Momentum trading…

I am forever seeking more and more condensed explanations for phenomena in economics. Rather like the process of developing unifying theories in physics. Just recently I figured out a new one. A way of expressing what is wrong with textbook economics (or at least a major component of what’s wrong) in just one sentence:

One of the biggest flaws in textbook economics is ignoring “momentum trading”.

Many of those reading this may now be thinking to themselves - how could this obscure technical sounding term have much of an impact on the whole economy? Let me explain. First of all I shall explain what momentum trading is, then I shall explain why it affects the entire economy.

Momentum trading is purchasing investment vehicles (like shares for example) purely (or largely) on the basis that their price appears to be steadily rising. The idea is that, even if you have little idea of why it is rising, you know from life’s experience that pretty much any phenomena that you observe carrying on in a certain way for a sustained period, tends to carry on behaving in that same way. If you are right, then you will be able to sell that investment vehicle at a higher price at a later time. Momentum trading may be an obscure term used by certain types of technical investors, but in the real world, many more people than just traders are practising it. Indeed the practice could be described as ubiquitous. Just look at the phrase “property ladder”. This is a two word phrase meaning “buy a house now because prices can only ever go up. It will be a good investment”. Its the personification of momentum trading!

The equilibrium models of textbook economics fall apart if lots of momentum trading is going on. They rely on the idea that rising prices discourage purchasing and falling prices encourage it. This may be true for most goods that are purchased in order to be consumed, but clearly is not true for goods (and I’m including shares and houses here) purchased wholly or partly as investment vehicles.

Economists from the Austrian school are equally guilty of this denial.

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