Friday, October 10, 2008

Why are stocks dropping so fast?

How is it possible that stocks could be dropping this fast all over the world while the current crisis is mostly limited to the US financial sector? Stock prices are supposed to represent the discounted present value of the expectations of future dividends, and possibly the liquidation value of the firms. What in that equation would lead to such price drops?

Lower expectations for dividends? Possibly, as people must by now realize that someone will have to pay for this horrible bailout package, and firms are likely to be the first ones on the hook in an election period. But that would not explain why stocks drop in the rest of the world, and it probably does not explain the amplitude of the drop in the US.

Changes in discounting? With the recent reduction in interest rates by the Federal Reserve Bank, we should in fact see increases in stock prices? So what is left? Irrational panic? While one cannot rule this out, there may be a perfectly rational explanation, and the lead article in the last American Economic Review gives one.

Ana Fostel and John Geanakoplos show how perfectly rational agents can generate something that looks like a panic. The premise is an economy populated with liquidity constrained individuals (no borrowing and short sales) who are heterogeneous in terms of optimism. They show that even a small group of agents heavily invested in a small sector of the economy can lead the economy into a so-called anxious state, where bad news is contagious for assets to which the news is orthogonal.

The crucial aspect is heterogeneity of agents combined with incomplete markets. The key is that some bad news increases volatility, because of the latter this does not necessarily increase the information. The result is more disparity in opinions. Some sell because of increased pessimism, others have to because of the liquidity constraint. It snowballs from there and looks like a panic, but everyone is acting in a rational manner.

Does this pertain to the current situation in the United States? The authors have emerging markets in mind, where indeed markets are much more incomplete than in the US. But the current US situation is one where it is very difficult to borrow and most agents never contemplate short sales, and some of those who do have just been forbidden to do so. And given that the model economy just needs few people in such a situation, I think the model applies.

But the model has good news. We'll get over it.


Vilfredo said...

It looks like to are putting a little too much faith in rationality here. Those that are selling now are panicking.

Kansan said...

Vilfredo, the point of the article, as far as I understand it, is that it may look like a panic, but it is still a rational decision. And the point of Economic Logician seems to be that the situation is partly to blame on trading restrictions that have been imposed.