Keynes' Beauty Contest

One of the professors teaching us this semester is Prof. Amitava Bose. Prof. Bose teaches us macroeconomics, a subject which I still have to learn and appreciate as much as microeconomics. In any case, there was a general demand from the class that he cover certain issues relating to the present financial crisis. Now, this demand was a very practical one from the part of the students, focused towards understanding what exactly happened given that this question was likely to feature in the Summer placement interviews (naturally).

In any case, Prof. Bose obliged – but what he delivered was not a simple, bland explanation of the forces at work partly because he believed that he had not studied the issue at hand and partly because he had called another economist who gave us the “it all began when …” kind-of story. What Prof. Bose did end up doing, was delivering a lecture introducing us to behavioural aspects of the financial markets (something which a lot of people are trying to do) although in a very indirect and subtle way.

Here are some of the points that he made, which I thought I should share.

1. He discussed the notion of every financial asset being a “claim”, and that the whole system was based on a set of “beliefs”. Hence understanding the nature of these beliefs was important to understanding markets. While real assets always remained real assets, financial assets vanish once these “beliefs” are lost.

2. He discussed Ponzi Schemes through an interesting Shibram Charaborty story.

3.He discussed a different version of the so-called Cinderella Effect, one where everyone riding a bubble always believes that there will still be someone else after him who would buy from him what he bought from the previous guy (and not the one about stepchildren being maltreated). He discussed how these beliefs could be self-fulfilling prophecies, i.e. “If everyone believes that a stock price will rise, it will”.

4. The Keynesian Beauty Contest : I was not aware of this famous text in economic literature. I found the very idea of the contest amusing, and the fact that it models the stock market so well even more remarkable. This is the Keynes’ quote from the 12th Chapter of the famous General Theory of Unemployment, Interest and Money

“It is not a case of choosing those [faces] which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.”

5. Then Prof Bose invoked this para from Sherlock Holmes to discuss the notion of Common Knowledge

“Moriarty: All I have to say has already crossed your mind.
Holmes: Then possibly my answer has crossed yours.”

He left us with a bunch of questions like “Is Cash wealth?”, “Can rational agents agree to disagree?”. In particular there was this story of what happens when a man drops his wallet full of cash in the Ganges? Is India poorer? India should be poorer because after all India’s wealth is the sum of each Indian’s wealth. But all the real assets that money can buy still exist and hence India should not be any poorer. Someone else would buy the resources that the farmer could have.

I hope this was interesting to those who like me would like to follow economic though in a casual, “undercover economist” kind of way. I’ll try and get permission to upload the ppt for this lecture soon.

Cheer,

November 19th, 2008 / 411 Comments / Tags: amitava bose, macroeconomics, economics, sherlock, keynes, beauty contest / Trackback