Thursday, August 11, 2011

Skinnerian rats and financiers

The behaviour of markets is baffling and erratic. Shares slump in the morning, only to recover in the afternoon. The latter gives people hope. More hope when the unemployment figures in the United States go down. Markets rally. These hopes are dashed by close of trade later in the afternoon or next morning, when another set of figures says something else. Gloom and panic buying and selling sets in. This is baffling and erratic behaviour.

But is it so baffling and erratic?

Markets are made of people, and peoples’ behaviour follows certain rules. These rules are commonly similar to rules observed in animals such as rats and pigeons. The American psychologist BF Skinner documented this years ago.

Let us take negative reward, such as pressing a button to avoid an electric shock (in financial terms, not losing money. The shock can be avoided by pressing the button at fixed times (say every 5 minutes) or fixed intervals, say after every 50th press. But the shock can equally be delivered at unpredictable times and unpredictable intervals. The latter two generate very high levels of button presses and are known, in monkeys at least, to induce severe gastric problems, including intestinal ulcers.

They also sometimes result in what is known as superstitious behaviour. If a rat, for example, while trying to avoid a shock in a random negative reinforcement schedule, circles the cage twice and is rewarded with a food pellet on a few occasions when it does this, then the chances are high that it will continue this bizarre behaviour while continuing to press at high rates, presumably in the belief that it will be rewarded again.

So much for the world of rat ideas. Now translate this into the world of financiers. The European Central Bank announces that it will buy Italian and Spanish bonds and some Harvard qualified economist says that this will miraculously solve the eurozone problem. They buy shares (superstitious behaviour) and the markets go up. But then, what they had not factored in, namely the calculation of ordinary brains that such bond-buying will not solve the malaise, sets in, and the markets go down. Then some fancy statement from the Federal Reserve says that interest rates will not go up (superstitious statement that does not take into account the underlying malaise), and the market goes up again. The reality of ordinary brain calculations then sets in, and the markets go down again. Then some official in some bank somewhere announces that there is a strong possibility of printing money (superstitious behaviour), and the markets go up again. The truth is that money printing, bond-buying and low interest rates amount to superstitious behaviour; they do not solve the underlying problems. The brain’s calculations are that those who have borrowed huge sums of money to service extravagant life styles cannot pay this money back without something more radical and convincing. Hence loss of confidence sets in.

All this amounts to high-rate superstitious behaviour. And this behaviour is due to the fact that the financiers do not really understand the system that they have created.

Perhaps they should revert to much simpler systems – ones that their brains, as well as ordinary brains, understand. Then they might find that their behaviour is not so erratic after all and that there is a rationale to this apparently bizarre behaviour.

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