June 29, 2022

The Boom-Bust Cycle is Not a Greed-Fear Cycle

The CNN Index invites a simple question. “What emotion is driving the market now?”

If you ever find yourself on the business section of CNN’s website, you’ll notice a peculiar thing on the top of your screen. There you’ll find a small ticker labeled “Fear and Greed Index.”

The ticker invites a simple question. “What emotion is driving the market now?”

As an economist, I was very interested in the underlying theory and methodology CNN business was using to determine what was driving the market. Presumably, anyone who understands what drives the stock market better than anyone else is making a lot of money on it. So I looked into the details.

On the index explanation page, a detailed explanation is given.

“The Fear & Greed Index is a way to gauge stock market movements and whether stocks are fairly priced. The theory is based on the logic that excessive fear tends to drive down share prices, and too much greed tends to have the opposite effect.”

So we have the theory now. What about the application? Well the site says, “the Fear & Greed Index is a compilation of seven different indicators” and “tracks how much these individual indicators deviate from their averages compared to how much they normally diverge.”

Unfortunately, armed with this information, it’s clear that the Fear and Greed Index isn’t any good for understanding markets at all. There are fundamental problems with both the underlying theory and the measurement of the index.

Theory: Animal Spirits Reanimated

The theory behind the CNN Fear & Greed Index is not new. In fact, it’s just a new way to talk about one of the most discussed ideas in macroeconomics—animal spirits.

The idea of “animals spirits” working in investment was created by mathematician John Maynard Keynes. Keynes was convinced that irrational waves of optimism and pessimism seized control of investors and drove them to make poor investment decisions. He referred to these forces as “animal spirits.”

Have you heard of bear and bull markets? These are Keynes’ “animal spirits.”

Keynes’ thinking on this topic has so permeated culture, that most of my students come into my macro class as default Keynesians without even knowing who Keynes is. I like to start my first day macro class with a quiz which asks students what they think causes recessions. Some variation of “fear” always tops the list.

In Keynes’ own words,

“There is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions … can only be taken as the result of animal spirits—a spontaneous urge to action rather than inaction”.

So what’s wrong with the animal spirits idea? Well, there are many issues. I’ll discuss four.

First, and most importantly, the explanation isn’t an explanation at all. It’s more of a label.

Consider that instead of saying waves of optimism and pessimism seize investors randomly, we could say that the universe generates good vibes and bad vibes that seize investors randomly. Or perhaps real spirits randomly control investors. How does this change the Keynesian animal spirits story?

It doesn’t. And that’s the problem with the idea. Keynes’ animal spirits explanation is essentially saying that something random (in the mathematical sense of the word) and beyond further explanation grabs hold of people and makes them do things. In other words, the explanation is something unexplainable. Fear and greed. Bear and bull. Unicorns and gargoyles.

Second, the animal spirits explanation displaces other explanations about what drives investment behavior. Before Keynes, the economics profession had a strong explanation for changing investment behaviors.

The idea is simple, and it follows the logic that undergirds all of microeconomics. As it becomes more expensive to borrow money over time, investors will borrow less money and take on more short term projects. When it becomes less expensive, investors borrow more and take on more long term projects.

The price of borrowing is called the interest rate, and interest rates are affected by savings. If people save more and increase the supply of funds available to borrow, that drives interest rates down making borrowing cheaper. Businesses make long term expensive projects while consumers save for them.

Although Keynes was unclear about his belief about saving an investment (in some places he says savings equals investment and other places he says it does not) the effect of animal spirits was to break the theoretical linkage between the two among economists. Basic economics was out and animal spirits were in. “Macroeconomics” was born.

Third, Keynes’ theory of random fear and greed leads to an underdeveloped view of how expectations are formed. In the quote above, Keynes argues investors won’t be “mathematical” about expectations. In other words, they aren’t acting in an internally consistent way given different probabilities and uncertainties.

This may sound reasonable at first. Economists who believe people do not consistently make the same mistake over and over (sometimes called rational expectations) are often derided because some think it implies people make their decisions by doing mathematical equations.

But this is a straw man. These economists do not believe people actually run sets of equations in their head. They believe that human behavior happens in a way that looks like they do.

For example, I don’t believe mountain goats calculate their jumps down to determine if the distance is fatal or not. But I do believe they act like they do that. Mountain goats who consistently misjudge jumps will literally die out. Similar channels operate in investment.

This under-developed expectations theory led to problems for Keynesian economists in the 1970s. These Keynesians wrongly believed they could consistently lower unemployment by printing money and tricking workers into taking jobs which seemed to be high paying. However, when inflation hit, workers’ expectations changed and unemployment soared. This was the first instance of “stagflation”—a situation involving high inflation and slow or negative economic growth—in US history.

So what is a good theory of expectations in place of Keynes? My position on this is with economist Ludwig von Mises who quotes Lincoln’s law (which may not have been said by Lincoln) in saying, “you can fool some of the people all of the time, and all of the people some of the time, but you can not fool all of the people all of the time.”

Fourth, Keynes applied his theory of animal spirits inconsistently. In investment markets, irrational pessimism and optimism reigned, but, as economist Murray Rothbard points out, Keynes excluded the possibility of animal spirits for the class of politicians and technocrats. As Rothbard highlights,

“this class, this deus ex machina external to the market, is of course the state apparatus, as headed by its natural ruling elite and guided by the modern, scientific version of Platonic philosopher kings. In short, government leaders, guided firmly and wisely by Keynesian economists and social scientists (naturally headed by the great man himself), would save the day.”

While this asymmetry in Keynes’ work does not undermine the explanation of animal spirits like the above three arguments do, it does undermine any application of the idea to policy-making unless a good reason for the asymmetry can be explained.

Measurement: The Past is Not the Present

I’ve done my best to provide a list of fundamental issues with the theory of animal spirits. But, CNN’s Fear and Greed Index suffers from application too.

Even if Keynes was completely right about animal spirits, the index would still not be much good.

Remember the methodology. The index tracks today’s deviations in asset values and compares them to historical averages of past deviations. But there is a fundamental problem here. Historical averages have nothing to do with modern valuations, and historical deviations tell us nothing about what modern deviations should be.

Imagine you built your house in 1970 and put in shag carpets. Now you’re selling the house and buyers tell you the shag carpets are something that takes away from the value of the house. You reply, “but I spent $300 on this carpeting!”

Alas, it doesn’t matter what shag carpets were worth in the 70s. It matters what people value them at today. The same hold for deviations of value. If hardwood floors are still popular in 2050, the shag carpet seller can’t argue that shag carpets shouldn’t deviate in value since hardwood floors didn’t. It simply does not follow.

There are plenty of good reasons why modern assets should deviate further below average than usual. For example, natural disasters and weather patterns could cause assets to fall below their average more than usual. Also, even if investors don’t systemically error, they can still error. Bad policies could drive investors to make bad investments which, when realized, cause the value of assets to fall further from average than usual.

In other words, an asset falling further in value than usual does not imply the market is responding to “fear.” These assets could be responding to real changes or discovered facts about the economy.

To use an extreme example, imagine an earthquake destroyed the headquarters of most major companies in the US and they all temporarily suspended operations. This would certainly take stocks to historic lows.

The CNN Fear and Greed Index would measure this drop and say that fear is driving the market. But it’s obvious that fear isn’t the cause of this drop—the earthquake is. The fact that people may feel afraid is irrelevant to the cause.

Perhaps not coincidentally, this measurement of “fear and greed” makes the same fundamental mistake of the animal spirits. The index observes when asset prices are further down than usual and simply names the phenomena “fear.”

But labeling a market change “fear” does not mean fear is driving the market. It means you named something.

The index simply assumes what has yet to be proved. A bust by any other name is just as sour. And calling the bust fear doesn’t make us any more informed about it.

This article, The Boom-Bust Cycle is Not a Greed-Fear Cycle, was originally published by the Foundation for Economic Education and appears here with permission.  Please support their mission.