Watching asset price movements here in India, this year's Nobel Prize in Economics could not have been more relevant or timely. India's equity markets as measured by the headline Sensex, closed at over 20,600 last evening. Less than 2 months ago, it had plummeted to less than 18,000 points. So what has happened since August 21 and October 14? A few changes, but clearly not unambiguous positive trends here.
This year's nobel has been awarded to 3 American economists for spending much of their careers in studying asset markets and making notable contributions in understanding asset price movements better. Of these, perhaps one of the most famed one is Robert Shiller. Anyone who has followed the US economy with some interest is unlikely to have missed Shiller, who is one half of the Case-Shiller house price indices, an important indicator of asset prices and larger macro economic trends. Shiller, a Yale economist, he has spoken of the role of human psychology in making financial decisions and that that economic agents may not always be entirely rational.
Here is a concluding excerpt from Shiller's 2007 paper "Understanding recent trends in house prices and home ownership" where he talks of psychology and its' relation to financial decisions:
"People’s opinions about long-term decisions, notably how much housing to buy and what is a reasonable price to pay, change in the short term only because their opinions about the long-term change. But, these opinions about the long-term are hard to quantify because they are usually not expressed. They are usually expressed only in story form, in attention given to homespun theories, and the like.
People base life decisions upon vague expectations for the future, and if they have the false impression that they have a unique property that is going to become extremely valuable in the future, then they may consume more, driving the economy, and they may drive up prices today. That is what we have seen happening over much of the last decade. The psychological expectations coordination problem appears to be a major factor in explaining the extreme momentum of home price increases. Investors who think that home prices will continue to go up because they perceive prices as going up generally around the world may not change this expectation easily since they will have trouble coordinating on a time to make the change. A housing supply response to high prices will tend to bring prices down, but the increment to housing supply in any one year is necessarily tiny given the nature of construction technology, and that supply can be absorbed easily if expectations are still strengthening. "
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