Sunday, July 29, 2007

The Worm's Eye-View - The Trader's Perspective on Booms and Busts (amv)

At present, financial markets are stumbling. Reading newspapers or watching the news (or reading the posts on Herdentrieb) it seems that it's all about pessimistic expectations. And indeed, expectations are of major importance. And since expectations are indetermined (or, what means the same, since man has Free Will), markets are driven by action under genuine or radical uncertainty. Uncertainty may lead market participants to play the so-called "beauty contest" and imposes volatility and noise to the performance of financial markets. So far so good.

But here are some "issues" for those, who do not go beyond the whims and passions of market participants:

1) Do you believe that reality and causality exist independent of our theories or at least that reality is a test for our theories? This does not mean that our reality is unaffected by our theories but that we cannot enforce our conclusions upon existence! Of course, it makes a difference what kind of theory we employ, because theory guides our actions and our actions shape our world. The crucial point is this: can everything happen according to our expectations, because we all expected it? Can the asset market be like a lottery in which everyone hits the jackpot, simply because everyone is believing it? (This problem is not solved if you claim that these believes rests on "fundamentals" like economic forecasts. A forecast is an expectation, nothing more. If, however, forecasts in respect to the performance of good and labor markets can prove their robustness - and thus become a reliable standard-, so why can't expectations of asset owners do so as well? But if they do, than expectations are caught within the boundaries of fundamentals (reality) and are not so much a cause of financial booms and busts, but an effect!)

2) For a general downturn on asset markets you have to explain falling stock prices. For prices to fall, exchange has to take place. Otherwise no new contracts could be enforced and no other prices than the initial ones could be realized. But for exchange to take place you need divergent expectations. While most of the market participants are pessimistic, some are desperately needed to buy these assets. But for someone to buy an asset, there must be someone else with a more optimistic/less pessimistic outlook in regard to the asset's future performance. Hence, the need to conceptualize divergent expectations. But because your theory does not go beyond expectations you have to assume from the beginning that ....

"... for a major downswing to occur on asset markets there are a lot of people with bad expecations who want to sell their assets, while there is a minority which is at least less pessimistic and thus wants to buy the same assets."

This is no explanation; this is a manna drop! Why are people doing what they are doing? Economics is not a science of the motion of aggregates, but of human action. You cannot offer a "theory" in which 'action' is the given!

3) Do you dispense with methodological individualism, which inter alia implies that our theories have to begin from the single but universal agent, that is, from individuals who are characterized by the same standards, even though they may behave differently because of different preferences and perspectives? If you do, why? - If you don't, you have a problem! For you do not explain why some agents behave like crazy and others have to act diametrical to allow your theory to make sense (i.e., to allow for falling stock prices).
4) If people are driven be myopic euphoria or depression, what is the role of prices? Obviously, they are poor coordinators of action, driven by our whims and passions rather than leading rational agents towards the satisfation of consumer wants.