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Economic psychology and boom/bust

  1. Clipped from Russell's report


    This piece below by Stephan Roach of Morgan Stanley is well worth reading. It addresses the question of when consumers are going to change their current "spend it and why worry" life-style.
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    <>Global: A Warning from the Nobel Prize

    Stephen Roach (New York)


    This year's Nobel Prize in economics is of great relevance to the debate
    currently raging in policy circles and financial markets. It gave long
    overdue credit to the breakthroughs of behavioral finance. In doing so, it
    underscores the extraordinary shock just inflicted on the American consumer
    by a popped equity bubble. These implications dovetail nicely with those
    rewarded by an earlier Nobel Prize (1985) -- the life-cycle hypothesis of
    saving, which stresses that households can only defer saving for so long.
    The combination of these two theories sends a tough message: It tells me
    that the days of resilience could well be drawing to a close for the
    over-extended American consumer.
    Princeton professor Daniel Kahneman is unique in the long string of Nobel
    Prize winners in economics -- he is a psychologist. His path-breaking
    research was actually a collaborative effort with the late Amos Tversky, a
    renowned psychologist from Stanford who is generally credited as the father
    of behavioral finance/economics. More than 30 years ago, Tversky and
    Kahneman first started to question the wisdom of textbook theories of
    individual economic behavior. They conducted a series of controlled
    experiments, some of which were aimed at sampling investor responses to
    hypothetical and actual financial market situations. (The co-winner in this
    year's Nobel Prize is Vernon Smith, who wrote the book on experimental
    economics).
    Out of the path-breaking tests of behavioral economics came a powerful
    result -- the "loss aversion motive," finding that investors are far more
    sensitive to reductions in wealth than to increases in their portfolios. The
    pain of loss was found to be well in excess of the joy of gain -- a result
    that I have long believed hints at a powerful asymmetrical wealth effect for
    a post-bubble US economy (see my April 28, 2000 dispatch. "The Asymmetrical
    Wealth Effect," which ended with the suggestion, "remember the name, Amos
    Tversky"). The caveat came in what Tversky and Kahneman called "prospect
    theory" -- that investor responses are also influenced by recent asset
    performance. Individuals who lose only "house money" were found to be less
    inclined to alter their fundamental economic behavior. Conversely, once the
    accumulation of losses eats into original investor principal, it's a
    different matter altogether.
    There can be no mistaking the implications of prospect theory for today's
    bubble-battered American consumer. All the major equity market indexes --
    the Nasdaq, the S&P 500, and the broader Wilshire 5000 -- have made
    round-trips back to levels prevailing in mid-1997. But the some $7 trillion
    loss in household equity values from peak levels prevailing in March 2000
    are just in current dollars. Adjusting for the 12% inflation that has
    occurred over that same five-year period, the opportunity cost of the equity
    bet is staggering. That's especially the case when the inflation-adjusted
    setback of about -2.5% per annum is compared with historical real returns on
    US equities that have averaged around 7% since 1800, according to Professor
    Jeremy Siegel of the Wharton School. For index-based investors, that puts
    the cumulative underperformance of the past five years about 50 percentage
    points short of the longer-term return norm. That hurts.
    It hurts all the more when these results are set in the context of another
    Nobel Prize-winning theory -- the life-cycle hypothesis of saving developed
    in the 1950s by Franco Modigliani. By pure coincidence, I had the pleasure
    of spending several hours with Professor Modigliani this week. The behavior
    of the American consumer has puzzled most of us in recent years and I could
    think of no better person who might be able to shed light on this. (Note: We
    will publish a more complete account of this fascinating give-and-take with
    Professor Modigliani at some point in the next couple of weeks).
    Like all scientists, Professor Modigliani remains steeped in the rigor of
    his discipline. He is suspicious of dismissing the evidence of a low
    personal saving rate and a devastating loss of equity wealth. While he
    conceded that has been puzzled about the lack of a consumption response so
    far, he remains convinced that one is coming. In his words, "the consumer is
    the most dangerous portion of the picture." The life-cycle saving theory is
    an intertemporal model of consumer behavior -- it stresses that households
    eventually must align their spending and saving balances in a fashion that
    is compatible with the needs of youth, middle age, and ultimately
    retirement. With the aging cohort of US baby-boomers now starting to focus
    on late-stage life cycle considerations, Professor Modigliani worries that
    "consumers are not well prepared." His theory leads to an equally powerful
    conclusion: A shift in the preference for saving is the only way out.
    We also spent some time discussing the latest rage in Wall Street consumer
    theories -- that low interest rates would provide a windfall to household
    income that would keep the consumer afloat. The record refinancing bonanza
    now under way certainly seems to hint at just such an outcome. But Professor
    Modigliani sounded a note of caution on this count as well. "For every
    borrower who gets a boost in purchasing power, there is a lender who loses."
    He went on to add that "they may be different people (borrowers and
    lenders), but it is the net effect that matters for the macro economy."
    At that point, a light bulb went on in my own atrophied brain. Years ago, my
    research revealed that there was a certain perversity to the response of US
    consumers to fluctuations in interest rates -- rising rates didn't seem to
    hurt nearly as much as most of us thought. It turns out that's because
    consumers are net lenders to the rest of the economy -- their interest
    income is well in excess of their interest payments. That still holds true
    today. For example, in 2001, US Commerce Department data show that
    households received some $1,091 billion in interest income, well in excess
    of the $592 billion paid in interest expenses. In other words, while refis
    help in a lower interest rate climate, those dependent on interest income --
    especially retirees -- are hurt. And to the extent that the consumer sector
    has more interest income than debt service, it may simply be wrong to
    conclude that surging refis are always accompanied by booming consumption.
    In my opinion, the combination of these two theories sends an unmistakable
    message: The carnage of a popped equity bubble spells a major adjustment for
    the saving-short American consumer. It's just a matter of when. Theories
    often suffer from the standpoint of timing -- they do fine in predicting the
    endgame but are often lacking in pinpointing the moment of adjustment. That
    lesson is equally important today. Just because the consumer hasn't adjusted
    yet, doesn't mean that won't be the case at some point in the not-so-distant
    future. Nobel Prizes are not to be taken lightly -- especially in this case.






























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