Trust, Emotions, Thresholds, Herding and Contagion Alan Kirman Presentation at the THEfoDA...

Presentation at the THEfoDA discussion forum Mallorca May 9th 2013

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Trust, Emotions, Thresholds, Herding and Contagion

Alan Kirman


Bob Shiller

• Of course, the problem with economics is that there are often as many interpretations of any crisis as there are economists. An economy is a remarkably complex structure, and fathoming it depends on understanding its laws, regulations, business practices and customs, and balance sheets, among many other details.

Presentation at the THEfoDA discussion forum Mallorca May 9th 2013 2

Bob Shiller

• Yet it is likely that one day we will know much more about how economies work – or fail to work – by understanding better the physical structures that underlie brain functioning. Those structures – networks of neurons that communicate with each other via axons and dendrites – underlie the familiar analogy of the brain to a computer – networks of transistors that communicate with each other via electric wires. The economy is the next analogy: a network of people who communicate with each other via electronic and other connections.


Bob Shiller

The brain, the computer, and the economy: all three are devices whose purpose is to solve fundamental information problems in coordinating the activities of individual units – the neurons, the transistors, or individual people. As we improve our understanding of the problems that any one of these devices solves – and how it overcomes obstacles in doing so – we learn something valuable about all three.

http://www.project-syndicate.org/commentary/the-neuroeconomics-revolution#01DugqtByVO8W50F.99


http://www.project-syndicate.org/commentary/the-neuroeconomics-revolution%2301DugqtByVO8W50F.99

http://www.project-syndicate.org/commentary/the-neuroeconomics-revolution%2301DugqtByVO8W50F.99


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Hume: Reason and Passions

• “Reason is and ought only to be the slave of the passions, and never pretend to any other office than to serve and obey them.”Treatise bk 2 pt 3

“Never literary attempt was more unfortunate than my Treatise on Human Nature. It fell dead-born from the press”

My Own Life, ch 1


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Empathy and affection

• Empathy was originally defined to be the capacity to put oneself in the other’s place and this was typically with respect to emotions.

• Adam Smith’s examples deal with the case of somebody watching someone else having a painful experience.


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A More Cognitive Approach

• « Your corn is ripe today, mine will be so tomorrow. ‘Tis profitable for us both that I should labour with you today, and that you should aid me tomorrow, I have no kindness for you and know you have as little for me. I will not, therefore, take any pains upon your account; and should I labour with you upon my own account, in expectation of a return, I know I should be disappointed, and that I should in vain depend upon your gratitude. Here, then I leave you to labour alone. You treat me in the same manner. The seasons change and both of us lose our harvest for want of mutual confidence and security ».Hume, 2000: 520–1


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Empathy: Understanding or Feeling?

9Presentation at the THEfoDA discussion forum Mallorca May 9th 2013


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Mirror Neurons

• These have received a great deal of attention though they have not been shown to exist in humans??

• The idea is that the observation of the movements or gestures of others triggers the same actions in the observer but this is not conscious.

• There has been a lot of incautious extension of this idea to cognitive activities in humans.


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Mentalising and Intentionality• The mentalising idea is intimately linked with the notion of

understanding the intentions of others. This, it is argued is a uniquely human attribute.

• Yet in macaque monkeys, grabbing reflexes are activated when a monkey sees another monkey grabbing for food, whilst no such activation occurs if the same gesture is made when there is no food and the monkey grabs an object to put it elsewhere.

• Thus, at least in the immediate present, the intentionality of gestures may be interpreted


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Common Knowledge

• By this is meant that not only do people know what others know but they know how all the participants in the game or economic activity reason and it is this that allows them to reach equilibria.


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Behaviour in Groups

Optimising or Learning ?


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A curiosity

• Hume argues at one point that it is difficult to predict the behaviour of an individual whereas the behaviour of groups, particularly large groups is much more predictable.

• The basis for such an argument now would be some sort of independence of the behaviour of the individuals.

• Yet often Hume argues that it is the interaction between individuals that is an important determinant of their behaviour.

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Isaac Newton

« I can calculate the motion of heavenly bodies, but not the madness of people »



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Past and Present• This brings us to the argument about the uniqueness of humans

which invokes our capacity to invoke the past and to use it to influence or predict what will happen in the future.

• This problem goes back at least to Hobbes and was discussed by Hume (1740) who was perhaps the first to make explicit reference to the role of mutual knowledge in coordination. In his account of convention in A Treatise of Human Nature, Hume argued that a necessary condition for coordinated activity was that agents all know what behavior to expect from one another. But, he does not argue that by so doing they will reach a good outcome.

• Yet ants and bees convey information about sources of food that they found in the past in order to induce others to use this information in the future.


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Expectations• « A very natural next step for economics is to maintain expectations in

the strategic position they have come to occupy, but to build an empirically validated theory of how attention is in fact directed within a social system, and how expectations are, in fact, formed. Taking that next step, requires that empirical work in economics take a new direction, the direction of micro-level investigation proposed by Behavioralism. »

Herb Simon (1984)

Perhaps BIG DATA can help in conjunction with the sort of experiments presented by Cars.


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Consistency of forecasts• Surveys indicate a considerable difference in individual forecasts

of economic variables• We know that even expert forecasters differ widely in their

forecasts even though (luckily) their forecasts tend to converge as the forecast horizon approaches.

• Efforts to explain the fact that the forecasts do not seem to be consistent with rational expectations have taken several forms.

• One idea is to concentrate on forecast revisions and for this, in particular “sticky information”(Mankiw) or “noisy information” (Woodford) models have been proposed.

• But given the dispersion of forecasts none of these alternatives can, alone, account for the differences


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Lessons from Social Insects

• Social insects achieve a great deal of coordination• Their behaviour on close inspection is far from

optimal• They can hardly be said to have rational

expectations• They act on local information and follow simple

rules• Are we nearer to them or to people who are

rational optimisers?


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Lesson from 6000 years ago

• "Look to the ant, thou sluggard. Consider her ways and be wise. Without chief or ruler or overseer she gathers her harvest in the fall to save for the winter."Book of Proverbs, The Old Testament


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The Phenomenon

• The basic mystery about ant colonies is that there is no management. A functioning organization with no one in charge is so unlike the way humans operate as to be virtually inconceivable. No insect issues commands to another or instructs it to do things in a certain way. No individual is aware what must be done to complete any colony task. Each ant scratches and prods its way through the tiny world of its immediate surroundings. Ants meet each other, separate, go about their business. Somehow these small events create a pattern that drives the coordinated behavior of colonies.Deborah Gordon Ants at Work


Ants

• Ants learn in an environment of which they have only very limited and local knowledge.

• Yet they produce quite sophisticated aggregate behaviour.

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Ants learn to find the route to food

• Ants communicate with each other

• either through a pheromone trail

• or by tandem recruiting.

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Bees and their sophisticated aggregate behaviour


Ants learn to find the route to food

• Ants communicate with each other

• either through a pheromone trail

• or by tandem recruiting

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Self Organisation• This idea that markets self organise was espoused by

Hayek• This has been used as a justification for not

interfering with markets.• Markets do clearly self organise but we have no

reason to believe that this is a stable process nor one which leads to optimal outcomes.

• As the actors within them modify their rules new norms appear and these can gently lead the system to major “phase transitions”.


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The Efficient Markets Hypothesis

• This is very simple• All relevant information is contained in prices

therefore there is no need to look anywhere else: paradox

• This basic argument comes from the work of Bachelier but his thesis adviser said…



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No panic !

Un Avertissement

• Quand des hommes sont rapprochés, ils ne se décident plus au hasard et indépendamment les uns des autres ; ils réagissent les uns sur les autres. Des causes multiples entrent en action, et elles troublent les hommes, les entraînent à droite et à gauche, mais il y a une chose qu'elles ne peuvent détruire, ce sont leurs habitudes de moutons de Panurge. Et c'est cela qui se conserve

Henri Poincaré Report on Bachelier’s thesis 1900


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Where does the efficient markets hypothesis go wrong?

• Remember Poincaré’s warning• Individuals do not only look at their own

information they also observe the actions of others and infer information from those actions.


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Looking into the sky quickly gets passers-by to follow.



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Sudden Aggregate Changes


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The Dow Jones 1990-1999


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Where did the change come from?

An Exogenous Shock??

A note on macroeconomic shocks

Condemned to work in an equilibrium framework the only explanation for sudden and major changes in the economy were exogenous shocks.

“Those of us who worry about endogenous uncertainty arising from the interactions of boundedly rational market participants cannot but scratch our heads at the insistence of the mainline models that all uncertainty is exogenous and additive.” Buiter (2009).

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forum Mallorca May 9th 2013 52

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Where did the switch come from?

• Our ants offer us an explanation• If all the agents herd on one forecast then that

will be realised• But eventually they will all shift to another

one causing a radical change in prices



How might we use the ants’ behaviour to model financial markets?

• Think of two types of agents’ forecasting rules• Fundamentalists who believe that prices will

come back to some « fundamental » level• Chartists who extrapolate from previous

prices.• Success of one rule reinforces the recruitment

to that rule.

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Models in this spirit• With Hans Foellmer and Ulrich Horst,we have built models of

financial markets to help understand where these sudden changes come from

• These models incorporate the idea that people follow the behaviour of others particularly when that behaviour is successful

• The behaviour is not irrational. Horizons.• These models capture the contagion effects• There is structure in financial time series but no convergence

to equilibrium in the standard sense.

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A Very Simple Example• So what we must do is to build models which capture

the role of the interaction between individuals, their local rationality and the impact of this on the aggregate evolution of the market or economy.

• The idea of our example is to show how the gradual but rational adoption of rules at the individual level may lead to radical change at the aggregate level

Presentation at the THEfoDA discussion forum Mallorca May 9th 2013 59Presentation at the Workshop for Chief

Economists of Central Banks, Bank of England May 2010


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Conclusions

• Aggregate decisions are not, in general, akin to individual decisions. Collective behaviour reflects the interaction between individuals.

• Rationality and emotions are intertwined• Thresholds play an important role• Looking at the way in which insects achieve organisation

and collective behaviour can provide an important source of understanding for social and economic systems.

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For those who wish to know more


Trust, Emotions, Thresholds, Herding and Contagion Alan Kirman Presentation at the THEfoDA...

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