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


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).