Herds, Houses and the Crisis* Andrew Oswald *Many thanks to Danny Blanchflower and Amanda Goodall for valuable ideas

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Herds, Houses and the Crisis* Andrew Oswald *Many thanks to Danny Blanchflower and Amanda Goodall for valuable ideas. Slide 2 "Men think in herds; they go mad in herds, they only recover their senses slowly, and one by one." C. Mackay Slide 3 Extraordinary Popular Delusions and the Madness of Crowds, by Charles MacKay, published in 1841. Slide 4 Far from the Madding Crowd, by Thomas Hardy, published in 1874. Slide 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). Slide 6 Herd behaviour is very often natural and individually rational. But it has the potential to be disastrous for the group. Slide 7 Slide 8 On a technical note To economists and any mathematicians here: Slide 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. Slide 10 A general point about the mathematics of imitation Slide 11 Caring about relative things is not sufficient to give us Keeping-up- with-the-Joneses. Slide 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. Slide 13 Then if v is concave (convex) in status, it is rational to act similarly to (deviantly from) the herd. Slide 14 The main point can be made without any mathematics. Slide 15 Subconsciously, humans are frightened of falling behind: Slide 16 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. Slide 17 When rewards depend on your relative position it will routinely be Slide 18 When rewards depend on your relative position it will routinely be (i)dangerous to question whether the whole groups activity is flawed (ii) rational simply to compete hard within the rules that govern success. Slide 19 When rewards depend on your relative position it will routinely be (i)dangerous to question whether the whole groups activity is flawed (ii) 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. Slide 20 Hence the pressures for conformity are strong. Slide 21 To students here These psychological forces are powerful and will come around again, a number of times, in your lifetime. Slide 22 Now to house prices, which started our problems. Slide 23 Real house prices in the United States over the century Slide 24 Real house prices in the UK 1975-2006 Slide 25 So all the historical data suggested that house prices were unsustainable. Slide 26 Yet -- even two or three years ago near the peak -- few people spoke up about the apparent likelihood of a crash. Slide 27 Plus continuing propaganda: 13 December 2006 House prices will continue to rise over the next two years. Council of Mortgage Lenders Slide 28 One of the simplest principles Slide 29 In most systems, including economic ones, there is a tendency to go back to trend. Slide 30 The tendency to trend-reversion Slide 31 This has a good side to it. We will bounce back even if we have a few rather bad years after this one. Slide 32 Excessive gloom can create herd behaviour and over- shooting in the negative direction Slide 33 Excessive gloom can create herd behaviour and over- shooting in the negative direction (just as it did in the upward direction). Slide 34 But we do need some lean years Slide 35 Trying to sum up Slide 36 1. For economists, I believe we will have to integrate herd behaviour into our subject. Slide 37 2. For students, it may be helpful to you to remember that the madness of crowds will be back in your lifetime. Slide 38 Slide 39 3. For citizens, herd behaviour means more regulation is required. [because there are spillover externalities across people] Slide 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. Slide 41 Herds, Houses and the Crisis* Andrew Oswald *Many thanks to Danny Blanchflower and Amanda Goodall for valuable ideas.