Agent-Based Models and Loss Aversion in the UK Housing Market

This is my third post featuring research presented at the conference on Applications of Behavioural Economics, and Multiple Equilibrium Models to Macroeconomics Policy Conference held at the Bank of England on July 3rd and 4th 2017.


Last week I featured two US central bankers, Jim Bullard, President of the St Louis Fed and Kevin Lansing, a Research Advisor at the Federal Reserve Bank of San Francisco. This week’s post features two papers on the housing market, presented by two researchers at the Bank of England; Arzu Uluc and Philippe Bracke. One of these papers uses an Agent Based-Modelling approach to study the effects of macroprudential policy in the housing market. The other is a large-scale empirical study which finds significant evidence against the hypothesis that we are all perfectly rational. Homo Economicus and Femina Economica display more subtle behaviour than simple neo-classical models admit. 

Let’s begin with a fascinating paper co-authored by Philippe Bracke and Silvana Tenreyo. You can find a video link where Philippe discusses their research by clicking on the image here.

Philippe is a senior economist at the Bank of England and Silvana is a Professor at the London School of Economics and she is also the latest addition to the Bank of England’s Monetary Policy Committee.

Philippe and Silvana’s paper studies history dependence in the UK housing market. They ask a simple and fascinating question. Imagine that there are two comparable houses for sale. They are both in the same neighbourhood.  They are both three-bedroom semi-detached houses with two bathrooms. Both houses have a front garden and off-street parking. Both houses are five-minute’s walk from an underground station. But they differ in one important respect. House A is owned by a person who bought the house when house prices were at an all-time high. House B is owned by someone who bought it when house prices were at an all-time low. By studying a comprehensive data set of house sales in the UK, Bracke and Tenreyo find that the owner of house A will typically hold out for a higher price than the owner of house B.

That is an interesting finding because rational Femina Economica should care only about the price. History should not matter. If that was the end of the story, the paper would be an interesting contribution to the literature and would likely be published in a top journal. But Philippe and Silvana go further. They distinguish two possible explanations for history dependence. 

The first explanation is that people are not rational in the sense of Femina Economica and Homo Economicus. Instead, they behave in a way that Tversky and Kahneman call loss aversion. If you are buying a house from a person who bought it a long time ago and who has made a big profit, that person will be willing to sell it for less than someone who is selling a comparable house, but is taking a loss on the sale. Bracke and Tenreyo call that anchoring.

A second possible explanation for the same observation is that the person who suffered a loss has a large mortgage and needs a higher price to move on to her next purchase.  To separate those two explanations Bracke and Tenreyo separate their data into those who have large mortgages and those who own their homes outright. If the second explanation were correct, there should be no evidence of history dependence among those who are debt free. The data does not support that hypothesis. Bracke and Tenreyo find that sellers demand a higher price if they bought the house when prices were high; and the effect is uniform across those with mortgages and those without.  Tversky and Kahneman studied loss aversion in experiments on human subjects. Bracke and Tenreyo find evidence that supports the loss-aversion hypothesis in real world housing data. 

Now let’s turn to Arzu Uluc, who discusses her co-authored work with Rafa Baptista, Doyne Farmer, Marc Hinterschweiger, Katie Low and Daniel Tang. You can find a link to Arzu’s description of her research by clicking on the image here.

The 2008 financial crash was not just an economic crisis; it was also a crisis for the dominant research paradigm: neo-classical economic theory. The paper that Arzu presented is an example of one of the alternative approaches to economics that have flowered as a response to a perceived failure of the neo-classical approach. Standard neo-classical economic models assume that the world is populated by rational people with infinite powers of future perception. Arzu and her co-authors use instead an agent based modelling (ABM) approach.

Agent Based Modelling draws its inspiration from the success of computer modelling techniques in the natural sciences.  For the uninitiated, I recommend the Online Guide by Robert Axelrod and Leigh Tesfatsion at the University of Iowa. In an agent based model, human beings are modelled as automata that respond in predetermined ways to their environment. Agent based models are highly non-linear complex systems that can generate a wide range of endogenous propagation mechanisms. The hope is, that by designing and experimenting with new policies in these models, we may learn how to design policies that stabilize real world economies. 

Arzu et al build an agent based model with four types of agents, each of which behaves in ways that mimic the behaviours of their real-world counterparts and they find that their computer model displays a rich pattern of complex dynamics. Importantly, the simulated dynamics of the model respond to policies that limit the loan to income ratio. When the market restriction is in place, the amplitude of credit cycles is diminished.  This is an approach that I expect to see applied more widely in the coming years.

Before you go here is a preview of the issues I’ll tackle in my next few posts – have a listen to the clips from other speakers at the conference last July, and watch this space.

Do Low Interest Rates Punish Savers?

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This is the second of my posts on the conference: Applications of Behavioural Economics, and Multiple Equilibrium Models to Macroeconomic Policy, held at the Bank of England on July 3rd and 4th. I feature two papers written by officials from the Federal Reserve System. James Bullard, President of the Federal Reserve Bank of St. Louis, discusses the implications of his recent research for low interest rates. And Kevin Lansing, a Research Advisor at the Federal Reserve Bank of San Francisco, discusses his work on multiple equilibria. 

James Bullard: President of the Federal Reserve Bank of St. Louis

James Bullard: President of the Federal Reserve Bank of St. Louis

Jim's fascinating and timely presentation was based on a research paper that he co-authored with Costas Azariadis, Aarti Singh and Jacek Suda. In that paper, Jim and his co-authors construct a stylized model of an economy with long-lived people and they study the determinants of interest rates. In a video, linked here, Jim discusses the implications of his academic research for a hot political topic: the persistence of very low interest rates almost ten years after the end of the 2008 financial crisis. In his view, there is not much the Fed can do about low interest rates; monetary policy is simply allowing the price of borrowing, aka the interest rate, to equate supply and demand.  In his words, “you don’t want to encourage the suppliers too much or you’ll get oversupply: you don’t want to encourage the demanders too much or you’ll get a shortage, so the price brings these two into balance”.

Figure 1: Source: Bauer and Rudebusch

Figure 1: Source: Bauer and Rudebusch

Although he doesn’t say it explicitly in his talk, Jim is referring here to what economists call the ‘real interest rate’; that is, the money interest rate adjusted for expected inflation. The real interest rate is the price that borrowers must pay to trade future for present consumption goods and much recent research suggests that this price has fallen steadily over the past couple of decades as the Chart in Figure 1 shows. This chart is reproduced from a Federal Reserve Bank of San Francisco Letter, by Michael Bauer and Glenn Rudebusch which discusses possible reasons for the decline in what Jim Bullard calls the “neutral price”. This is the market real interest rate that equates the supply of savings by lenders with the demand for savings by borrowers. Critics of the Fed blame loose monetary policy and past Fed mistakes for the current period of low rates and although I have some sympathy for this argument, it is not easy to come up with convincing explanations for permanent effects of Fed policy on the real as opposed to the monetary interest rate. In my view: the jury is still out.

Jim takes the position in his talk that the neutral real interest rate is independent of central bank policy. But is it? A second theme that arose at the conference is that any given central bank policy can lead to more than one equilibrium outcome. That theme was taken up by Kevin Lansing, a Research Advisor at the Federal Reserve Bank of San Francisco. I discuss Kevin's work below. You can hear Kevin describe his paper, in his own words, here.

Kevin Lansing, Research Advisor at the Federal Reserve Bank of San Francisco

Kevin Lansing: Research Advisor at the Federal Reserve Bank of San Francisco

Kevin's pioneering research research explores the idea that there may be more than one inflation rate associated with any given monetary policy. In normal times, the interest rate is positive and the central bank raises or lowers it to cushion the effects on the economy of shocks to demand and supply. But if the central bank lowers the interest rate too far and too quickly, as it did in 2008, the economy may become stuck in a low inflation rate trap. One possible solution that Kevin discusses is to raise the central bank’s inflation target. This is an idea that has been floated by a number of authors; (see for example, the Vox piece by Laurence Ball of Johns Hopkins University). Kevin finds that although a higher inflation target may mitigate the problem, it doesn’t remove it entirely.

How should we reconcile these two conference contributions? 

Jim is sympathetic to the idea that there may be multiple equilibria and he has discussed the idea elsewhere that the economy may switch occasionally between two regimes. In one regime, the real interest rate is high: In the other regime it is low. He does not take a stand on what causes the switch from one regime to the other.

Kevin’s research addresses a related, but different question. Like Jim, Kevin does not take a stand on what determines the real interest rate. He asks, how does central bank policy influence inflation and he points out that any given central bank policy may be consistent with more than one inflation rate.

What is Keynesian Search Theory?

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I've been asked recently how my work on search theory differs from the approach pioneered by Peter Diamond, Dale Mortensen and Chris Pissarides (DMP). I call the DMP approach classical search theory, and in my book Prosperity for All, I distinguish classical search theory from a new approach; Keynesian Search Theory, that I introduced in my paper Aggregate Demand and Supply, published in 2008. I coined the term Keynesian search theory, in Prosperity for All, to clarify the distinction between my work and previous literature. If a macro model is closed with classical search theory, beliefs are determined by economic fundamentals. If a macro model is closed with Keynesian search theory, beliefs represent a new fundamental that is determined by the psychology of market participants. I call this new fundamental; the belief function.

Here's how I described this issue in a post on this blog in 2014

"Until recently, new-Keynesian economists didn't bother to model unemployment. Instead, they followed the new-classical approach in which all that matters is labor hours spent in paid employment. More recently, a number of authors including  Bob Hall, and Mark Gertler and Antonella Trigari have incorporated explicit models of search unemployment into otherwise standard macroeconomic DSGE models. ...  What is different about more recent work ...  [in classical search theory, that builds] ...on Hall's 2005 paper, is the way the model is closed. 

... When a firm meets a worker in a search model, the worker and the firm enter a bilateral bargaining situation. The worker would be willing to accept a job, and the firm would be willing to employ the worker, for any wage that is greater than the worker's reservation wage and less than the worker's marginal product. In his 2005 paper, Bob showed that one way to close the model, is to assume that the wage is fixed.

...That way of attacking the problem is, ... [in my view] ... a mistake. The new-Keynesians are squeezing the square peg of labor market search theory into the round hole of Samuelson's  neoclassical, synthesis. 

... An alternative approach, that has a better shot at understanding the data, ... [is to drop] ... the bargaining assumption completely and ...  [ to assume instead ] ... that firms and workers are price takers in the labor market..."

In classical search theory, firms and workers bargain over the wage, and the value of a firm depends on the outcome of the bargaining process. Expectations about the value of assets, aka beliefs, must ultimately be consistent with labor market fundamentals.

In Keynesian search theory, this process is turned on its head. Market psychology is a new independent fundamental that determines asset prices and the division of the product, between workers and firms, must ultimately be consistent with asset market beliefs. In this new way of seeing the world, market psychology is a new causal factor.

Here is how I presented the contrast between these approaches in Prosperity for All [Page 121]:

"[Keynesian search theory] explains permanent shocks to the unemployment rate as inefficient shifts from one unemployment equilibrium to another. If I am right, we can and should try to counteract permanent shocks to the unemployment rate by active intervention in which the central bank, acting as an agent for the treasury, buys or sells shares in the stock market to smooth out financial fluctuations."

As I argue in this video, Keynesian search theory offers the promise of a marriage between psychology and economics. Classical search theory does not. If you are young, ambitious and uncorrupted by tired establishment views, consider joining me in developing a truly interdisciplinary approach to the future of macroeconomics.

The Marriage of Psychology with Multiple Equilibria in Economics

This is the first of a new weekly blog series, Monday’s Macro Memo with Roger Farmer, which will discuss a wide range of economic issues of the day. The blog will appear on both the NIESR site and on Roger Farmer’s Economic Window and in the first few weeks, I will be posting a series of videos, recorded at a conference held at the Bank England  on July 3rd and 4th of 2017.  The conference was titled "Applications of Behavioural Economics and Multiple Equilibrium Models to Macroeconomic Policy" and the photograph below is of the presenters, discussants and some of the attendees.

Participants at the Conference

Participants at the Conference

I had been planning, for some time, to run a conference on the topic of multiple equilibria sponsored by Warwick University. Andy Haldane and Sujit Kapadia had been talking with Alan Taylor of U.C. Davis about organizing a conference on the topic of behavioural economics. After talking with Andy, Sujit and Alan, we decided it would be ideal to combine our plans into a single conference that would highlight the promise of studying the marriage of psychology with multiple equilibria in economics. The video, linked below, explains why this is a fruitful idea. 

For more than thirty years, I have advanced a research agenda which  promotes the idea that psychology, aka beliefs, matters for economics. Beliefs are central to determining economic outcomes and should be treated as a new fundamental. My own research and the research of my graduate students, Konstantin Platonov and Giovanni Nicolò, also featured at the conference, studies models of multiple equilibria. But these models are incomplete. When an economic model has multiple possible outcomes, the social scientist who constructed the model has not finished her job. She must explain what feature of the social world selects which of the many possible equilibrium outcomes will prevail. That’s where psychology enters the picture.  Economists talk of animal spirits as a factor that helps to determine the unemployment rate and the inflation rate in the real world. Psychology tells us where animal spirits come from and how they are determined.

There is increasing interest in the way that stories influence the real economy. This was the topic of Robert Shiller's 2017 Presidential address to the American Economic Association. Stories have no role to play in conventional economic models because Robert Lucas, writing in 1972, persuaded the profession that the expectations of market participants are determined by economic fundamentals. That idea makes sense in economic models where there is a unique equilibrium. It makes little or no sense in models like the ones I promoted in my 1993 book, the Macroeconomics of Self-Fulfilling Prophecies,  where there are multiple equilibria. The papers presented at the Bank of England conference are about the tensions between these two sets of ideas.

In addition to the introductory video, linked above, we also recorded videos from many of the conference presenters and discussants. I will be releasing these videos in a series of posts in the coming weeks and I will discuss the research associated with the accompanying topic. You can find links to the original papers on the conference website linked here. Stay tuned.

Post-Keynesians and New-Keynesians: A Lesson From Evolutionary Biology

I was privileged last week to present one of six plenary lectures at the annual meetings of the Society for Economic Measurement in the brand new Samberg Center at MIT. The conference was organized by the eminent macroeconomist Bill Barnett, founder of the Society for Economic Measurement and founding Editor of Macroeconomic Dynamics. Other keynote speakers included Erik Brynjolfsson on the measurement of welfare, Peter Diamond and Larry Kotlikoff, with alternative takes on social security, Peter Ireland on the importance of divisia aggregates and Gita Gopinath on Global Trade.  My talk was predicated on the fact that there can be no measurement without theory and I revisited a theme that I first presented last June at a Post-Keynesian conference held at the University of Greenwich.

Here is an excerpt from a paper that I wrote for the Post-Keynesian conference, forthcoming in the European Journal of Economics and Economic Policies, with the title, Post-Keynesian Dynamic Stochastic General Equilibrium Theory.  A prepublication version is available on my website here and the slides for the MIT talk are here.  

Who is a Post-Keynesian? Who knows? Who cares? I believe that intellectuals are, or should be, inclusive in their acceptance of alternative approaches to interesting questions and I am not going to propose a Keynesian version of the Nicene Creed. If you self-identify as Post-Keynesian; that's good enough for me. I do think, however, that we can draw an interesting analogy with evolutionary biology. In his wonderful book, the Beak of the Finch, Jonathan Weiner describes evolution in action on the Galapagos Islands.
In response to a prolonged period of drought, Weiner describes how the characteristics of the birds that inhabit different parts of the island begin to diverge. If drought conditions persist, the finches on one part of the island stop breeding with those on another and, slowly, separate species begin to emerge. When eventually, the rains return with the arrival of El Niño, inter-breeding recommences and the divergent characteristics of the emergent populations are merged, once more, into a single species.
When did Post-Keynesians stop interbreeding with their orthodox cousins? It was in 1955. That was the year when Paul Samuelson introduced the neo-classical synthesis into the third edition of his influential introductory textbook.[1] According to the neo-classical synthesis, the economy is Keynesian in the short-run, when prices and wages are ͚sticky͛, and classical in the long-run when they have time to converge to their Walrasian levels. Participants at this conference do not need me to point out that this idea has very little to do with Keynes.
The intellectual descendent of the neo-classical synthesis is New-Keynesian economics, an approach that is neither new nor Keynesian and that has more in common with Hume's essay, Of Money, than with The General Theory. New-Keynesian economics was constructed on the core of a representative agent real business cycle model by a group of neoclassical economists, notably Michael Woodford in his Magnus opus Interest and Prices. It is built onto the real business cycle framework by adding costs of changing prices and the resulting theoretical construction makes Frankenstein͛'s monster look like a beauty queen.[2]
But although the New Keynesian reconciliation of Keynes with Walras is ugly, we should not infer that all possible reconciliations of Keynes with Walras will be similarly unattractive. New Keynesian economics is built on two assumptions. The first is that aggregate quantities can be modeled ‘as if’  they were chosen by a single optimizing household with superhuman perceptions of future prices. The second is that an ‘evil agent’ throws sand into the adjustment process and prevents prices from quickly moving to equate the demands and supplies of all commodities.

I argue in my body of work that we can make considerable progress in advancing our understanding of the macroeconomy by relaxing each of these assumptions. Lets discuss these two assumptions in turn. First, by dropping the representative-agent assumption, I have constructed models with multiple equilibria that can be Pareto ranked. Second, I have introduced a new branch of search theory that I referred to in Prosperity for All as Keynesian search theory. This alternative approach to search theory provides a reconciliation of Keynes’s concept of involuntary unemployment with Walrasian equilibrium theory that is different and more elegant than the sticky-price explanation of New Keynesian economics.

In my talk, I also discussed my work with Konstantin Platonov, "Animal Spirits in a Monetary Economy", in which we develop a micro-founded version of the IS-LM model that maintains the Keynesian idea that involuntary unemployment can be maintained as a long-run steady state equilibrium. In June I presented these ideas to a group of  Post-Keynesians. Last week, I presented the same ideas at MIT, the intellectual home of the New-Keynesians. I continue to be encouraged by the ever growing embrace of my ideas and my agenda and the recent Greenwich and MIT conferences were no exception. To quote once more from my JEEP paper,

Post-Keynesian finches and their New Keynesian cousins have avoided each other for far too long. Just as the arrival of El Niño in the Galapagos Islands allowed diverging species to once more merge, it is my hope that the shock of the Great Recession will catalyse interbreeding between New Keynesian and heterodox economists. If I am right, more of my neoclassical contemporaries will need to listen to the drum beat that post-Keynesians have been sounding for 60 years. And post-Keynesians will need to explain to neoclassical and New Keynesian economists, in their own language, what they are doing wrong. General equilibrium theory, broadly interpreted, like mathematics, is a language. If you are young enough to have not yet been corrupted by establishment elites of either subspecies, I urge you to think hard about joining me in establishing post-Keynesian DSGE theory as the future of macroeconomics.

1.  See Kerry Pearce and Kevin Hoover (1995) for a discussion of the evolution of the ideas contained in Samuelson’s textbook, Economics: An Introductory Analysis. The neoclassical synthesis first appeared in the third edition in 1955. I discuss the history of the development of New Keynesian economics, and its roots in Samuelson’s interpretation of Keynes, in my book, How the Economy Works.

2. Anyone who has ever tried to teach the New Keynesian Phillips curve will grasp my meaning. The student is first introduced to the ‘Calvo fairy,’ a mythical creature who randomly decides which firms, in any period, are allowed to contemplate changing prices. Next, one must assume that, in an inflationary environment, firms do not pick a price, they pick a mechanistic rule for adjusting their price on a weekly basis. The pricing rule must be aggregated over identical monopolistically competitive firms and the resulting equation must be linearized around a hypothetical stationary growth path. See my book, Prosperity for All for a discussion of the connection between the ugly and unrealistic assumptions that underpin the New Keynesian model and the concentric circles used by Ptolemacian astronomers to justify their assumption that the Earth is at the center of the Solar System. I first discussed the relationship between Ptolemacian astronomy and New Keynesian economics in my paper, "Animal Spirits, Persistent Unemployment and the Belief Function".