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Neoclassical Finance and Reality
Lecture 1: The relative strengths of
neoclassical and behavioral finance for
understanding bubbles and systemic crises
Robert Shiller, Yale University
Princeton Bendheim Lectures in
Finance, October 8, 2013
Neoclassical Finance and
Reality
• The title of these three lectures is inspired
by the first Princeton Bendheim Lectures
in Finance, Stephen Ross “Neoclassical
Finance” and by Christopher Sims’ 1980
Econometrica article “Macroeconomics
and Reality”
•
Stephen A. Ross
Neoclassical Finance,
Lecture
2001,
PUP
2004
No arbitrage
opportunities
• “Information
efficiency”
• “Private information
that is relevant and
has yet to be
revealed” explains
volatility
•
Ross, Neoclassical Finance,
Continued
“Since it [neoclassical
finance modeling] has fewer
degrees of freedom in its unspecified parameters, it
should be easier to reject in empirical estimation.
Most importantly, though, is the question of what the
theory does not allow. The appeal to investor
sentiment seems almost limitless in its ability to
explain just about anything. Once we have
jettisoned the discipline of a market in which
arbitrage is eliminated, we can reverse-engineer any
observed pattern of prices and deduce a demand
structure that would support it. Furthermore,
psychology is sufficiently imprecise in its predictions
of human behavior that it places no brake on this
activity. P. 93.
•
Christopher A. Sims
Macroeconomics and Reality
1980
“..though large scale statistical macroeconomic models
exist and are by some criteria successful, a deep vein of
skepticism about the value of these models runs through
that part of the economics profession not actively
engaged in constructing or using them.
• “I will argue that the style in which their builders
construct claims for a connection between these models
and reality—the style in which ‘identification is achieve—
is inappropriate, to the point at which claims for
identification in these models cannot be taken seriously.”
Outline of the Three Lectures
1. (Today) The relative strengths of
neoclassical and behavioral finance for
understanding bubbles and systemic
crises
2. (Tomorrow) Why don’t sound financial
innovations get adopted?
3. (Thursday) Phishing for Phools: the
economics of manipulation and deception
(forthcoming book with George Akerlof)
•
•
•
•
•
•
Some Components of
Neoclassical Finance Have
Been
Rejected
Edward Miller 1971 pointed out that short sales
restrictions eliminate possibilities for “smart money”
to bring overpriced stocks down
There are many short-sale barriers [Jones and
Lamont JFE 2002]
In absence of barriers, short-sale strategies do work
[Diether Lee and Werner JFE 2001]
Many other behavioral anomalies
Value investing has paid off for century
Higher test-scoring institutional investors have better
average performance (Chevalier and Ellison)
Neoclassical Economics
• First use of term: Thorstein Veblen “Preconceptions of
Economic Science” QJE 1900 “It is no longer that certain
phenomena belong within science, but rather that the science
is concerned with any and all phenomena as seen from the
point of view of economic interest.” (pp.262-3)
• Wikipedia: “Neoclassical economics is a term variously used
for approaches to economics focusing on the determination of
prices, outputs, and income distributions in markets through
supply and demand, often mediated through a hypothesized
maximization of utility by income-constrained individuals and
of profits by cost-constrained firms employing available
information and factors of production, in accordance with
rational choice theory”
Neoclassical Economics and
Neoclassical Finance, Google Ngrams
Thomas Sargent “Interpreting Economic
Time Series” JPE 89(2):213-48 1981
• “The private agents are assumed to face
nontrivial dynamic and stochastic
optimization problems. . . It seems that
there is potential for specifying dynamic
preferences, technologies, constraints and
rules of the market game that roughly
reproduce the serial correlation and crosscorrelation patterns in a given collection of
time series measuring market outcomes.”
p. 215
Real S&P500 and Earnings
1871-2013
Real Home Prices and Housing
Fundamentals, 1890-2013
Epidemics and Word of Mouth
• Spread of ideas is similar to spread of
infectious diseases
• “Memes” (Richard Dawkins, The Selfish
Gene, 1976) and “thought viruses”
replicate as do viruses
• Mathematics of epidemiology is therefore
relevant to economics
SIR Model (Susceptibles,
Infectives, Removed) Kermck and
McKendrick, 1927
• n individuals, x susceptibles, y infectives, z
no longer contagious, n=x+y+z. Infection
rate is β, removal rate is γ, and define the
relative removal rate ρ=γ/β.
• dx/dt=-βxy
• dy/dt=βxy-γy
• dz/dt=γy
Properties of SIR Model
• No epidemic can start unless relative removal
rate ρ < x0 (the initial number of susceptibles)
• In an epidemic, number of infectives first rises,
then falls.
• Epidemic peaks when x falls below ρ
• “Size of epidemic” z∞ is the total number of
people who eventually contract the disease
• Size relative to population is determined by ρ,
low ρ promoting large size
Economics of Rumors Abhijit V.
Banerjee REStud 1993
• [In earlier literature on epidemic models in
economics], no attempt is made to derive
an optimal decision rule for each decision
maker. In this paper, the decision to
believe in the rumour and to pass it on is
based on optimizing behaviour.”
• Banerjee wants to incorporate epidemic
models into neoclassical economics, all
players are true Bayesians
Individuals agreeing with the statement: “The
stock market is the best investment for longterm holders, who can just buy and hold
through the ups and downs of the market”
Individuals agreeing with the statement: “The
Housing market is the best investment for longterm holders, who can just buy and hold
through the ups and downs of the market”
•
How would one ever calculate
the probability that the
statements
above
are
true?
The statements
represents memes,
that have intuitive
sense of truthfulness
• They are evaluated
by Daniel
Kahneman’s System
1, instantaneously,
without computations,
not System 2,
Thinking Fast and
Slow, 2011
Dawkins: Memes and Memetics
• Term Meme was coined by Richard Dawkins in
The Selfish Gene 1976
• A meme is the cultural analogue of a gene “good
ideas,” “good poems,” “mantras,” any mutation
that is spread by replication from brain to brain
• Socrates genes may be gone, his memes live on
• Dawkins 2013 says the term was “hijacked” with
“Internet meme” which is different in that it they
are deliberately altered, not result of mutation
Case Shiller & Thompson BPEA
2012
Table 4a: Regressions Testing Hypothesis of Rational Expectations of
Future 12-Month Home Price Change 2003-2011
Alameda
Regression
Boston Milwaukee
Orange
All Cities
Independent Variable
Constant
Trimmed-Mean Own-City
Expected 12-Month Change
Nobs
R Squared
-12.79
-4.75
-5.67
-9.48
-9.13
(8.84)
(2.85)
(4.52)
(5.16)
(2.52)
2.57
1.50
1.43
2.71
2.34
(1.42)
(0.71)
(0.94)
(0.78)
(0.46)
9
9
9
9
36
0.32
0.39
0.25
0.63
0.43
Ten-Year Expectations
And 30-Year Mortgage Rate
Excerpts from WSJ Story on
Shutdown & Markets
Oct 5-6 2013
• “Many investors say stocks remain
buoyant because they expect the Federal
Reserve to continue its efforts to support
the economy . .” [Rather than my
metaphor: Ben Bernanke is like nothing
more than the janitor who could turn down
the thermostat in a conflictual conference
room at a tense moment.]
• “The reason [markets aren’t reacting] is,
we’ve seen this coming from a mile away.”
•
Implications of Keynesian
Beauty Contest Metaphor for
Speculative
Trading
On Aug. 4, 2011, the market,
as measured by the Standard
& Poor’s 500-stock index, fell
by almost 5 percent. The next
day was quiet, but the
following Monday, the index
dropped almost 7 percent. In
successive days, it rose 4.7
percent, fell 4.4 percent and
rose 4.3 percent. after the
near-default.
• Keynesian beauty contest
• Peculiar timing of public
reaction to near default may
repeat this month
Alan Greenspan, Aug 7, 2011
(just before the nearly 7% drop)
• “What I think the S.& P. thing did was to hit
a nerve that there’s something basically
bad going on, and it’s hit the self-esteem
of the United States, the psyche.” “And it’s
having a much profounder effect than I
conceived could happen.”
• He was talking about what other investors
were thinking, not about the substance of
the S.& P. downgrade.
Franklin Allen, Stephen Morris, and Hyun Song
Shin “Beauty Contests and Iterated
Expectations in Asset Markets” RFS 2006
• This paper attempts to transform Keynes
beauty contest story into neoclassical
economics, with a “fully rational asset
pricing model”
• Stresses failure of the law of iterated
expectations for average belief
The Economist June 16, 2005
• “PERHAPS the best
evidence that
America's house
prices have reached
dangerous levels is
the fact that housebuying mania has
been plastered on the
front of virtually every
American newspaper
and magazine over
the past month.”
Time Magazine, June 13, 2005
• “HOME $WEET
HOME: Why We’re
going gaga over real
estate
– Will your house make
you rich?
– Super hot markets.
– Is it time to buy or
sell?
– The case for renting”
Barrons, June 20, 2005
• “Economist Robert Shiller
whose book predicting a
stock market rout arrived
just before the Nasdaq
began its sickening slide
in 2000, sees another
bubble ready to burst.
Home prices, he
contends, could fall by as
much as 50% adjusted
for inflation.”
• (Ex post: Actual US peak
to trough decline was
43%, over 50% in many
Percentage of Respondents’ Unprompted Use
of “Housing Bubble” in Open-ended Questions
Percent of Respondents
Unprompted Use of “Land” (usually as in “land
shortage”) in Open-Ended Questions
Google Trends: Web Searches for
“Housing Bubble” peak Aug 2005
Celebrities Example: Mona
Lisa’s Smile
• Giorgio Vasari
biography of
Leonardo, smile
“more divine than
human”
• Vasari’s description of
painting shows
serious discrepancies
with painting we view
today
Two Events in 1910 Increase
Infection Rate for Mona Lisa
• Theft of Mona Lisa from Louvre, leads to
international manhunt that results in capture of
the thief in 1914.
• Publication of book about Leonardo by Sigmund
Freud said Mona Lisa’s smile was reaction to
suppressed memory of Leonardo’s mother, who
had an unnatural affection for her son
• Newspaper references to Mona Lisa increased
twenty-fold between 1899-1909 and 1915-1925
Conclusion
• Epidemic models highly relevant to the
kinds of things that shock the economy
• Information cascades add a rational
component
• Information interacts with epidemic models
to produce social changes
• New information technology changes the
kinds of ideas and trends that show high
contagion rates