming Guardian (15/10/08)
In praise of …The Great Crash 1929 Guardian (15/10/08)
Questions
| 1. |
Write a short paragraph summarising Galbraith’s life and work. |
| 2. |
Assess the extent to which his arguments in relation to the fragility of the financial system are still relevant today. |
| 3. |
Galbraith commented that all stockmarket bubbles exhibit “seemingly imaginative, currently lucrative, and eventually disastrous innovation in financial structures“. Discuss the extent to which this kind of innovation (e.g. derivatives and sub-prime mortgages) may have been responsible for the current financial crisis. |
Each day many investors anxiously watch the stock market to see if their shares have gone up or down. They may also speculate: buying if they think share prices are likely to go up; selling if they think their shares will fall. But what drives these expectations?
In recent years there is a new factor to account for growing stock market volatility. The Keynesian beauty contest is increasingly being played by computers. They are programmed to buy and sell when certain conditions are met. The hundreds of human traders of the past who packed trading floors of stock markets, have been largely replaced by just a few programmers, trained to adjust the algorithms of the computers their finance companies use as trading conditions change.
Stock markets under computer control