Exploring Credit Cycles & Behavioural Economics

In March last year, the IMF held a significant conference titled “Macro and Growth Policies in the wake of the Crisis.” One of the key lessons espoused by the co-organiser, Joseph Stiglitz, was the need to further our understanding of credit and incorporate these insights into the macro-economic models used by policymakers. On this topic, fellow co-organiser Olivier Blanchard suggested the need to gain insights from behavioural economics. Fortunately, there has already been some work done on understanding credit channels as well as advances in the field of behavioural economics.

One of the main theoretical ideas that was considered to be absent from Economic models was that of the credit channel. Most of the main economic models used before the crisis were based on a frictionless money market. The movements in the interest rate caused by central bank actions were seamlessly transferred to the real economy. Given the outcome of 2008 it now seems wrong to assume a frictionless financial market. With this knowledge, the challenge is now to incorporate any frictions of the financial sector into economic models, thus making them more realistic and increasing their predictive power.

The financial accelerator.

The economics literature was not silent in this area. Bernanke had done work in this area during the last decade. At the core of this work is the concept of a financial accelerator. This idea was aimed at understanding the build up of credit in a booming economy. It is based on the concept of an external finance premium. This is the premium paid by a borrower when accessing funds externally. For example, a firm can choose to finance an investment internally via it’s cash flow or externally via a lender. There is always a premium on accessing external finance but this premium depends on the economic cycle.

This effect works through the balance sheet of a potential borrower. When the economy is growing, incomes and the worth of assets tend to be higher, thus improving the creditworthiness of the borrower. This increases the access to credit during the growing economy. The reverse of this is a decelerating economy and these factors work in reverse. The balance sheet of the borrower is less healthy, which increases the external finance premium and consequently reduces the access to credit. What results from this process is credit that accelerates with a booming economy and decelerates with a slowing economy.

This seems to be an intuitive account of why credit cycles follow economic cycles, but again, these concepts have not been incorporated into the major economic models that were used before the crisis.

Behavioural insights.

The conference also highlighted the need for behavioural economics to help in understanding credit and economic cycles. While behavioural economics is relatively new as a discipline, there are general concepts that have been examined that may help in developing the more thorough models that are needed. The first concept relates to the psychological notion of ‘loss aversion’. Basically, this implies that we value the loss of given amount much more than we value the gain of the same amount. A simple demonstration of this involves the loss and subsequent find of a £10 note. Although at the end of the day we are at the same point financially from this, we are worse off psychologically. We are ‘pained’ more by the loss of the £10 note we gain from finding a £10 note.

Secondly, the insights gained from social psychology in terms of group behaviour may also help in understanding these cycles. One of its most basic insights is that it is very difficult to go against a group even when you know it is heading in the wrong direction. This was most vividly demonstrated by the Asch experiments in the 1950s, illuminating the effects of social pressure and conformity. Soloman Asch set up a situation where the figure below was presented to a group of subjects. Unbeknown to the real subject, the other people in the room were confederates of Asch and answered incorrectly to the question of which line is the same length of Exhibit 1. In the majority of cases, and in a majority of similar examples, the real subject followed the crowd and answered incorrectly, despite the fact that the others had obviously answered incorrectly.

George Orwell’s economic insight

In Nineteen Eighty Four, George Orwell expressed the notion of ‘Doublethink’, the act of holding two contradictory thoughts in one’s mind and accepting both. While psychologists have a similar concept called ‘cognitive dissonance’, both of these ideas may describe a link between the behavioural economics described and Bernanke’s more technical description of credit cycles. One could make the argument that both the lender and the borrower who are actively participating in a bubble are holding two contradictory thoughts in their minds. One thought may be that this market is currently in a bubble and that prices cannot go on rising forever. The contradictory and over-riding thought would be that there is ‘still’ an investment opportunity to be grasped. A paper by Fehr and Tyran (2005) cites two examples that highlight these cognitions and behaviours. Firstly, in a large survey of U.S. investors, researchers found that 50 percent thought the stock market was overvalued in the last two years of the boom (1999-2000) but only 25 percent of these investors thought that it would decline. Secondly, a case study of a well-informed investor in the famous SouthSea bubble revealed that despite knowing that stocks were overvalued, the bank earned more in two years by riding the bubble than it did in the previous 20 years. Either this irrational investor behaviour or Bernanke’s Financial Accelerator may explain credit cycles on their own, but joined together they highlight the difficulty for policymakers who attempt to smooth the credit cycle.

As long as the music is playing, you’ve got to get up and dance (Charles Prince, Citigroup CEO 2007)

Some economists believe that bubbles cannot exist as investors are always rational. Even if there are irrational investors, the logic goes, in aggregate their influence will be negligible. If the 2008 crash did not destroy this concept, then academic papers such as Fehr and Tyran have demonstrated that irrational behaviour can effect the aggregate outcome. The focus of the recent IMF conference was to draw lessons from the crisis for Macro economic theory and practice. In light of this it has been suggested that a minimum loan to value ratio in the housing market should be set at 85%. This fits in perfectly with Bernanke’s theory as house price fluctuations would have less effect on the creditworthiness of a borrower. However, policy recommendations and regulations will always have to contend with human nature: it is very difficult to resist group behaviour, just as it is to resist dancing when the music is playing.

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3 responses to “Exploring Credit Cycles & Behavioural Economics

  1. Pingback: John Geanakoplos & the Leverage Cycle | globalmacromatters

  2. Pingback: How can human nature be modelled in Economics? | globalmacromatters

  3. Pingback: Adaptive Market Hypothesis, human behaviour & the Cubic IS Curve | globalmacromatters

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