Fragility of Credit Markets

Project Start:07/2014
Category: Macro Finance, Experiment Center
Funded by:LOEWE

Can the recent extreme events in financial markets be explained by individual irrational behavior? Economists do not have a definite answer to this question. On the one hand, some economists argue that behavioral biases play an important role in financial booms and busts. On the other hand, other economists argue that competitive markets offset these biases. Irrational investors should indeed either be driven out of the market as their wealth evaporates or be outweighed by the more rational participants.

To study whether markets are successful in offsetting individual behavioral biases, we compare the outcomes of experimental financial markets in a standard market economy to a more artificial “island economy” that removes market interactions. Comparing aggregate outcomes between these two environments tells us about the causal impact of an essential feature of competitive markets.

We find that market and island outcomes differ. Market prices display a bubble pattern while average prices across islands closely track the fundamental value of the project. These results do not support the claim that competitive markets correct individual biases, rather the contrary.

We also find evidence of gambling for resurrection: Investors take more risk after experiencing larger losses. This initiates the formation of a bubble. As a result, average losses increase, the desire to resurrect intensifies, and the bubble further inflates. As wealth evaporates, subjects become more and more constrained and have to decrease their demand at some point. The bubble bursts as a result.