Saturday, February 18, 2012
People paid extraordinarily high prices for houses because they felt they were trailing the Joneses. Brokers sold unsound mortgages because they had to keep up with rival brokers. Funds managers - remunerated according to their relative performance against other managers - traded shares with the same motive.
So, the study of herd behaviour must be a pretty important part of economics, right? Wrong. Between 1970 and the onset of the crisis only nine out of 11,500 articles in three esteemed economic journals discussed herd behaviour. And when they did discuss it they usually viewed it as "informational learning" - learning what I should do from your behaviour. If you hear a fire bell and see people running for the exit, you don't inquire further, you just join them.
Yeah, sure. That explains it. Fortunately, one economist who's taken a great interest in herding is Professor Andrew Oswald, of the University of Warwick, in Britain, and the IZA research institute, in Bonn. Oswald spoke about herd behaviour and keeping up with the Joneses at a conference this week to celebrate the contribution of Professor Ian McDonald, of Melbourne University.
Unlike his peers, Oswald has spent his career crossing the boundaries between economics and the other social sciences. Now he's forging links with the physical sciences and is on the board of editors of the journal Science.
On herding, Oswald took his lead from a seminal zoological paper written in 1971. "Before that article, the standard theory in biology was that herds had some inexplicable communitarian instinct," Oswald says. But the article argued that an animal clusters with others because its relative position is what matters. When you're being threatened by a predator, clustering with others reduces the chance it will pick you as its prey.
What has this to do with humans? Just our preoccupation with our position relative to others. Our desire to be in fashion - to wear what our peers are wearing - is motivated subconsciously by our strong desire to keep up.
And falling back worries us because it involves dropping down the status ladder. So, our often demonstrated desire to do what other people are doing seems to show a deep, though unconscious, concern to defend or advance our status (or rank) relative to others.
Economists have long been suspicious of survey evidence, of asking people what they think about things or why they do things. It's too subjective; how can you be sure they're telling you the truth? This is one of the profession's reservations about the study of happiness (of which Oswald has been a leader among economists).
So, Oswald has been interested in finding more objective ways to measure feelings such as happiness. When I compare your rating of your satisfaction with life with your spouse's or your friend's rating of your satisfaction, do they line up? (Yes, they do.)
He's done a lot of work using the British medical profession's system for rating people's mental health, rather than just asking people how they feel about their lives.
Another approach is to use magnetic resonance imaging (MRI scanning) to see what happens inside people's brains when they have certain feelings or encounter certain ideas.
Yet another approach Oswald is pursuing is the use of "biomarkers": can changes in a person's physiology - their heart rate or blood pressure, say - tell us about what they're thinking and feeling?
Oswald quotes the results of a study by German economists who put pairs of people in adjacent brain scanners and asked them puzzle questions, with money rewards for correct answers. They found that outperforming the other guy had a positive effect on the reward-related parts of the brain. People compare themselves with others and enjoy feeling they're winning.
You reckon that's pretty obvious? Not to an economist. Their standard model assumes away all interpersonal comparison. My likes and dislikes ("preferences") are unaffected by other people's preferences and never change over time.
Raise my income by $10 and my satisfaction ("utility") increases. Raise my income by
$20 and there's a commensurately greater increase in my utility. Raise my income by
$10 while you increase my mate's income by $20 and I won't mind a bit.
Actually, we know from happiness research that relative income (how my income compares with yours) has a big effect on how satisfied people feel with their lives.
Oswald asks whether our satisfaction from social status accelerates or decelerates as we increase in status. That is, does our pursuit of status bring increasing marginal utility or decreasing marginal utility?
This question is still being researched empirically. Oswald quotes the case of top tennis players. The gain in utility from going from being third in the world to second is likely to be much bigger than the gain from going from eighth to seventh.
But increasing marginal utility is probably limited to the very top of the status ladder, with diminishing utility applying to most of us.
We know, for instance, that though people with high incomes are happier than those with low incomes successive increases in income buy progressively smaller and smaller increases in satisfaction with life.
Another thing we know is that the rising average real incomes the developed economies have achieved over the decades haven't led to any increase in average levels of satisfaction.
This raises what Oswald calls a "disturbing possibility". "Maybe modern society is stuck," he says. "Individually, we chase higher income and 'rank', but for society as a whole this cannot be achieved."
Here's another worry: "Herd behaviour is often very natural and individually rational. But it has the potential to be disastrous for the group," he says.
"When rewards depend on your relative position it will routinely be dangerous to question whether the whole group's activity is flawed, and be rational simply to compete hard within the rules that govern success."
In the dotcom bubble a decade ago - where the shares of internet companies that had never made a dollar of profit traded for ever more ridiculous prices - those analysts who said it made no sense got fired.
"In financial markets, people are now routinely rewarded in a way that depends on their relative performance" - whether they're in the top quartile, second quartile or whatever. "That's dangerous," he concludes.