The Hindu Business Line : Lest your wealth ends as a bubble

WHAT is wealth? It is the product of man's capacity to think, defines Ayn Rand. Wealth is a tool to measure human welfare, Bill Gates tells Bill Moyers in an interview (www.pbs.org), when recounting how he and Melinda decided that wealth wasn't something that would be good to just pass to the children.

While that may prick the bubble of wealth-as-an-end notion that many may have, let us look at a recent research paper on www.ssrn.com titled, `Relative Wealth Concerns and Financial Bubbles' by Peter M. DeMarzo, Ron Kaniel and Ilan Kremer.

A bubble, for starters, is "an economic cycle characterised by rapid expansion followed by a contraction," as www.investopedia.com defines. Bubble is "a rise in the price of an asset based not on the current or prospective income that it provides but solely on expectations by market participants that the price will rise in the future," says Deardorff's Glossary of International Economics.

The crux of the paper on hand is that relative wealth concerns can play a role in explaining the presence and dynamics of financial `bubbles'. To appreciate how `relative wealth' works, you need to understand the `standard model', that is, where "rational agents exploit price anomalies by selling overpriced assets and buying undervalued assets". Simply put, `buy low/sell high'. Tough to practise, you'd fret, but this model `eliminates price distortions in equilibrium'.

Enter `relative wealth', which is when you become `sensitive to the wealth of others'. In such a situation, trading against the crowd increases the risk of your relative wealth. What is the consequence?

Despite being a rational trader, you may sustain prices that are too high, and that deviate substantially from fundamentals, point out the authors.

The paper cites Thorstein Veblen who coined the term `conspicuous consumption'. He'd argued more than a hundred years ago that as society becomes richer, the amount of consumption necessary to maintain one's social standing increases.

There are other references too in the paper; for instance, Frank (1985) had emphasised the important of relative wealth in determining social status, and Abel (1990) incorporated the idea in asset pricing models.

"All these papers assume that utility functions are such that other people's wealth or consumption levels impact one's own utility through an exogenous dependence of the utility function on relative wealth," note the authors, before proceeding to show that "the relative wealth effects that are necessary to create and sustain price bubbles can also arise endogenously in a fully rational model in which agents care only about their own consumption."

Endogenous means originating or growing within; and the opposite, exogenous, means originating outside. And, if you have been wondering if `agent' refers to James Bond, here's help from www.econmodel.com: "Economists like to refer to the people they study as economic agents. Economic agents come in two basic varieties, producers and consumers." So, you and I may well end up as agents were we to show up on an economist's radar.

"If there are scarce goods whose prices increase with the wealth of investors, then agents' abilities to consume will depend on their relative wealth. These relative wealth concerns can induce herding that has an aggregate impact on equilibrium prices," explain the authors.

They take up as an example of `scarce goods', future investment opportunities. "When the wealth of middle-age investors is high, competition for these investments drives down equilibrium returns, raising the cost of funding their retirement." Frightening that wealth can be handled so ineffectively, and more frightening that the possibility can hit most of us.

Bubble-like price dynamics can arise in equilibrium, postulates the paper. "In a striking representative example of the equilibrium we present, the price of the risky security rises to an 80 per cent premium over the price of the risk-free annuity while it continues to pay dividends, with this premium vanishing as soon as a dividend is missed," reads a snatch.

The authors study `this seemingly odd behaviour' and reason as follows:

Agents realise that the wealth of their cohort will drive up future asset prices and thus lower their returns. (In statistics, `cohort' means a group with statistical similarities)

To meet any given level of retirement income, agents need to save more when their cohort is wealthy.

This externality induces a herding incentive. (`Herding instinct' is a social tendency in humans to identify with and model many behaviours and beliefs after a larger group of individuals with whom they identify, says Wikipedia.')

Thus, agents choose to imitate the portfolio choices of their cohort to avoid being poor when their cohort is wealthy.

As a result, young investors may herd into the risky asset, driving up its price.

The price distortion grows over time since as the young become wealthier. Their impact on asset prices grows, thus further strengthening the herding incentive.

The bizarre result is that otherwise rational traders sustain prices that are too high "even though they understand that these prices deviate substantially from fundamentals".

The authors explain that given the price dynamics and the portfolio allocations produced by the model, "an outside observer that does not account for relative wealth considerations might be tempted to conclude that some of the agents in the model are actually risk loving." As if `seeking the bubble reputation even in the cannon's mouth,' like in As You Like It.

Insightful research, if you are keen on preserving and growing your wealth, rather than letting it end as `bubbles in a late-disturbed stream' that Lady Percy speaks of in King Henry IV.

dmurali@TheHindu.co.in