Herds, Houses and the Crisis* Andrew Oswald

1
Herds, Houses and the CrisisAndrew Oswald

• Many thanks to Danny Blanchflower and Amanda
  Goodall for valuable ideas.

2

• "Men think in herds they go mad in herds,
  they only recover their senses slowly, and one by
  one."
• C. Mackay

3

• Extraordinary Popular Delusions and the Madness
  of Crowds, by Charles MacKay, published in 1841.

4

• Extraordinary Popular Delusions and the Madness
  of Crowds, by Charles MacKay, published in 1841.
• Far from the Madding Crowd, by Thomas Hardy,
  published in 1874.

5

• Extraordinary Popular Delusions and the Madness
  of Crowds, by Charles MacKay, published in 1841.
• Far from the Madding Crowd, by Thomas Hardy,
  published in 1874.
• (in which a herd of sheep plunge to their doom
  from a cliff).

6

• Herd behaviour is very often natural and
  individually rational. But it has the potential
  to be disastrous for the group.

7

• Herd behaviour is very often natural and
  individually rational. But it has the potential
  to be disastrous for the group.

8
On a technical note

• To economists and any mathematicians here

9
On a technical note

• To economists and any mathematicians here
• I have in mind a class of problem where utility
  depends on relative actions.

10
A general point about the mathematics of imitation

11
A general point about the mathematics of imitation

• Caring about relative things is not sufficient
  to give us Keeping-up-with-the-Joneses.

12

• Imagine a person is choosing an action a to
  solve
• Maximize u(a) v(a a) c(a)
• where a is what everyone else is doing.

13

• Then if v is concave (convex) in status, it is
  rational to act similarly to (deviantly from) the
  herd.

14

• The main point can be made without any
  mathematics.

15
Subconsciously, humans are frightened of falling
behind
16
Subconsciously, humans are frightened of falling
behind

• Home buyers paid extraordinary prices in order to
  keep up.
• Bank lenders and brokers felt they had to match
  rivals.  
• Money managers -- rewarded on relative
  performance against other managers -- copied what
  the others did.

17
When rewards depend on your relative position

• it will routinely be

18
When rewards depend on your relative position

• it will routinely be
• dangerous to question whether the whole groups
  activity is flawed
• rational simply to compete hard within the rules
  that govern success.

19
When rewards depend on your relative position

• it will routinely be
• dangerous to question whether the whole groups
  activity is flawed
• rational simply to compete hard within the rules
  that govern success.
• Before the dotcom crash, the analysts who got
  sacked were the ones who correctly said this
  bubble cannot last.

20

• Hence the pressures for conformity are strong.

21
To students here

• These psychological forces are powerful and
  will come around again, a number of times, in
  your lifetime.

22

• Now to house prices, which started our problems.

23
Real house prices in the United States over the
century
24
Real house prices in the UK 1975-2006
25

• So all the historical data suggested that house
  prices were unsustainable.

26

• Yet -- even two or three years ago near the
  peak -- few people spoke up about the apparent
  likelihood of a crash.

27
Plus continuing propaganda

• 13 December 2006
• House prices will continue to rise over the
  next two years.
• Council of Mortgage Lenders

28
One of the simplest principles

29
One of the simplest principles

• In most systems, including economic ones,
  there is a tendency to go back to trend.

30
The tendency to trend-reversion
31

• This has a good side to it.
• We will bounce back even if we have a few
  rather bad years after this one.

32

• Excessive gloom can create herd behaviour and
  over-shooting in the negative direction

33

• Excessive gloom can create herd behaviour and
  over-shooting in the negative direction (just as
  it did in the upward direction).

34
But we do need some lean years
35

• Trying to sum up

36

• 1. For economists, I believe we will have to
  integrate herd behaviour into our subject.

37

• 2. For students, it may be helpful to you to
  remember that the madness of crowds will be back
  in your lifetime.

38

• 2. For students, it may be helpful to you to
  remember that the madness of crowds will be back
  in your lifetime.

39

• 3. For citizens, herd behaviour means more
  regulation is required.
• because there are spillover externalities
  across people

40
Points to take away

• We need to integrate herd behaviour into
  economics.
• The madness of crowds will be back.
• Herd behaviour means that some regulation is
  required.

41
Herds, Houses and the CrisisAndrew Oswald

• Many thanks to Danny Blanchflower and Amanda
  Goodall for valuable ideas.