Near rational agents and house price booms

House price run-ups, especially when they appear excessive, are difficult to explain. It is it even more difficult to explain how they are not coordinated across countries in a globalized world. Indeed, right now house prices are severely depressed in the United States, while you can have strong suspicions of bubbles in China, Norway and Switzerland. Bubbles are substantial deviations from fundamentals that could be due to some deviations from rationality or herd behavior, or both. But "rationalizing" this is a major challenge because of the apparent randomness of the occurrence of such house price booms.

Klaus Adam, Pei Kuang and Albert Marcet think they have a way to explain this using the concept of internally rationally agent. Such a agent, like the economist, does not know the true process of prices but tries to infer it from past observation using Bayes' rule. The belief about prices then becomes part of the state space and leads to some sort of path dependence. With shocks that are not perfectly correlated, it is then possible for different countries to experience different paths for house prices.

Emotions in economic interactions

How do you get people to cooperate. By increasing utility, of course, but that is difficult to measure, obviously, and there may some components beyond rationality in emotional contexts. However, we have some interesting ways to get some neurological hints about positive and negative emotions by measuring the conductance of skin. This may help to explain why people are sometimes willing to hurt themselves in order to punish others.

Mateus Joffily, David Masclet, Charles Noussair and Marie-Claire Villeval conduct an experiment where cooperation, free-riding and punishment can happen. They measure skin conductance to reveal the intensity of emotions and let players reveal whether their emotions are positive or negative. Cooperation and punishment of free-riding elicit positive emotions, the latter indicating that emotions can override self-interest. That is also because punishment relieves some of the negative emotions from observing free-riding. And one does not like being punished, which lends one to cooperate more in the future. Finally, people like being in a set-up where sanctions are possible, in particular because it allows a virtuous circle of emotions that reinforce each other and lead to more cooperation.

Inattention and bank overdrafts

It happens to everyone: you are not careful and despite having sufficient funds, your checking account is drying up at the wrong moment and you incur an overdraft fee from the bank. Oh well, you say, the penalty is somewhat stiff, but bad planning has consequences. But for those who have genuine liquidity problems or those that are really bad at planning, those fees can add up quickly and become substantial. Even on an aggregate level, it is important. Apparently, US banks earn $35 billion a year from overdraft fees, or a staggering $100 per capita.

Victor Stango and Jonathan Zinman study what can make that people avoid those fees. A lot has of course to do with education and self-discipline, thus reminders become an important tool. Indeed, they notice that people who were exposed to information about overdraft fees in surveys are less likely to incur such fees in the next month, by 12%, and this effect builds up over multiple exposures. This works best with those who need it the most: low education and low financial literacy. And as people avoid overdrafts by making fewer transactions, not increasing balances, it indicates they lower their expenses as a reaction to realizing that they may not afford that much spending. In other words, financial and economic literacy are important and should be favored.

The high welfare cost of small information failures

Are stock markets efficient in the sense that stock prices reflect all available information? This question has preoccupied finance lately as many have started to doubt the efficient market hypothesis during the latest crisis. One critical aspect of this is whether current tests of the hypothesis actually give an accurate picture, and if not whether this matters in a significant way.

Tarek Hassan and Thomas Mertens
claim that it is possible for stock markets to aggregate information properly, that small errors at the household level can accumulate and amplify if these errors are correlated, and that the welfare consequences can be substantial even if the initial errors were small. This cost emerges for a portfolio misallocation due to the higher volatility of stock prices. To get to such a result, they take a standard real business cycle model, add to it that households get a noisy private signal about future total factor productivity. They then look at the stock market for additional information to form expectations. If you allow households to be on average more optimistic than rationality in some state, and more pessimistic in others, you get the above results. Interestingly, Hassan and Mertens show that households face little incentives to correct individually for these small common errors (0.01% of average consumption), but collectively the consequences are large (2.4%). Talk about an amplification.