Magical thinking & the illusion of control

Strong stockmarkets and quantitative easing now seem inextricably interlinked. While they move together simultaneously, little further analysis seems needed. Indeed, mere rumours hinting at more money printing are enough to trigger another buying flurry. And, while shares are going up, there is little motive for investors to question the logic of QE, or the risks.

The investor psychology involved is one of the more unusual ones of behavioural finance. Magical thinking involves a blind faith in a hidden and barely credible mechanism. Such is the strength of conviction in the benefits of quantitative easing, markets seem little concerned to look more closely. Should investors be so complacent?

If investors are guilty of behavioural weakness in QE, so are the authorities. Politicians and central banks seem to be suffering from the illusion of control, wrongly believing their actions might make things better. Experts are particularly vulnerable to this psychological weakness, as they can become preoccupied by their ability to analyse great amounts of data in detail. A belief in superior knowledge can easily divert experts from questioning what is really worthwhile.

The failure of the first round of QE to deliver measurable sustainable benefit to the real economy should force a reappraisal before more is done. If confidence in economic growth has not been restored, it seems unlikely that any of the new money will be invested in new productive capacity. Certainly, it can drive money out of deposits for a period, but it may not go where the central banks want. Instead, the cash being pumped in appears again destined for emerging markets, in the search for sounder economies and currencies.

Central banks – having criticised investment banks for their arrogance and risk taking – are now guilty of making similar mistakes, but on a much bigger scale. The stockmarket understands that the European Central Bank cannot simply subscribe to all the new sovereign debt that countries like Ireland and Portugal offer without undermining its own credibility. Yet, such is the power of the illusion of control, that the experts involved at the ECB do not question their ability to bury bad credit out of sight.

If longer term evidence is needed on QE, then Japan surely sounds a warning. And, Zimbabwe demonstrated that it is possible to print Z$100 trillion bank notes, but it did not make it the richest country in the world. What it did do, briefly, is make the Zimbabwean stockmarket a top performer in 2007. But that illusory performance could simply not be converted into anything worthwhile in the outside world. The Dow may move to new peaks, but will those Dollar returns have meaningful value? Viewed in terms of gold or Euros, the US has been in a bear market since 2000.

Some of the subtlest behavioural weaknesses are also the most powerful. Politicians, central bankers and investors alike do not readily admit to belief in the supernatural. But magical thinking is a well-documented psychological weakness that strikes when we are least questioning. Wishing something to be true – that wealth can be created simply by printing money – makes us drop our guard. High and rising nominal values of shares or commodities denominated in US Dollars can undermine our sense of value. Investors need to recognise these behavioural weaknesses, and question what quantitative easing might do for the real economy.