Observation
Economists build models using assumptions that all too often fail to reflect the reality that there is a lack of convergence between belief and reality. The classic efficient market hypothesis assumes that people have equal and timely information and that markets are efficient and always clear, namely markets reflect true value of the assets being traded. This premise is wrong most of the time. There is a frequent failure of reality and belief to align. Economics also fails to both understand this fact and its models all too often fly in the face of reality. The appropriate aphorism for this is: Do you believe me or your lying eyes? The problem is that people often act on belief, facts be damned. In addition there is a herd mentality associated with belief. Yet there is an objective reality, house prices are too high, and the belief being that they will continue to go that way. The challenge is how does one incorporate a belief set, and in reality a stochastic belief set, into economics. People have trust in their belief. Yet trust also can go from total trust to total lack thereof.
Discussion
This assumption is also called the efficient market hypothesis, or a few other names, and is at the heart of many if not all of the models economists use in modeling the economy.
In reality the markets fluctuate from being efficient and to being highly inefficient. Namely there are times when people have equal information, they act rationally, and the price reached in the market reflects the value of what is being transacted. On the other hand there are times when there are bubbles, people have little information and they act irrationally and the price fails to reflect any reality. Real estate bubbles are common. I would also argue that there are bubble being created in university level education, namely the price being paid is a gross distortion of the value being produced. One could also make a similar argument with respect to health care.
Now there is also the dichotomy between when the EMH is valid, namely when the market is fair, and when people believe it is valid, namely what people think. Bubbles typically result when people believe it is working, namely when EMH is valid, but when it is actually not functioning. This is the dichotomy between belief and reality. There are times when they align but all too often they do not and that lack of alignment leads to bubbles and market collapse.
This has been called the Rowe conjecture, the fluctuations between reality and belief. Economists have assumed a consistent alignment of reality and belief. Rowe has conjectured that reality and belief may not always align, and in fact may have some cyclic behavior. We can show that the balancing of reality and belief is a fundamental element of the instabilities in the markets.
Basis
There is a herd mentality and the time scale of the herding may be affected by the media available but it exists and demonstrates a stickiness factor which means it does not adapt or reflect reality in an instantaneous manner.
Examples
Bubbles are the most common of the examples here and the housing bubble is the most recent of them. Bubbles occur when reality and perception have a tendency to flip.
Implications
All economic models assume alignment of reality and belief. In reality that is not the case and people often act on belief and not reality. An example is inflation, peoples actions are often driven by expectations of say an inflationary trend.
Model
The above is an analytical model of belief versus reality in want was assumed an efficient market. Note that it cycles, namely this is the phase plane plot and the (belief, reality) points moves along this curve. Thus there are times when reality says there is no efficient market, namely a Bernie Madoff type market exists, and for a while everyone believe it cannot happen and then after a while they believe in the reality.
Conclusions
Economics must factor belief as well as reality. Belief is difficult to measure but it is a powerful force in markets, whether efficient or otherwise.
Posts
