Published by EH.NET (February 2002)
Bertrand M. Roehner, Hidden Collective Factors in Speculative Trading: A
Study in Analytical Economics. Berlin: Springer-Verlag, 2001. xvi + 229 pp.
$49.95 (cloth), ISBN: 3-540-41294-8.
Reviewed for EH.NET by David A. Zalewski, Department of Finance, Providence
College.
Eric Kandel, who shared the 2000 Nobel Prize in medicine with Paul Greengard
and Arvid Carlsson for his work on human cognition, began studying brain
physiology after he realized the limits of psychoanalysis in explaining
behavior. Intrigued by the possibility that various organisms share biological
features that influence memory, Kandel began studying simple creatures for
insights on brain function. Specifically, he focused on Aplysia, which are sea
slugs that appear to learn despite having nerve cells that are larger in size,
but smaller in number than those found in people. Ultimately, what Kandel
discovered about the function of Aplysia synapses during cognition provided him
with profound insights into how the human mind works.
Are there any Aplysia for economists to pluck from trading floors to conduct
similar inquiries into speculative behavior? Experimental economics most
closely resembles Kandel’s methodology; however, as Bertrand M. Roehner notes
in this book, these studies cannot adequately capture the complex forces at
work in modern financial markets. This leaves two substantively different
approaches for studying this issue. One is standard economic inquiry in which
scholars first formulate theories of market behavior based on the assumption of
investor rationality and then empirically test their hypotheses. According to
Roehner, these scholars have it backwards. Researchers should start with
empirical analyses to detect regularities in the data over time or across
markets and then attempt to understand the forces generating them. This
approach has become known as econophysics, which has recently grown in
popularity. Although Roehner’s success in isolating several intriguing
speculative price patterns reflects positively on this methodology, he falls
short in the more difficult task of explaining the behavior responsible for
these results.
Roehner follows the opening chapter in which he outlines the econophysics
approach by describing the markets in his sample. Because he intends to derive
general principles from observed similarities in price behavior, Roehner
includes as many “speculative” markets as data availability permits. It is the
inclusion of unconventional markets such as those for antiquarian books,
postage stamps and diamonds that distinguishes this work from others that
usually focus on equity markets. Moreover, Roehner carefully describes the
relevant institutional details for each market, and his inclusion of property
and stock price data series will be helpful to those who wish to replicate his
findings. Of course, determining whether speculation drove price spikes or if
they resulted from changes in fundamentals can be a speculative exercise in
itself. However, I believe most readers will agree that the markets studied
were at least partly influenced by speculative forces, despite the fact that
Roehner could have provided more evidence justifying the existence of bubbles.
Roehner’s most significant contribution is his discovery of common speculative
price patterns across several markets. These include the price multiplier
effect, which describes a direct relationship between price amplitude and the
level of prices at the beginning of the speculative episode. Moreover, Roehner
finds that speculation in property markets spreads to contiguous regions
despite a decline in price momentum as the speculative impulse disperses. The
result is that speculative peaks lag both in time and in amplitude across
regions. Moving down the price distribution curve, Roehner next uncovers a
sharp-peak, flat-trough pattern for many prices. Specifically, commodity prices
often increase rapidly during speculative periods and then decline at a slower
rate after they reach their maximum. On the other hand, Roehner shows that real
estate prices often follow a flat-peak, flat-trough pattern in which rates of
change are slower on both sides of the curve. Roehner attributes this behavior
to time lags in market responses, which are more common in property markets
than for commodities.
A note of caution to prospective readers concerns the background required to
understand the empirical chapters. The jacket notes claim that the book is easy
to read and requires no technical background in economics, finance or
mathematics. This statement misrepresents the content of these chapters, which
include log-linear regressions, bounded Pareto distributions, and Green’s
function of the standard diffusion equation. Although most of the book does not
include mathematics at this level, Roehner’s use of these tools is critical to
establishing the empirical regularities that form the core of his work.
Are there any explanations for this price behavior? Because econophysics does
not provide Roehner with a theoretical foundation for interpreting his results,
he considers several unrelated factors in a somewhat disorganized fashion. For
example, Roehner presents three chapters on speculative behavior before
isolating and describing his findings, which more closely follows mainstream
methodology than econophysics. Many of the influences Roehner describes, such
as the role of the media, patterns of emulative behavior and the prevalence of
speculators versus end-users in the market, are well known. Moreover, Roehner’s
argument that what is rational in an economic sense depends on the social and
cultural environment of the period is puzzling. Roehner’s definition of
rationality differs from the standard one, which is merely an assumption about
human behavior. Under the conventional interpretation, what Roehner considers
conditionally rational is actually irrational or euphoric. This point, along
with the absence of any reference to work in behavioral finance, suggests that
Roehner is unfamiliar with this literature. Moreover, Roehner also does not
evaluate mainstream explanations for speculative behavior such as excessive
credit expansion or policy mistakes.
Although behavioral finance helps explain market phenomena that long puzzled
mainstream economists, many scholars argue that theories based on “psychology”
are unscientific and lacking in rigor. As Roehner correctly points out,
however, the unanswered questions of financial economics require an
interdisciplinary approach. This brings us back to biology, which may usefully
supplement econophysics in helping scholars understand market behavior. In a
recent study, M.I.T. economist Andrew Lo and Boston University neuroscientist
Dmitry Repin measured the physiological responses of currency traders to market
developments. They found that traders — especially less-experienced ones —
reacted emotionally rather than rationally to changing economic and market
conditions. Because this study did not examine the extent to which emotions
influenced decision making, more work is needed in this area. If studies of
this type can eventually provide a biological explanation for collective
impulses that influence financial decision making, researchers may finally
uncover the “hidden factors” that underlie speculative bubbles.
David A. Zalewski is Associate Professor of Finance at Providence College. His
most recent publications in economic history are “To Raise the Golden Anchor:
Financial Crises and Uncertainty during the Great Depression,” (with J.P.
Ferderer), Journal of Economic History, (September 1999) and “Stock
Market Speculation and Federal Reserve Policy: Lessons from the Great Bull
Market,” Essays in Economic and Business History (2000).