What can be explained by economics and what cannot be explained? 3

Today I want to continue with this topic and discuss how rational sophisticated investors can still create a bubble in the stock market. Let's talk about bank-run first. There is one explanation for bank-run that bank-run is caused by a black swan event when many individuals unintentionally take out their money out of their banks at the same time. This could also happen to the stock market. When many people unintentionally sell off their stocks at the same time, this will create a phenomena of bubble bursts that the stock market will fall sharply. This does not create a bubble but definitely creates a phenomena of a bubble burst. 

When we are talking about bubbles, there is always a difficulty of defining a bubble before a bubble bursts. For example, we cannot be certain about if there is a real bubble in the cybercurrency market. Moreover, because of the constraint of receiving and analyzing information, no one is certain if they actually know the fundamental of the stock market; therefore, it is normal for rational investors to misestimate the fundamental of their stocks. In addition, because of the uncertainty of the future, the stock prices in the future are always uncertain, they will be revised after resolution of uncertainty every period. Therefore, when a state with a very insignificant probability actually takes place, there will be a sharp price drop in the stock market. When this stock attracts lots of attention because it is less risky and generates good capital returns, such event takes place, it will influence a large amount of investors. When a large amount of investors suffer capital losses, their live standards might be impacted and they may need to liquidate some of their other assets, this will influence the entire stock market. This will also produce a phenomena of bubble burst. 

To conclude, we still cannot define a bubble before a bubble actually bursts. Since we only recognize a bubble after a bubble bursts, if we can see a similar pattern in the market as a bubble bursts, we can see that rational investors can still create such pattern in the stock market and we can refer this to what we usually call as a bubble.

The UK gender pay gap

The UK government requires some companies to report the gender pay gap within their companies and only half of the companies submit their reports before the deadline. The reports generally show the females receive lower incomes than the males on average. However, I do not think the reports can fairly represent the issue of gender pay gap because of its design. The main issue in this report is too many variables are omitted in the reports.

The report represents the gender pay gaps overall and in several quantiles. However, we do not have any idea about what exactly causes the pay gaps. The differences in salaries could be caused by many factors, not only their genders. Without gender discrimination, we have to admit females and males are different. In addition, females and males do choose different career pathways. Some people may argue the different career pathways are caused by the gender discrimination that exists in our society; however, we cannot truly blame the companies that force the females to choose such career pathways unless if the companies forces females to fit in the positions that they do not want. In addition, de jure discrimination is much easier to be corrected, but de facto discrimination is extremely difficult to be corrected. The UK government wants to use the report to observe; however, if the government identifies it is a de facto discrimination, it should observe the early stage of people's live, such as education and entry jobs. Because after people overcome their early stages of career, their future incomes are far more predictable. Therefore, it is more important to observe the early pathways people choose rather than observe the entire labour population as a whole.

What can be explained by economics and what cannot be explained by economics? 2

I would like to continue my topic, "what can be explained by economics and what cannot be explained by economics". Today I want to talk about what can be explained by economics in the stock market.

Let's talk about the volatility in the stock market. Normally we calculate stock price as a function of the sum of all future discounted returns (dividends); however, this is not how we judge our stocks' values. Companies are growing, so their values are not constant and can change over the long run. This is a very important source of uncertainty. Once there is a source of uncertainty, then the people's expectations do not agree with each other because of their constraints to receiving sufficient information and analyzing information. Such constraint exists and it is impossible to remove such constraint, it is as natural as the production constraint (we can see the outcome of analysis is our product). Because people have different expectations, then they will sell when the market price is above their expected prices and they will buy when the market price is under their expectations. This is why trading takes place in the market. The difference between trading in the stock market and trading in the good is that traders in the stock market do not consider the cost of trading, instead they make decisions based on their expected outcomes with their expected probability distributions.

In addition, some people say it is irrational for investors to be influenced by others. However, we can explain why it is rational for investors to be influenced by others. Everyone in the stock market is potentially a buyer as well as seller. When you see a market price increase, it indicates that your potential buyers are now willing to accept higher prices, and this also increases the probability of meeting your price targets (in the case that your price target is above the current market price), as we believe price increases are caused by resolution of uncertainty. Moreover, because we know our constraints and ability limits, it is rational for us to adjust our evaluations and expectations with the professionals who have more information and are more capable of analyzing financial issues.

I will discuss it is possible for bubbles to exist in a rational market tomorrow.

What can be explained by economics and what cannot be explained?

An economic man is often used in some economic theories to portray rational and self-interested humans that involve in economic activities. Many people use Kahneman’s book, “Thinking, Fast and Slow”,  to point out there is irrationality in human beings. In his book, Kahneman points out there are two systems of thought: one is fast and following instinct and emotion, the other is slow but logical. The fast system is considered to be the irrational system; however, it is so useful that it helped our human beings to survive in the wild, it is just not so helpful when we are making complicated decisions nowadays. Our human beings have lived for millions of years and we only have our civilisation for under ten thousand years, this means only for under ten thousand out of millions of years, we need more of the help from the second system than the help of the first system; therefore, it is sensible to say that the existence of the first system is good for our human beings and it is rational for our human beings to use the first system for most of our time (here, I mean our entire species). Therefore, this argument may not be true. Thinking about our species’ entire time, we might just be in a transferring period of transferring more work from the first system to the second system.

There is another argument that support the irrationality in human beings, which is loss aversion. However, if we are able to use the concept of marginal returns, maybe we can explain loss aversion. The concept of marginal returns suggests when we get more of one kind of goods, the marginal utility gained from one extra item becomes small from the last one. If the utility gained from get one particular item equals the utility lost from losing the same item (assuming we already have some of this type of goods), the marginal utility lost from subtracting one good is greater than the marginal utility gained from one good, since the concept of decreasing marginal utility tells when the amount increases, the good has a decreasing utility and when the amount decreases, the good has an increasing utility, the goods subtracted have a higher utility than the goods added. And this can explain loss aversion, which is an important concept in behaviour economics, which is considered to the subject of studying irrational behaviour in economic activities.

Is it possible for a long-lasting trade war?

Many people are talking about the ongoing “trade war” between the US and China and the leaders of the two countries have had some very tough words on this issue. Some people focus on the tariffs on steel and aluminium and see this as the start of the trade war; however, I do not think this is the key in the trade relationship between the US and China and I even do not think the fear of trade war would last long.

I think that the key between the US and China focus at the hi-tech sector. The most important and significant advantage of the US, not just in the trade but also in other many sectors (including military), is its hi-tech. Undoubtedly the most advanced and innovative technologies are in the hands of the US. If China has the ambition of catching the US up, China has to catch the US up in the hi-tech field. China has been trying to use acquisitions and merges to get high technologies from foreign companies. The US has been trying hard to avoid such situation from happening (not just from China, but other countries as well), the government shut up the merge between Qualcomm and Broadcomm is one example. The semiconductor industry is the sector where China has a relative disadvantage; and the semiconductor is a very important sector, the technology in this sector is believed to be the driver of the next generation revolution, the AI revolution. All countries, especially China and the US, want to take a lead in this revolution. Therefore, I do not think steel and aluminium, these traditional industries will be the key in the trade relationship between the US and China.

In addition, the US has a democratic political system; therefore, the policies are influenced by the population. If a trade war significantly worsens the population’s life standards on average, the population will turn against the trade war decision, even though it may have a long term positive influence. Moreover, even all politicians may know the positive effects in the long term, their voters may not have the patience to wait that long for the positive effects to come, so if they want to win the election, they have to give up some of these policies. From this point of view, China is more capable to fight a long term trade war.

To conclude, I think the semiconductor industry is the key in the trade relationship between the US and China, and I do not think a wide scale trade war between China and the US has a high probability; and even if it happens, I do not think it can last long.

Financial decisions when the market is "boiling"

I want to use "boiling" to describe what the current financial market looks like. The market is as volatile as boiling water, it could hurt people in the market as well as create "steam" (opportunities) for the market. The function of financial markets is a place for people to borrow or lend their money, investment is a type of lending money. Consumption and investment could be put into separate categories that people do not make decisions correspondingly. This is because once people put some money into investment, they do not use the money generated by investment for consumption in short run. Because people expect their investment will generate positive returns eventually, they will not change consumption levels unless their salaries change significantly.

In such boiling market, people could have two directions that they can think that the trade war is undergoing and destroying the current world trade and business order, or they can think that the market is overreacting to the tariff increases. If you belong to the first group, then you will sell off all your holding risky assets and even short some assets; if you belong to the second group, then you think it is the time to buy assets at cheaper prices. Either side can provide reasonable argument to support their opinions. If you have made the mind, then do what you think is right to do. However, many people may be swinging between the two sides. Under such circumstance, you can either give up the opportunities or impose a hedge strategy.

However, it would be very risky for any investors to invest in the current financial market (of course, it implies there are more profitable opportunities in the market). Stock prices are very sensitive to information, bonds might abe a good alternative to stocks for those who are more risk averse.

The day has come

The trade war has come since 25% tariffs on $60bn Chinese imports were announced. Though China has been trying to influence the White House and political parties via lobbyists, it seems useless or at least insignificant so far. If two countries both make their decisions to enter this disastrous trade war (whose damage has been reflected by today’s stock performance partially), then there are multiple tools that the countries can use to actively improve their goods and services more competitive within and outside their domestic markets.

Firstly, monetary policies can be helpful to depreciating currencies. When a country has a relatively cheap currency, its goods and services are relatively cheap in the global market, so they are competitive in terms of prices. Secondly, monetary policies also need to control the domestic inflation. When the domestic inflation rate is low, the domestic products and services are cheap, especially compared with the goods and services from the countries where have higher inflation rates. This might be contradicted by currency depreciation policies. Thirdly, fiscal policies can provide companies with subsidies to be more competitive. Fourthly, governments can create difficulties for foreign companies to cooperate within their countries. Fifthly, governments can even further create legal barriers to keep foreign companies out of their countries.

To conclude, countries have multiple tools to use in a trade war.