Why are markets so volatile?

Mainstream economic thinking has considerable difficulty in explaining the massive degree of volatility of financial markets over the past few months. Both shares and bonds exhibit large fluctuations on an almost daily basis.

The problem is particularly acute for the concept which is fundamental to a great deal of modern macroeconomics, based on the so-called ‘representative agent’. This would not matter if it were purely a piece of esoteric reasoning, but models which embody this concept proliferate in central banks and international financial regulatory bodies.

The simplifying assumption is made that the workings of the economy can be explained in a model in which there is just a single decision maker, deemed to ‘represent’ the behaviour of everyone.

The ‘representative agent’ is certainly a curious assumption to make in the light of the financial crisis, when much of the focus is on the differing behaviours of creditors and debtors. In the Euro area crisis), for example, it makes no sense at all to speak of the ’representative agent’, the German government has quite different behavioural rules and constraints from that of, say, the Greek and Italian administrations.

Kenneth Arrow, a Nobel Laureate, wrote in 2004 that the representative agent assumption cannot explain the fundamental existence of markets at all! ‘if we did not have [agent] heterogeneity, we would have no trade’. In other words, if people did not have different opinions about the value of a share or a bond, why would trade take place at all?

Keynes put it a different way. If all traders think identically, market prices will fluctuate between zero and infinity!

And here we have the explanation for market volatility. The more that traders follow the herd, the more the market as a whole begins to think as a single agent. And so prices fluctuate more.

Traders form their views on a mixture of their private opinions and on market sentiment. You may think the Italian government’s finances are sound, but if most other people disagree, it takes a very brave soul to stick to his or her private opinion.

In the current circumstances, when there is considerable uncertainty, traders are giving much more weight to market sentiment than to their private opinions. The more the world looks like the world of mainstream economic theory, the more volatile it becomes!