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June 20, 2010

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links for 2010-06-19

Posted: 19 Jun 2010 11:03 PM PDT

Tail Risks, Time Lags, and Herding Behavior

Posted: 19 Jun 2010 03:33 PM PDT

Rajiv Sethi explains how herding behavior toward high risk outcomes can occur, and how this can happen without assuming the kinds of departures from rationality observed in behavioral economics:

[For] tail risks...: there can be a significant time lag between the acceptance of the risk and the realization of a catastrophic event. In the interim, those who embrace the risk will generate unusually high profits and place their less sanguine competitors in the difficult position of either following their lead or accepting a progressively diminishing market share. The result is herd behavior with entire industries acting as if they share the expectations of the most optimistic among them. It is competitive pressure rather than human psychology that causes firms to act in this way, and their actions are often taken against their own better judgment. 
This ecological perspective lies at the heart of Hyman Minsky's analysis of financial instability, and it can be applied more generally to tail risks of all kinds. ... As an account of the (environmental and financial) catastrophes with which we continue to grapple, I find it more compelling and complete than the psychological story. And it has the virtue of not depending for its validity on systematic, persistent, and largely unexplained cognitive biases among professionals in high stakes situations.

More here.

Update: Brad DeLong:

Rajiv Sethi Misses a Point..., by Brad DeLong: Mark Thoma sends us to Rajiv Sethi, who writes:

Rajiv Sethi: On Tail Risk and the Winner's Curse: [T]hose with the most optimistic expectations will take the greatest risks and suffer the most severe losses when the low probability events that they have disregarded eventually come to pass. But tail risks are unlike auctions in one important respect: there can be a significant time lag between the acceptance of the risk and the realization of a catastrophic event. In the interim, those who embrace the risk will generate unusually high profits...

What Rajiv misses is that it may not be "in the meantime." To the extent that the optimism of noise traders leads them to hold larger average positions in assets that possess systemic risk, their average returns will be higher in a risk-averse world--not just in those states of the world in which the catastrophe has not happened yet, but quite possibly averaged over all states of the world including catastrophic states.

In general, noise traders' returns average returns are:

  • higher because of their optimism about risky assets
  • lower because their fluctuating opinions tend to make them buy high and sell low
  • higher because their irrational changes of opinion make the risky assets they concentrate on even more risky--and so drive rational risk-averse investors away, push the prices of such assets down, and returns on such assets up.

There is another factor:

  • it is possible for noise traders to have a higher average return and yet a lower median market share--repeated independent investments of agents with crra-like utiity functions tend to generate log-normal distributions, and because noise traders' distributions have higher variance they may have a greater expected wealth but a ower median wealth because of a long upper tail.

But Rajiv doesn't want to put his noise-trader optimists into a model with flint-eyedsteel-nerved ice-bloodedrisk averse rational calculators. He wants the other agents in his models to be:

[L]ess sanguine competitors in the difficult position of either following [the optimists'] lead or accepting a progressively diminishing market share. The result is herd behavior with entire industries acting as if they share the expectations of the most optimistic among them. It is competitive pressure rather than human psychology that causes firms to act in this way, and their actions are often taken against their own better judgment...

I wouldn't say "rather than": I would say "along with." For, as my teacher Charles Kindleberger liked to say:

Kindleberger: Overestimation of profits comes from euphoria, affects firms engaged in the production and distributive processes, and requires no explanation. Excessive gearing arises from cash requirements that are low relative both to the prevailing price of a good or asset and to possible changes in its price. It means buying on margin, or by installments, under circumstances in which one can sell the asset and transfer with it the obligation to make future payments. As firms or households see others making profits from speculative purchases and resales, they tend to follow: "Monkey see, monkey do." In my talks about financial crisis over the last decades, I have polished one line that always gets a nervous laugh:

There is nothing so disturbing to one's well-being and judgment as to see a friend get rich...

Capacity Utilization versus Unemployment

Posted: 19 Jun 2010 12:25 PM PDT

In the past, there was a fairly close contemporaneous relationship between capacity utilization and unemployment. However, much like the relationship between output and unemployment, a lag in the relationship has developed in the last two recessions (see graph). That is, in past recessions an upturn in capacity utilization was matched by an upturn in employment, there was no delay in the relationship, but in recent recessions there has been about a half year delay before unemployment reacts to changes in capacity utilization (or perhaps even a bit longer).

Caputil-vs-un
[Note: To highlight the relationship, the graph shows 100-(UN rate) on the right-hand scale. Thus, an upward movement in the red line represents a decline in unemployment.]

I've been relatively pessimistic about the recovery of employment, but I don't want to just present evidence that supports my views, and there are two things about this graph that are encouraging. First, the "V" in capacity utilization seems steeper than it was in the last two recessions. If the steep recovery of capacity utilization continues and employment follows, the recovery could be a bit faster than I've been anticipating (though the recovery of capacity utilization could certainly flatten out, and that possibility has to be factored into any policy response -- in the past two recessions the initial change in capacity utilization was also steep for the first few months, but it didn't last).

Second, the lag between changes in capacity utilization and the change in employment appears to be shorter than the last two recessions. If so, then employment will recover faster. But the word "appears" here is important. Looking at the response of unemployment in the last (2001) recession, there were initial encouraging signs for unemployment just like this time, but then the recovery of unemployment stalled and actually increased a bit more before finally beginning to decline consistently. It's certainly possible that will happen again.

Thus, while there are some encouraging signs here -- the steepness of the recovery for capacity utilization and the apparently shorter lag between improvements in capacity usage and improvements in employment -- but neither of these are unqualified, the steepness could change and the shorter lag isn't yet certain, so I'm hesitant to change my priors about the recovery too much based upon this one piece of evidence. But good news is better than bad news, even if the good news is tentative at best.

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