October 17th, 2008


Herd Theory

As we watch the volatility continue to downright goofy levels, I find myself idly wondering whether economists have started formalizing the madness of crowds yet.

I mean, even if you believe that homo economicus is rational (which I don't really), it's very clear that people en masse are not. Herd mentality is a very powerful force, and tends to overwhelm rational behaviour. Indeed, it's not even 100% irrational: if you expect everyone *else* to be nuts, following along can be the most appropriate course.

Consider: I didn't get involved with the 1998 tech bubble at all, because it was so clearly ridiculous. Which meant that, while I didn't lose anything in the crash, I also didn't gain anything in the runup. (A few people *did* manage to profit quite nicely from the bubble.) And bank panics are very sensible, in a way: the more people pull their money out of a bank, the greater the chance that it will go under, which means that you had probably better pull your money out of the bank.

I'd bet that there are some fairly consistent curves that can be interpolated into the standard economic ones, though: even if you assume human behaviour is irrational, that doesn't mean it is inconsistent. There are almost certainly chaotic feedback effects -- it's a dynamic system, and those are always complicated -- and it's very hard to predict on the small scale, but I'd bet that it is susceptible to smart modeling that can at least make some statistical sense out of the madness...