5. Are emotions causal in markets?

Mike Joffe

Imperial College London


As everyone in the UK now knows, it has become ever more difficult for first-time buyers to get onto the property ladder. This is especially true in London, making it extremely difficult, e.g. for young couples – as documented for example in the Financial Times in November 2013.[i] Rapidly rising prices in 2014 are adding to that pressure. What are the wider implications?

Mixed emotions in rising markets

Consider the emotions of a first-time buyer looking for a home for her own use, not for resale. From everyday experience, as well as from considerations of plausibility, she is worried – that a potential home that is affordable now will be out of reach if she doesn’t find a place soon, or there is a delay in the sale going through.

To put this more generally, the effect of a rapidly rising market is to create anxiety among buyers: that they will miss out, if property prices continue to rise faster than the combination of their available deposit plus the mortgage that their incomes can justify. This pressure to complete the sale as quickly as possible creates the conditions under which buyers will be prepared to offer more in the short term, in order to avoid delays. This in turn fuels the rising market. Sellers are only too willing to accept the higher offers, or alternatively they can wait and watch their assets rise in price.[ii] Thus, in the context of owner-occupation, it would seem that a rising housing market is driven by reciprocal causation: a perception that prices will rise creates anxiety, and this in turn maintains the upward momentum – for as long as this process is able to maintain itself.

The circumstances are different in financial markets or other contexts where buying is primarily for resale: here the emotion associated with rising asset prices is likely to be excitement, even euphoria. The same is likely to be true in housing markets, on the part of investors: people who are buying for commercial reasons, i.e. a combination of rental and capital gains. Reciprocal causation would seem to apply here too, with the prospect of profiting from a rising market creating a buzz, which in turn further stimulates the upward movement.

The question of “animal spirits”

The latter is typical of the situation studied by Akerlof and Shiller in their book “Animal Spirits”.[iii] They make a mostly convincing case that rises and falls in the economy – especially in property and financial markets – are due not to economic motives and rational calculations, but rather to psychological factors, specifically confidence, fairness, corruption and anti-social behaviour, money illusion, and stories. Confidence is subject to a multiplier – optimistic belief and trust create confidence in further dynamism, leading in turn to more optimism and trust. The opposite is true in a downturn. These movements are accompanied by stories, for example “real estate markets never fall”, which come and go with the macro fluctuations.

I do not doubt that such emotions may exist in some systematic way. But the question I am asking here is whether they are causal, i.e. the properties (price movements) of the market are attributable to them.[iv]

Returning to housing markets, I have suggested that upward movements could result from reciprocal causation involving emotion: anxiety in the case of owner-occupiers, and excitement among those with a commercial motive. In practice, however, the situation is mixed – in particular, both may coexist in the same market. Does it then make any sense to say that an upward movement is due to emotion, if it is both anxiety and excitement?

An explanation that does not rely on emotions being causal: trend extrapolation

A far more convincing account is possible, also involving reciprocal causation: an upward price movement leads to the widespread perception of a rising trend, and this is then extrapolated to form the prediction that prices will continue to increase, which in turn influences price-setting behaviour. This focus on trend extrapolation is compatible with the evidence on bubbles, in which context it may be accompanied by herding, e.g. on the basis of trend-following analyses. (Additional factors may also accentuate a bubble, e.g. excess liquidity, or moral hazard.)

Such trend extrapolation is based on a judgement – almost a calculation, albeit not as precise as is assumed in some economic models, and certainly far from the assumption of perfect foresight. It will only be effective if this judgement is widely shared, and this is likely to be on the basis of stories that circulate, e.g. in the media, as Akerlof and Shiller describe. Trend extrapolation can sometimes be accompanied by emotion, e.g. anxiety or excitement; the simplest view on its causal status is that any emotion is epiphenomenal, i.e. it is caused by the perception of a rising trend, but plays no part in stimulating further price rises. However, this is not necessarily the case – it is possible that strong feeling can add additional impetus to the fundamental response based on trend extrapolation, which is an empirical question.

Akerlof and Shiller provide a one-sided account of the housing market in chapter 12, “Why do real estate markets go through cycles?”, which is posed entirely in terms of investment and opportunity rather than owner occupation (although “last chance ever to buy a house” does get a mention later, on page 169). And they are inconsistent on the question of whether emotions play a causal role. Causal language is avoided in certain passages, e.g. on page 67, “When the market collapsed in 1929 the stories changed completely”. On the other hand, In some passages in the book, and in other writings, causation is asserted. For example, Shiller has written “A speculative bubble is a social epidemic whose contagion is mediated by price movements. News of price increase enriches the early investors, creating word-of-mouth stories about their successes, which stir envy and interest. The excitement then lures more and more people into the market, which causes prices to increase further …”[v] [emphasis added]. The former non-causal, or at least agnostic, statement is far preferable as an account of what actually happens.

Emotion vs. rationality: a false dichotomy

Animal spirits is written explicitly as an antidote to over-reliance on accounts of economics based on the rational pursuit of self-interest, the invisible hand, and the notion that markets are always self-correcting and/or express all existing information. They are undoubtedly correct that the extreme conception of rationality found in some traditional economic theory is a poor description of reality (although it may sometimes be justifiable as a modelling assumption). But to respond by suggesting the opposite is an over-reaction, which portrays the situation as more polarised than it really is.

If rationality (in this ideal form) and emotion are unconvincing as explanations of how the economy works, what other interpretation is appropriate? The system as described above only requires a rather weak form of situational rationality to operate: the traditional view in economics that people tend to respond to incentives, plus realistic psychological processes – in the present instance, that people tend to extrapolate trends. Economic reality is not well served either by the assumption of extreme rationality, nor by reacting to the opposite extreme and insisting on the primacy of emotions. All economic behaviour is human behaviour, and ought therefore to be described in such terms – of the calculations performed on the basis of people’s actual computational ability, the heuristics involved, the social influences, and so forth – the results being largely rational but only in a rather weak sense. This description would be compatible with foresight in the context of uncertainty (here dominated by trend extrapolation). It would also be compatible with multiple causation, i.e. the fact that other factors may be operating.

Systems and individual behaviour

To summarise, we have arrived at a description of how bubbles appear to work. It involves a system of reciprocal causation, i.e. reinforcing (positive) feedback, driven by trend extrapolation, along with the tendency to respond to incentives.[vi] But once one starts thinking seriously about economic fluctuations from a systems viewpoint, it quickly becomes clear that reinforcing feedback is not the only possibility – cyclical behaviour can occur without a bubble. In the systems world it is well known that balancing (negative) feedback systems can also produce boom and bust if there is significant delay in the system.

An excellent description of commercial real estate market fluctuations due to balancing feedback with delay is given by Sterman,[vii] who provides a model structure that explains the observed behaviour, augmented by field-study and laboratory evidence. In an upswing with rising demand for space, many new projects are started; after 2-5 years their completion leads to excess capacity. If developers were able to take account of the supply line of buildings on order and under construction when estimating future supply, they could avoid the overbuilding. The evidence shows that in contrast, construction still continues after the price peak. Interviews with senior executives in leading real estate firms showed that their mental models do not take account of cycles, time lags, or any related dynamic concept – they have no understanding of the underlying feedback structure. Their focus instead is on such factors as location, availability of finance, etc – always with a short-term time horizon, merely extrapolating recent trends. They are subject to pressure and herd mentality, and rely heavily on intuition and ego. In addition, on the upswing in the cycle, speculative behaviour tends to occur – reinforcing feedback (a bubble) superimposed on the baseline that is already fluctuating due to balancing feedback with delay. The lenders who financed the projects are subject to similar behavioural tendencies.

One lesson here is that it is all too tempting to see the economy as driven directly by the behaviour of individuals, whether this involves emotions or the contrary concept of rational calculation with perfect information. However, a better fit to the observed performance of the economy can be achieved by an analysis based on systems principles, including attention to the behavioural features that propel the system. This has a broader significance, given the importance of system behaviour in the economy.

A second lesson is based on the observation that the features of the real estate market documented by Sterman are specific to that context, and do not apply even to other types of market that are prone to bubbles, such as stock markets. Different types of market have different dynamics.


[i] http://www.ft.com/cms/s/2/24f4b0b2-57c4-11e3-86d1-00144feabdc0.html#axzz2y1YWdcOF

[ii] I do not know of any high-quality evidence whether or not this account is accurate, but I am ready to be corrected if anyone knows of evidence that it is not.

[iii] Akerlof GA, Shiller RJ. Animal spirits. Princeton University Press, 2010.

[iv] I am dealing here with price setting in markets, not with the emotions and broader behavioural aspects involved in setting up a business, or in a major new investment by an existing business. These can include e.g. ambition, determination, passion for the subject matter, etc – in addition to excitement and anxiety.

[v] Shiller RJ. Bubbles without markets. Project Syndicate, 2012.  http://www.relooney.info/0_New_14411.pdf

[vi] There is a lot more that could be said about system causation, but that is a large topic in itself.

[vii] Sterman JD. Business dynamics. Irwin McGraw-Hill, 2000, pp 698-707.



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