Investors’ irrationality deepens economic crises

Behavioural inclinations of managers, often leading to management errors on a microeconomic level, can accumulate, causing at least ineffectiveness, if not serious disruptions in the economy on a macro scale, thinks Professor Adam Szyszka of the Warsaw School of Economics Collegium of World Economy.
Investors’ irrationality deepens economic crises

Prof. Adam Szyszka (©archiwum własne)

Obserwator Finansowy: Research has shown that behavioural factors are inherent in practically all economic crises. You have analysed this aspect in relation to the financial crisis of 2008, and it proved very helpful in explaining its extent and dynamics. Is it similar in relation to the Covid crisis?

Adam Szyszka: History shows that economic crises can have very different sources. Nevertheless, regardless of the primary causes of a crisis, it is possible to notice some common behavioural features. In my papers I have presented a behavioural view of the turbulence in financial markets first observed in connection with the sub-prime crisis in the US, and then with the debt crisis in the euro area countries.

These events have certainly already been eclipsed by the current global pandemic-related issues. Yet, it is possible to distinguish some common features of human behaviour that are manifested during this crisis as well as other crises. Usually in pre-crisis periods people often tend to behave overconfidently and overoptimistically. They are guilty of extrapolation bias, expecting the good times to last for very long and underestimating the importance of unlikely events with potentially colossal implications. Additionally, they are also guilty of confirmation bias, which consists in uncritical acceptance of information confirming their previously formed views, while avoiding opportunities to confront them with new information or even denying information that would contradict their prior expectations.

As a consequence, a crisis comes unexpectedly for most people and it comes as a shock, which often leads to a sudden shift from overoptimism to fear or even panic. At the same time, the degree of risk aversion changes dramatically (post factum, unfortunately). While before the crisis we are inclined to accept higher levels of risk, then – having experienced painful losses – we often exhibit excessive risk aversion and become overcautious, being unable to seize investment opportunities that may appear during crises.

A crisis comes unexpectedly for most people and it comes as a shock, which often leads to a sudden shift from overoptimism to fear or even panic.

Such psychologically motivated fluctuations in risk assessment may therefore result in erroneous decisions being taken by entrepreneurs.

I’ve already had the pleasure of discussing in “Obserwator Finansowy” the findings of the study I co-authored, which analyses the impact of behavioural factors on financial decisions in companies and their connection with macroeconomic data. Our study conducted among managers of Polish companies before the pandemic demonstrated that overconfidence could significantly affect IPO (Initial Public Offering) decisions and corporate capital structure. Moreover, by using the innovative agent-based modelling method, we showed how behavioural bias on a micro scale can accumulate and influence the economy on a macro scale.

So, can irrational managerial practices concerning, e.g. investment policy on a micro level, affect macroeconomic indicators in the economy, such as investment, employment and growth?

Behavioural inclinations of managers, which often lead to management errors on a microeconomic level, can definitely accumulate, causing at least ineffectiveness, if not serious disruptions, in the economy on a macro scale.

My team and I have just started to carry out another grant-funded project from the National Science Centre Poland, entitled “Behavioural bias in corporate risk management and investment decisions during the COVID-19 pandemic and their impact on selected macroeconomic indicators in Poland.”  In collaboration with researchers from the University School of Advanced Studies (IUSS) in Padua, Italy, we are conducting research among Polish and Italian managers of stock exchange listed companies. Apart from Poland, naturally, Italy is the focus of our attention, mostly because it was the first country in Europe to have suffered enormously at the very onset of the pandemic.

First of all, we investigate the attitudes of corporate managers in the face of the surprise and uncertainty caused by the pandemic. Next, we move from the micro to macro level and try to analyse how managers’ bias can accumulate and affect the economy on the macro level. In particular, we are interested in: investment, employment and economic growth.

What research tools do you use in the analyses combining micro and macro levels?

In our research we use the ABM method, which stands for Agent-Based Modelling. It’s a relatively new tool used for simulations in social sciences. We’ve already used it in our previous research, which allowed us to demonstrate the impact of behavioural bias in IPOs and corporate capital structure on the stability of the overall financial system, unemployment and gross domestic product.

This time we intend to model the relationships between irrational preferences and attitudes towards risk amid increased uncertainty and fear and aggregate investment, employment and economic growth.

In an interview for Obserwator Finansowy conducted at the initial stage of the pandemic you pointed to a number of possible implications of the pandemic for global manufacturing processes. Time has shown that many of these predictions are coming true. How do you assess these phenomena today?

It is a cliché to say that the COVID-19 pandemic has caused serious disruptions in the global economy and the behaviour of people and societies at large. When it comes to businesses, the pandemic has had a significant impact on the behaviour of managers, triggering irrational attitudes towards risk, among others, and leading to suboptimal decisions in investment policy. This could be felt particularly at the initial stage, when managers were overcome by such feelings as surprise, uncertainty and sometimes even fear.

The pandemic has changed our perceptions of globalisation, production reallocation and supply chain organisation. In view of the disruptions in the global flow of goods and the logistic problems we are coping with until today, the efforts to diversify the sources of supply and to shorten supply chains are gaining special significance. The current situation will have long-term consequences for the strategic allocation of resources and production capacities all over the world. The search only for the lowest production costs has come to an end. From now on enterprises will be taking into consideration not only the costs, but also the security of supplies.

The physical distance between the place of acquisition of raw materials and components and the place of production of end products will probably be shrinking. Production allocation will become more diversified geographically, and for strategically important components and commodities countries will be developing domestic production capacities, putting security before cost accounting.

The current situation will have long-term consequences for the strategic allocation of resources and production capacities all over the world.”  

Asia may therefore lose its dominant position as the world’s manufacturing site, which in turn may present an opportunity for alternative locations such as Central and Eastern Europe. The new rule – “manufacture where you usually sell” – will have a significant and negative effect on the volume of international trade and it will favour countries with access to large domestic markets.

And how can this affect the place of our economy in this network of links?

Such a scenario presents an opportunity for Poland, which not only enjoys a relatively large domestic market but also can become a strategically located manufacturing base for both commodities for the EU market and components for other enterprises in the EU. For the opportunity to translate into a permanent competitive advantage of the Polish economy, it is necessary to foster productivity growth, especially in the context of rising labour costs, and support the orientation towards implementing innovations as well as the stability and predictability of business conditions.

Productivity growth is crucial for maintaining long-term competitiveness of the Polish economy, since the advantage of low labour costs is gradually diminishing. Greater productivity may arise from, for example, implementing innovations. Hence, it is so important to support innovative investments, also by providing long-term funding of innovative projects.

This year’s Nobel Prize in economics is yet another award for the experimental approach in economics. This trend in economic science is familiar to you, considering your scientific achievements to date.

This year’s Nobel Prize in economics has clearly been split in two – a half for David Card, the other half divided between Joshua Angrista and Guido Imbensa. I should add at this point that David Card conducted his research together with Alan Krueger, who unfortunately died two years ago, and they don’t award the Nobel Prize posthumously. In the justification of the first part of the prize we read about the empirical contribution to labour market research. In the justification of the second part of the prize we read about the methodological contribution concerning causal relationships. At first sight, you might have the impression that the prize was awarded for achievements in two rather distant areas. But this distance is only apparent.

Firstly, the empirical studies conducted in the labour market by David Card and Alan Krueger are based on the methodology of causal relationships analysis proposed by Joshua Angrista and Guido Imbensa. Secondly, one of the most interesting applications of the methodology of causality analysis is precisely the identification of the regularities found in the labour market, e.g. the relationships between the minimum wage and the number of job vacancies, and between the duration of education and earned income.

What are the distinguishing features of the recent Nobel Prize laureates?

I think there are two fundamental methodological aspects of this year’s prize distinguishing it from the previous prizes and highlighting the importance of the experimental approach in economics.

The first aspect is the use of so-called natural experiments in economic studies. In the early 1990s David Card and Alan Krueger analysed the impact of changes in the minimum wage on the number of job vacancies. In their study they compared data from the American state of New Jersey, where the minimum wage had been raised, with data from the neighbouring Pennsylvania, where the minimum wage had not changed. They focused on the situation in the fast food restaurant industry, where most employees are paid badly, working for the minimum wage. It turned out that after the rise, the number of job vacancies in the sector did not fall at all, as compared to Pennsylvania, where the minimum wage was not raised. Until now it has been commonly believed that so-called randomised controlled experiments as a rule cannot be conducted in economic studies.

The second aspect is highlighting the issue of causality. Regrettably, in a lot of economic research conclusions are formulated on the basis of the mere fact of an observed interrelation, or correlation between a change in the value of one variable and a change in the value of another variable. We must remember, however, that correlation does not necessarily prove a causal relationship. In economic research, it is of crucial importance to establish whether there is a cause leading to a particular effect. This matters, for example, when determining socio-economic policy and recommending policy makers that they use particular tools leading to planned results. Joshua Angrist and Guido Imbens, using the method of instrumental variables known from econometrics, have shown what conditions are required to obtain accurate results from natural experiments.

Can the previous experience of the pandemic crisis help strengthen the behavioural trend in economics?

The coronavirus pandemic has affected numerous areas of our life and directly influenced human behaviour in a significant way. Necessarily, this has to have an impact on social sciences, including economics. And since – as I’ve already mentioned before – we’re talking about an impact on human behaviour, in quite unprecedented, previously unknown circumstances, I think that behavioural approach is by all means justified and will be used more and more often by researchers.

Finally, one last question to you as an academic teacher: are you happy about the return to traditional classes?

In the academic world, personal teacher-to-student contact can’t be overestimated. Though online learning at universities has passed the test in the extreme pandemic circumstances, it would be hard to sustain over the long term. However, e-learning can be a valuable complement to traditional classes.

Still, I’m afraid that in the light of the ongoing fourth wave of the pandemic in Poland, the relatively low percentage of vaccinated people and serious cases of the disease among increasingly younger people, we may soon be forced to switch to remote or at least hybrid learning.


Interviewer: Ewa Rzeszutek


Adam Szyszka is a professor of economics and finance at the Warsaw School of Economics Collegium of World Economy. He heads the Centre of Interdisciplinary Research in Financial Markets; he is a member of the High-Level Forum on capital markets union at the European Commission, a member of the Warsaw Stock Exchange Supervisory Board and an independent advisor to business entities.  

Prof. Adam Szyszka (©archiwum własne)

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