Glass half empty: Market pessimism may be root of financial crisis

UNIVERSITY PARK, Pa. — While the stock market is generally believed to be merely a barometer of economic health, new research co-authored by a professor at Penn State’s Smeal College of Business finds the pessimism in our stock markets may actually be the cause of our struggling economy, rather than just an indicator of it.

Negative beliefs

In the current financial crisis, the rapidly spreading negative beliefs about the value of mortgage-backed securities may have contributed more to the economic meltdown than the actual properties of those securities.

That is, negative perceptions about the economy may weigh more heavily on economic performance than the actual health of production and investment activity that drives the economy.

“Our research shows markets can exacerbate the negative,” said Anthony Kwasnica, associate professor of business economics at Smeal, who conducted the research along with Shimon Kogan of the University of Texas and Roberto Weber of Carnegie Mellon University.

“Even when fundamental economic properties remain unchanged, we find financial markets can lead investors to highly pessimistic beliefs that become self-fulfilling and can cause the economy to underperform.”

Kwasnica said short selling and other techniques that reward negative performance communicate pessimism about the economy that can infiltrate the markets and may actually cause economic performance to dip into the negative.

In the current U.S. economy, with the news media constantly focused on the stock market’s performance, the negative effect of perceptions can do even more damage, the researchers said.

As more and more bad news is conveyed by the stock markets, pessimistic beliefs are reinforced over and over again and the markets can make a bad economy worse, and do so quickly.

Two fixes

To get out of this vicious cycle, Kwasnica and his coauthors said there are at least two fixes that are already at work in the U.S. economy now.

The first option is to quiet some of the pessimistic views on the economy by disallowing investors to profit from negative predictions that come true.

The recent ban on short selling is one example of this remedy.

Leadership

However, the best way to put an end to the rapid spiral of pessimism is through leadership, the researchers said.

The major investments made recently by billionaire Warren Buffett are one example of such leadership, although the authors caution that his actions and reassurances aren’t enough to overcome all the pessimism currently impacting the economy.

Experiments

The researchers used two experiments to examine how the performance of an economic system can be damaged by trading in financial markets.

One of those experiments, a coordination game, allots each individual a set of assets, which the individual may invest in a pool that pays out according the lowest contribution level.

For example, if every player contributes all of their assets, then the payout is maximized. But if one player contributes less than the maximum, then all of the other players lose some of their investment.

According to Kwasnica, prior research shows the simple economies created by the coordination game typically run efficiently when there are three or fewer players involved.

That is, each player maximizes his return. However, when the researchers introduced markets in which investors bet on the success or failure of the coordination game economies, that efficiency was lost.

In their experiment, when the markets forecasted a negative outcome for the coordination game, that result was realized most of the time.