This piece was first published by The India Cable and The Wire and has been republished here.
The Union Budget for 2022-23 can be seen as Prime Minister Narendra Modi’s last-ditch attempt at reviving private sector investment, which has stagnated for eight years. It must be worrying Modi that he is close to finishing a decade as prime minister, and his legacy could be remembered for poor growth in incomes, private investment, employment, savings and capital formation ― the most unenviable record for any prime minister since reforms began in 1991.
With higher revenue mobilisation and the government asset monetisation programme, the Budget aims to give a big push to public investment in infrastructure under the National Infrastructure Pipeline programme, which has identified specific projects in which Rs 20 lakh crore is to be invested annually for five years. This is the cornerstone of what finance minister Nirmala Sitharaman described as “crowding in private investment” through massive capital investment by the government. This is the core initiative to revive growth and employment. But will it succeed?
The budget allocates a 35% increase in funding for infrastructure, with Rs 7.5 lakh crore for 2022-23. It hopes that state governments will contribute their share of infrastructure funding under the PM Gati Shakti project, which aims to monetise government assets to fund new infrastructure projects earmarked in the National Infrastructure Pipeline. But to what extent will the “crowding in of private investments” be triggered by the government’s big public investment push?
The key risk flows from rising global inflation, which is at 30 year highs, and moves by central banks in the developed world to rein in liquidity and raise interest rates rapidly in 2023. The US Federal Reserve intends to raise interest rates three or four times to combat inflation, which can be the biggest dampener for growth and employment. India cannot be insulated from this broader trend and assumptions of GDP growth and employment generation based on massive infrastructure investment cannot but be impacted by global liquidity conditions and inflation.
M.K. Venu is a Founding Editor of The Wire. As an active economic and political writer, he has held leadership roles in newspapers such as The Economic Times, The Financial Express and The Hindu. He has written extensively on economic policy matters.
If I ask you what’s common between choosing the wrong major and not being able to lose the last 5 kgs that you thought you’d lose by summer, most of you would think there isn’t one. But if I ask you the same question for the stock market behaviour during the dot com bubble (most of you were probably not even born by then) and the same stock market behaviour during the recent pandemic, you can probably name a few. However, the common thread amongst all of them is that they are all driven by incorrect beliefs about future events.
You were so sure that economics was the right major for you, but at the end of the second year, you realize you have gravely underestimated the technical skills required to finish it and now you wish you had chosen something else. It is natural and quite common to have a wrong belief or estimate about a future event since future events are fundamentally uncertain.
Economists have been aware of incorrect beliefs and their impact on decision making but modelling them formally has started fairly recently. Taking motivation from psychology and neuroscience, economists have started modelling decision-making under the assumption that the agents are cognitively constrained. They can make mistakes while predicting some uncertain events about the future which can have severe consequences on their life and living.
It’s the same cognitive constraints that drive the seemingly irrational behaviour in the stock market. But the mistakes that people make in the stock market or most economic context are not random. By studying the patterns of mistakes, we can design effective policies to improve welfare.
In the context of the stock market, recent studies by Bordalo et al (2020) have found that people overreact to good news and overvalue them in the long run. If we overestimate the long-run valuation of stocks, then eventually we will be disappointed since our predicted value will not be materialized. This can lead to perverse behaviour in the market.
For example, during the current pandemic, the stock market remained more optimistic than what would be expected from the condition of the economy per se. It might be driven by the overestimation of the long-run fundamentals of the stock market. The problem, however, is that the pandemic initiates a “regime change”, which means we cannot be sure where the fundamentals of the stocks would lie in the post-pandemic period.
Another cognitive function that severely affects our belief is that of memory. Various puzzles in the stock market can be related to the nature of memory. There are different features of the memory that affect what we believe. The most obvious one would be the temporal nature of memory; we remember things with more clarity that have happened in the recent past than a distant past. This implies that while forming belief we put more weight on the recent phenomenon that is the underlying trend. This can lead to having an overreaction to bad news.
The other, more complex feature of memory is representativeness, which implies that different cues about the same underlying object can lead to very different beliefs depending on what comes to mind. In a recent study by Wachter and Kahana (2020) has shown that we often associate two events that are temporally related. If one of these events repeats again we remember both the events, as they are contextually related events. This can lead to further distortion in belief and some examples of such behaviour would be under or over-reaction to news, fear being a leading motivator of financial decision-making, and so on.
However, we should note that this literature is fairly young and researchers all over the world are trying to understand the impact of cognitive functions on beliefs and subsequently on decision-making. So we should proceed with caution when interpreting the results from the early experiments. Just like any other scientific discipline, we can only conclusively make remarks after several studies have reproduced similar results.
One major problem here is that human behaviour is complex and when combined with the stock market framework the scope of non-standard (from a neoclassical economics perspective) is large. This makes analyzing and predicting behaviour in the stock market particularly difficult. But one way forward would be to understand how humans form beliefs generally and extend that to the stock market scenario. This will also help us become better decision-makers and be more consistent with our own world-view.
Srijita Ghosh is an Assistant Professor of Economics at Ashoka University and has done her Ph.D at New York University.
Sources:
Expectations of Fundamentals and Stock Market Puzzles by Pedro Bordalo, Nicola Gennaioli, Rafael La Porta, and Andrei Shleifer (2020)
Memory and Representativeness by Bordalo, Pedro, Katherine Coffman, Nicola Gennaioli, Frederik Schwerter, and Andrei Shleifer. 2020
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