Sixteen years ago I wrote down the above title on my “Work in Process” list, thought about it for a few minutes, and put it at the bottom priority. Granted, it was a complex and poorly understood topic for which I intended to offer a new formulation – but it was hardly a burning issue. To find familiar examples I would have had to reach back to the Great Depression of the 1930’s, or the post-war hyper-inflationary periods in Germany and Hungary – historical curiosities that had no perceivable relevance to our world in 1996. Common wisdom and expert opinion agreed: We were beyond all that.
But here we are in 2012 and all that has changed. We have seen the unthinkable occur, again and again: a major investment bank going bankrupt, housing prices plunging across the board and staying down, a global near financial meltdown, people actually paying serious attention to Nassim Taleb – and now we face the imminent possibility of default on sovereign debt by major European nations, and perhaps even the collapse of the Euro.
The topic now seems, if anything, too timely. Every second article in the financial press seems to be about when the next break in the global economy will come, how far it will spread and how rapidly. Rest assured, this is not yet another Chicken Little post. The economic sky may in fact fall, but that’s for others to predict.
What I’m interested in here is: What actually happens with individual investors that results in panic, contagion and mass market movements, and how can we spot it before it comes crashing down around us?
Let me be clear: by “contagion” I am not referring to the truly terrifying structural linkages by which, say, default by Greece would inevitably take down numerous European banks and probably a few other countries. These are “hard-wired” into the system and only require occurrence of the initial unthinkable event to set them off. What I am interested in exploring is the “psychological contagion” that looks like a mass panic, where for example the failure of one well-regarded bank leads to runs on other, sound, banks, or a drop in certain stocks leads, not to the expected offset by opportunistic buyers, but to an “unreasoning” stampede out of stocks in general. How can we make sense out of these seemingly senseless mass market movements? Let’s begin by marking out the territory to be explored.
- Start with a sharp break from prior market behavior. It looks as if, across the board, something important changes, which results in markedly different behavior.
- Spread rapidly, like flu epidemics or panicked stampedes in burning buildings.
- Are essentially impervious to reason, reassurance and cold, hard facts.
Some obvious questions: What is the important change that results in the sharp break in behavior? How, exactly, does the contagion spread? And why, oh why, do people ignore informed pleas for reason as they figuratively stampede to the nearest exit?
The usual candidate for “what changes” is: market sentiment. But that’s just a label, not an explanation – one day “the market” sees cautious opportunity, the next day it sees massive risk. Why? And why does it happen so abruptly?
We have even less understanding of how the “contagion” spreads into “panic”. Note the quotation marks: they are intended to remind us that “contagion” and “panic” in this case are metaphors, borrowed from realms in which they are actual facts. Diseases are in fact contagious and we know both what causes them and the biological mechanisms by which they spread. We know nothing at all comparable about market “contagion”. Likewise, panics actually happen in crowds when someone perceives danger, takes strong action to avoid it and others react to the danger-avoiding behavior. Physical proximity is an essential part of the spread of panic; there is no physical proximity in market panics except, for example, among traders jammed together on a trading floor. The puzzling thing about market “panics” is precisely that there is no physical proximity and therefore no plausible explanation for how the “panic” spreads.
Finally, the “explanations” for why informed pleas for reason are ignored simply say that this is emotional, therefore irrational, behavior. This is the standard dismissive fallback of economists (even behavioral economists) and as we have seen in prior posts, it completely misses the point. Behavior makes sense; saying that it doesn’t just means you don’t know where to look to understand it. We can do better with all three questions because, as Descriptive Psychologists, we know where and how to look.
We start by restating and then expanding one of Descriptive Psychology’s core formulations about people and behavior:
A person acts on the state-of-affairs he currently finds himself to be in. (“Finds himself” does not imply passivity; the current state-of-affairs routinely is the result of the person’s prior intentional actions.) Certain things are actual parts of the current state-of-affairs; they are real to the person when she acts. Other things are potential parts of the state-of-affairs; they are possible to her when she acts. People value both the real and the possible, and they value them differently. Specifically, a person will value a real something over the “same” possible something.
To this we add the third and final piece of this formulation:
Possible parts of the current state-of-affairs divide into two categories: things the person takes to be actually possible, and things she takes to be merely theoretically possible. A person will take actually possible things into account in acting; he will not take into account things that are merely theoretically possible.
So what is the important change that results in the sharp break in behavior? Just this:
Something changes from merely theoretically possible to actually possible for this person.
And that something – whatever it is – is now taken into account in the person’s actions, whereas before it was not.
Note a few things about this formulation:
- The change from theoretically possible to actually possible is a categorical change – not a matter of degree, but of kind.
- This change is a state change. Just as state changes in quantum physics happen instantaneously and without an intervening process, so too do changes from theoretically possible to actually possible.
- There is no room at all here for talk about “probability”. Either a thing is actually possible to a person, or it is not.
The near-meltdown of the financial system in 2008 occurred when, for many investors, bankruptcy of a major investment bank changed from merely theoretically possible to actually possible. What made it actually possible was a real occurrence – it actually happened to Lehman – and therefore could possibly happen again to other banks. From that point on, the possibility of major bank failure was actually considered by the investors – and for a large majority of investors the actual possibility of bank failure is too great a risk to countenance. Runs on (and collapse of) other banks would have been inevitable had not the U.S. government taken extraordinary (indeed, unprecedented) measures to assure investors that another bank failure would not be allowed to happen – and that they had the will and financial muscle to back up their assurances.
Notice that there is no place in this account for talk about emotion or irrational behavior. A person may very well feel a cold lump of fear on realizing that they have been ignoring a large and important risk, and they may experience shock when they suddenly realize things are different than they thought – but those are just feelings that accompany a rational assessment of the situation. A person acts – sensibly – on what they take to be the case, not essentially on what feelings accompany their assessment.
How does this spread? Not primarily from person to person, but systematically. Simply, it’s the assessment of what is actually possible that spreads through the market, as more and more individuals discover they have reason to reevaluate those “merely theoretically possible” things. The rich stew of information, stories, rumors, and prognostications that form our daily media fare is available to everyone, and while insiders usually know about risks before the rest of us, eventually something happens that tips the scales: The impossible or theoretically possible becomes an actual possibility, and then behavior changes rapidly, en masse – as if a panic were occurring or an epidemic spreading. But of course it is actually a large number of people reaching a state-changing conclusion within days or even hours of each other.
This formulation leads to some important further questions:
- Why are these market “panics” so resistant to facts and reason?
- What does it take to make the theoretically possible actually possible?
- Once something becomes actually possible for a person, does it stay that way?
- Can we spot when a state change in the market is about to occur, and can we do anything about it?
Answering these questions will require a bit more conceptualization from Descriptive Psychology. We will take these up in the next post in this series.
One parting note: Consider a recent statement from the New York Times:
“Markets, which had always assumed that major Western governments would honor their obligations, struggled to learn to adjust to a new world where that was not so certain.” The Year Governments Lost Their Credibility, NY Times 12/30/11
Has “major Western government” default become actually possible in the market’s eyes– or are we still just flirting with a theoretical possibility? Perhaps government bonds currently are, as British slang once put it, “safe as houses”. That’s an ironically unsettling thought.