Inventing stories

Paul de Grauwe, an economics professor at the University of Leuven in Belgium, relates a nice tale about the value of Belgian chocolates and how that can tell us something about the value of the dollar in today’s Financial Times (subscribers only):

A few weeks ago an interesting experiment was undertaken at the Brussels food fair, a yearly affair where food lovers wander around among the many stalls stuffed with all imaginable delicacies. A shop was put up selling boxes of Belgian chocolates. The first day the price was set at €9 for each box. Sales went well. The next day the price was raised to €15 per box. Steeped in economic theory, you might think that demand now declined. Wrong. Demand doubled. On the third day the price was lowered to €2 for each box. Demand for chocolates collapsed. What went wrong with the law of demand?

The explanation is given by psychologists. It is very difficult, if not impossible, for the consumer to find out the quality of chocolates by just looking at their appearance in the shop. When confronted with such uncertainty about the intrinsic value of things, consumers use simple rules of thumb that they understand. Psychologists call these “heuristics”. In this case, the price of the chocolates provides the rule of thumb.

Most consumers have some experience that allows them to associate high price with high quality. It is not always like that, but on average it probably is. Thus when looking at the €15 box the consumers infer that the high price reflects high quality and they buy the chocolates. Consumers who see the boxes priced at €2 infer that the quality of these chocolates is not to be trusted, and they do not buy them. The law of demand is turned upside down.

So it is with the dollar, argues de Grauwe. Because within certain bounds, no one knows the “right” value, they follow the herd. If the dollar is going up, there must be something to it. Ditto when it is going down. The analyst earns his keep by inventing stories appropriate to the situation.

The analyst, who does not know more about the fundamental value of the dollar than the unsuspecting buyer, invents stories. Thus when the dollar goes up, the analyst goes on a search for variables that move in the right direction and that can be linked to the rising dollar, carefully eliminating from the analysis all the other fundamental variables that move in the wrong direction. And so we are told that the strength of the dollar last year was due to interest rate differentials favouring the dollar. The further widening of the current account deficit, which in a previous analysis got centre stage, is carefully dropped from the new analysis.

The honest story of why the dollar increased last year is that we simply do not know. But we do not like to admit that we do not know. Our psyche abhors the darkness of ignorance. That is why analysts’ services continue to be demanded. They fulfil a psychological need to understand. Exchange rate economics these days satisfies this need by telling a new story each time the dollar goes up or down.

Like just about everyone else, at the end de Grauwe confesses he thinks the dollar must come down. “But,” he warns, “do not ask me when this will happen.”

One thought on “Inventing stories

  1. Doug

    At this stage, I think it is customary to repeat that the market can stay irrational longer than any of its participants can stay liquid.


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