Image: Aaron Goodman
In Brief
- The worldwide financial meltdown has caused a new examination of why markets sometimes become overheated and then come crashing down.
- The dot-com blowup and the subsequent housing and credit crises highlight how psychological quirks sometimes trump rationality in investment decision making. Understanding these behaviors elucidates the genesis of booms and busts.
- New models of market dynamics try to protect against financial blowups by mirroring more accurately how markets work. Meanwhile more intelligent regulation may gently steer the home buyer or the retirement saver away from bad decisions.
It has all the makings of a classic B movie scene. A gunman puts a pistol to the victim’s forehead, and the screen fades to black before a loud bang is heard. A forensic specialist who traces the bullet’s trajectory would see it traversing the brain’s prefrontal cortex—a central site for processing decisions. The few survivors of usually fatal injuries to this brain region should not be surprised to find their personalities dramatically altered. In one of the most cited case histories in all of neurology, Phineas Gage, a 19th-century railroad worker, had his prefrontal cortex penetrated by an iron rod; he lived to tell the tale but could no longer make sensible decisions. Cocaine addicts may actually self-inflict similar damage. The resulting dysfunction may cause even abstaining addicts to crave the drug any time, say, the thudding bass of a techno tune reminds them of when they were stoned.
Even people who do not use illicit drugs or get shot in the head have to contend with the
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61 Comments
Add CommentWhile there are many reasons for the seeming irrationallity of our economic system, there is ,in fact, a very real dislocation that forces a retrenchment at intervals that is needed to restore balance albeit temporarily. It is simply enough the fact that the collective income of our labor force cannot buy the goods and services that they produce. If these goods and services were sold at a price equivalent to these collective wages and salaries our companies would break even, not acceptable in our business world. To deal with this in earlier days we had layaway plans, then installment buying leading us to the credit card. It always has to be means of borrowing, for a time the money needed to buy what we need and also what we may want even if we don't need it. Two processes bring this about. First, profit adds to the price then corpoate taxes (actually paid for by the consumer) , local government adds sales taxes as well. Working in the other direction, there is a social security tax, a federal income tax, a state income tax and, of course all the other assessments that beseige a homeowner. The spread between the final price of our goods and services and our depleted incomes no longer bear any relationship to their original cost to produce. The leveraged credit systems allow us to buy until our dicretionary income is used up and then we have to pause in our buying until at least some of this debt is repaid so that we can start over again.
Reply | Report Abuse | Link to thisCapital markets are unstable. In the past there was no way to make them stable. But today we have computer power that can be used to make them stable.
Reply | Report Abuse | Link to thisBy using the greater computer power of today we can have a much higher turn over of capital in the capital market. This higher turnover will make the market harder to game or control and the market will no longer have the unstable run ups or declines. Who can change or control the market when say 20% of the capital is trading each day?
So now that we have the compute power to provide for all these transactions that will smooth out the market how do we force people to turn over at a rate of 20% a day? Easy, put a cap gains tax of 0% (zero) on all gains of 7 days or less and put a cap gains tax of 90% of all gains of more than 7 days.
The likes of Yahoo, Micosoft and/or Sun Micro Systems will give us the systems that will provide automated software agents to support turning over one's investments every 7 days (based on the specs you give the agent).
A system like this will make the financial markets work as smoothly as the local fruit market.
Capital markets are unstable. In the past there was no way to make them stable. But today we have computer power that can be used to make them stable.
Reply | Report Abuse | Link to thisBy using the greater computer power of today we can have a much higher turn over of capital in the capital market. This higher turnover will make the market harder to game or control and the market will no longer have the unstable run ups or declines. Who can change or control the market when say 20% of the capital is trading each day?
So now that we have the compute power to provide for all these transactions that will smooth out the market how do we force people to turn over at a rate of 20% a day? Easy, put a cap gains tax of 0% (zero) on all gains of 7 days or less and put a cap gains tax of 90% of all gains of more than 7 days.
The likes of Yahoo, Micosoft and/or Sun Micro Systems will give us the systems that will provide automated software agents to support turning over one's investments every 7 days (based on the specs you give the agent).
A system like this will make the financial markets work as smoothly as the local fruit market.
The capital markets were a good idea, in their purest ideal, to more rapidly bring to many people the genius of invention and the affordability of mass production. But now, with the green light of tax advantage from the federal govt. they have mutated and metastasized into a primordial ocean of money soup with a "wild, wild west" flavor. They now, more than ever, reflect the complexity and motivation of advanced primate behavior seeking social status and hierarchical advantage. The relationship between currency and wealth is retreating as this one of two major parasitical populations increasingly tap into the blood of the workhorse people of the world's civilization. I refer to these parasitic populations as the pigs and mice. While there are legitimate requirements for managerial people at all levels of business, it appears that there are many on "Wall Street" (what was that wall originally for?) that simply try to reel in as much money as possible without creating any wealth, and there are millions of poor people in America who will do or say anything to "collect a check" from the government before actually going out and trying to earn something. Time will eventually solve this unstable situation, but I lament the unnecessary hardship and incivility that awaits the future generations that have to deal with the radioactive, and all other forms of fallout, that our current greedy mansion-dwellers and "familia grandes" will inflict on them long after they are gone.
Reply | Report Abuse | Link to thisTalking about the business cycle while ignoring the Austrian Economics analysis is inexcusable in this age, considering the availability of information.
Reply | Report Abuse | Link to thisPlease educate yourself: www.mises.org
Economic bubble bursts and bang and bust of asset values are a part of the economic ups and downs,and our stock markets represent it on a faster time capsule snap shot.Of course psychology is involved since decision taking is a cognitive process,and while we think we are being rational in making a conscious decision,studies in science reveal that a lot of meta-reason ,emotion and passion go into rational[so-called]conscious decision making.There is mounting evidence for influence of unconscious processes which almost predetermine conscious cognition,to such an extent that one is almost predetermined .Hence the ups and downs of the human mind,the frailties and follies of the unconscious,are also reflected in economics.Hence the bubble and its bursts.
Reply | Report Abuse | Link to thisSURESHKUMAR,SCIENTIST AND ADVISER,NIIST,CSIR,TRIVANDRUM,INDIA
"ignoring the Austrian Economics analysis is inexcusable in this age, considering the availability of information."
Reply | Report Abuse | Link to thisScience relies on empiricism to develop meaningful knowledge. Austrian economics is based on praxeology and rejects empiricism, so the modern rational world doesn't care about Austrian economics.
Capitalists are illogical. As everyone knows, there's no such thing as a free lunch. If you want money, you've got to work for it by adding value to something. When markets will have been regulated to ban speculation, the economy will become logical and markets will become stable again.
Reply | Report Abuse | Link to thisAn economist I know recently expressed a view that is shared by many people: the financial crisis "simply exposed the stupidity of market participants." Classical economic theory is based on the notion of homo economicus, a rational being pursuing his or her self-interests. If everyone acts in this manner, so the theory goes, the wisdom inherent in free marketsthe invisible handassures an optimal outcome.
Reply | Report Abuse | Link to thisWith personal greed at the core of functioning markets, classical economic theory simply doesn't allow scope for any irrational behavior by market participants. But after two major asset price bubbles in the past decade, some observers are beginning to think that maybe market participants really are irrational, if not plain stupid. Hence, new disciplines like behavioral economics are aiming to redefine the foundations of economic theory.
While not disputing the merits of the behavioral approach, I think it isn't needed to explain the current financial meltdown. Rather, in my view the case can be made that each market participant, individual and corporate, probably made quite rational choices leading up to the crisis. In fact, I argue that it is the sum of all these individual rational choices that led to a very suboptimal outcome.
Highlighting the dangers of conflicting self-interests goes back at least to the emergence of game theory in the 1950s and the famous prisoners dilemma. The police catch two suspected criminals but don't have enough evidence for a full conviction. Thus, if both criminals decide not to cooperate with the police, they will each face one-year prison terms. If one criminal decides to talk while the other doesnt, the talker will go free and his accomplice will get a ten-year sentence. If both decide to cooperate, they will each get five years in jail. Studies show that despite the advantages of stonewalling, each individual sees a decisive incentive to cooperate. Each is acting in an apparently rational, self-interested way but the outcome, a five-year prison term for both, is far from optimal.
I think this story best explains the behavior of the market participants leading up to the crisis. Individual stupidity was not the problem; rather, an aggregation of narrowly defined but rational decisions was the market's undoing. Homo economicus is still on his feet, but the invisible hand blindsided him.
What does this tell us about the future? If governments want to avoid a replay of this financial crisis, they need to see that aggregated, cumulative individual behavior does not lead to the marke.
Classical economics is dead.
Reply | Report Abuse | Link to thisThe fundamental currency of our planet is measured in units of energy. The living, unbuilt world has evolved an economy built on limited resource supplies; its mechanisms were before the eyes of the first nomads to leave Africa for Asia and Europe, at the beginning of our prehistory. Those mechanisms are intuitively respected by traditional cultures, and ignored at everyone's dire peril.
My guess is that many people who have fared well in the stock market over the recent few years are the people who have put their money in sustainable and ethical investment funds.
The ecologist HT Odum blazed a trail through the economics of energy that others ought to learn about. Have a look at
www.epa.gov/NHEERL/publications/files/wvevaluationposted.pdf for a recent application of his concepts.
Classical economics is dead.
Reply | Report Abuse | Link to thisThe fundamental currency of our planet is measured in units of energy. The living, unbuilt world has evolved an economy built on limited resource supplies; its mechanisms were before the eyes of the first nomads to leave Africa for Asia and Europe, at the beginning of our prehistory. Those mechanisms are intuitively respected by traditional cultures, and ignored at everyone's dire peril.
My guess is that many people who have fared well in the stock market over the recent few years are the people who have put their money in sustainable and ethical investment funds.
The ecologist HT Odum blazed a trail through the economics of energy that others ought to learn about. Have a look at
www.epa.gov/NHEERL/publications/files/wvevaluationposted.pdf for a recent application of his concepts.
what an excellent idea !
Reply | Report Abuse | Link to thisLets all blame what happen over the last decade on some arcane economics /game theories. This semi philosophical talking points (altogether with other such nonsense vehiculated on other media channels) would make sure that none of the perpetrators of this criminal money grab would ever have to face the music, let alone forced to return their misbegotten gains.
Between these talking points and the daily routine of kicking the Madof pinata, the popular demand for blood should be well satisfied.
Soon we shall all happily align for the next killing, with a fresh set of theories to match the "sophisticated" new suckers (pardon me, I meant investors).
"Science relies on empiricism to develop meaningful knowledge. Austrian economics is based on praxeology and rejects empiricism, so the modern rational world doesn't care about Austrian economics."
Reply | Report Abuse | Link to thisThe meaningful knowledge, to which you are referring, is normally a model, which we use to predict future events. The previous booms and crashes have been predicted with considerable accuracy by Austrian Economists.
Scientists should examine any model which is capable of predicting future events. It may be that the model is unpalatable, but Gallileo's model for the solar system was unpalatable for his peers in the 17th century. We search for the "Truth" about our world. Models need to be consistent across a broad range of predictions. In modern physics, we even accept the Quantuum Mechanical view that we cannot know the position of a particle, also that the question itself may be meaningless. A well respected, modern, scientific theory also rejects the notion that all things can be measured. This is very similar to the praxeological position.
This article makes no reference to the "Invisible Hand", to "The Theory of Money and Credit", "The Theory of Marginal Utility" to the contradictions contained in "The General Theory of Employment, Interest and Money". Modern economic analysis depends largely on Lord Keynes' theory and rejects the classical view, yet it is the classical model which makes the most accurate predictions. Scientific American should examine the simple elegance of classical theory against the complications of modern interventionist theory. "Acting Man", though complex, meets his needs using simple rules. Scientific American is in an ideal position to critically examine and test the varied theories.
This article neglects to point out that both the high-tech and real estate bubbles were based on fraud and deception. The high-tech bubble was caused by manufacturers setting unrealistically long lead times which then caused purchasers to put in multiple orders to different distributors in hopes of getting the needed parts as soon as possible. This created a very high book-to-bill ratio, which made it look like the companies sales were growing dramatically even though most of the orders would eventually be cancelled.
Reply | Report Abuse | Link to thisSimilarly, in the real estate bubble, people were talked into taking on real estate loans which they could not possibly pay back. The loans were then packaged up and sold to investors who had no idea how risky these investments were.
Peoples ability to see how things are going is not all that bad if they actually have the correct information. Get rid of the fraud and you will get rid of these bubbles. As long as the perpetrators keep getting away with this, we will continue to see this sort of problem. I predict the next bubble is going to be based on this environmental cap and trade scheme currently being promoted.
Read a very long article filled with psyco-babble and Piled Higher and Deeper B,S. only one valuable observation was that autistics can see through the fog in economic bubbles. Many is the time a finance guru or a banker has told me I was not smart enough to understand High Finance when I told them that a particular investment made no real economic sense.
Reply | Report Abuse | Link to thisSure glad I have that mental disease. Maybe more people need that affliction. At least those that manage money.
re:
Reply | Report Abuse | Link to this" "Acting Man", though complex, meets his needs using simple rules. "
oh dear.
I hope there are not more than three simple rules. The spot behind my forehead may influence me to seek a sex change, to deal with all this simplicity.
perhaps the_heat_is_on could refer me directly to a list of these simple rules, be it to my relief or my dismay.
The attempt to link social disasters to the human imperfectness and not to the existing political system have the same background as, for instance, attempts of the owners of nuclear reactors to link accidents to the "human errors", not to the institutional failures.
Reply | Report Abuse | Link to thisHuman "design" cannot be changed, let us look at the political system.
The attempt to link social disasters to the human imperfectness and not to the existing political system have the same background as, for instance, attempts of the owners of nuclear reactors to link accidents to the "human errors", not to the institutional failures.
Reply | Report Abuse | Link to thisHuman "design" cannot be changed, let us look at the political system..
Let the Sword (Sacred Word) of living Truth cleave asunder the real from the unreal and cut this Gordian Knot of economic nonsense. Denial is no longer an excuse. Ignorance is no longer an excuse.
Reply | Report Abuse | Link to thisWhen Lucifer and his angels fell, they were immediately cut off from the Source of all Life, God's Light and Energy. Like a spinning fan whose plug has been pulled from the wall, they continued to spin for a season. At first they had great power in the earth, even the ability to create a counterfeit creation of mechanized men, robots without a soul or conscience. Jesus called them "the tares among the wheat" and he rebuked them on sight. In order to sustain themselves these fallen ones and their legions of robots contrived all manner of schemes and devices to steal the Light of God from a secondary source, God's sons and daughters.
The children of God receive his Light and Energy over a connection called "The Crystal Cord" or "River of Life". It enters the crown of the head, where the soft spot on a baby's head was. It enters the spiritual centers called chakras in Sanskrit, first the Heart Chakra and thence to the other 7 major chakras and thence to the remaining 144 minor chakras. Chakras are like step-down transformers and allow the nourishment of the organ systems and all atoms, cells and electrons of the body. Jesus proclaimed that man does not live by bread alone.
When we work at our sacred labor, the energy we use is God's energy. In return for that work we receive money, an agreed upon substance that is a representation of God's energy that we can then use to purchase goods and services. The substance that most nearly equates to God's energy is gold and most all civilizations have recognized it's intrinsic worth.
By hook or by crook, murder, extortion, blackmail, robbery, trickery, forgery, stock schemes, banking schemes, control of commodities and markets, etc., etc. ad nauseum, the fallen ones have managed to deprive the children of God of gold, lands and all that represents true wealth. They have hoarded all of the gold and silver but it will be to no avail. The energy momentum in their "fans" is running out. All of the gold in the world will not restore them to Life. Only if they repent, confess their wickedness and ask God for forgiveness will they be restored. Some have done this and have been restored. They are now a band of angels called "The Restored Angels" and they again serve God. Our God is merciful forever, but he is first merciful to himself. Those unrepentent will exist no more.
Marty,
Reply | Report Abuse | Link to thisCapital markets are a chaotic process. Modeling them is a bit like modeling the weather. Any amount of compute power is thus insufficient.
Eco-Steve: Don't confuse rationality with stability. And speculation has its place as a means of shifting risk from those who don't want it to those who will bear it. The instability comes not from speculation itself, but from too-low or circumvented capital requirements. Further, one can show that insurance (which is just a different type of risk shifting) generally models systemic risk very poorly. Warren Buffett himself wrote about this in the aftermath of Hurricane Katrina. Put bad insurance underwriting together with too-low capital requirements and you get instruments like credit default swaps. Regulation should not eliminate speculation -- this would cause tremendous harm to the economy. Regulation should instead enforce proper capital requirements, with an especially conservative requirement for any opaque or systemic instrument like a default swap.
I very much agree with Andreas on applicability of the Game Theory to the situation in the past few years. Bad outcomes happen even when all participants make rational decisions. Actually, there are many branches of Economic science that explain all kinds of "bad" things that can and do happen - monopolies, for example.
Reply | Report Abuse | Link to thisBesides, classical market economics makes a lot of assumptions about the markets and market participants, in particular about homogeneity of products on a particular market and availability of full information to participants. That is clearly not the case for either housing market or capital markets. I've often heard people to say "hey, the bank gave me the morgage, so they think I can pay it, that must mean I can". And we all know what people thought about the house prices continuing to grow forever - the population is growing, the prices must grow, right? How about the income of that population? Or the appraiser appraised the house at exactly the price I agreed to pay for it, so the price must be right. The appraisers are tought that the market price is the price at which the house would sell. Then indeed, whatever someone has agreed to pay for it is the market price, right?
On top of that, the incentives for corporation leaders and big players move from long-term healthy growth to "make a real big quick buck and who cares what happens next". I wish some conversations from 2000 - 2007 behind the wals of those big financial institutions were recorded. That would be revealing that it's not just that people had no idea that the bubble is forming/formed. They didn't care. The conversations were around how much extra we will make today, and it didn't matter that an extra $1 this year will cost extra losses of $5 in the next 2-3 years. There were warnings, but they were ignored. The bonuses were desided based on extra $$$ today. This is definitely one thing that needs to get fixed for ALL people involved in the business of risk and risk management. Cash bonuses based on current volumes and profits should be prohibited. And that's where the government/regulator intervention is necessary. The companies will not have incentives to do that themselves.
MITDgreenb : Yes, markets are governed by chaos theory and are not fractals as is commonly believed, as human behaviour is so often irrational.
Reply | Report Abuse | Link to thisAs for speculation, examine the usual case : A speculator finds a company that pays good wages. He considers the shareholders could earn more by delocalising and paying lower wages. So he speculates on the shares, buying them knowing the price will increase, where HE will make the most profit. The final result is that the original well-paid workers (who created added value through their work) are sacked, and the speculator gets a free lunch, just by keeping the new labour force relatively impoverished.
It is clear then that speculation does not contribute to the creation of wealth and as such is anti-social, unless of course you happen to be an ultra-liberal capitalist?
Here I think how economic crises occurs:
Reply | Report Abuse | Link to thisA small number of people pull away a significant portion of cash money from the market by using a scam-like operation. After that deficiency of money in the market disrupts its proper function. So best way to fix it is inject large amount of money back to the market. I believe already being done currently. Also, the fault does not really belong to capitalist system itself. It belongs to few individuals.
Empiricism is the rejection of the observation-based, rationally systematic study of natural causes, ie, science. Empiricism is the arbitrary, pseudo-mathematical description of a random flow of experience.
Reply | Report Abuse | Link to thisAustrian economists predicted the Great Depression and our current depression.
This article is a pseudo-scientific, Marxist/Biblical attack on man's mind and capitalism. The failure to discuss Austrian Business Cycle Theory and the govt interventions that caused "Famous Bubbles of Yesteryear" is inexcusable, a scientific disgrace.
Reply | Report Abuse | Link to thisFrom kings who "clipped" gold from coins to the Fed, govts have often counterfeited money, credit and interest rates to tax people without resistance or even without people knowing what happened. Real money is gold or gold-backed paper. War and welfare have been financed this way.
The money, credit and interest rates misled and otherwise influenced businessmen into unsustainable investments (BOOM) for which there was no real savings. When businessmen eventually discover a lack of money to complete the investments and to buy their products, they slow or stop investing (BUST). This has been known since, at least, Mises' 1949 _Human Action_ . Several decades of Republicans and Democrats and the Fed are responsible for this socialist boom-and-bust cycle.
As for "animal spirits," it would apply to everyone, including the author of this despicable article and the "scientists" he cites. Failing to recognize this is the fallacy of self-exclusion. The destructiveness of liberal subjectivism is becoming increasingly obvious. See Aristotle, Francis Bacon, and Ayn Rand for induction-based objectivity.
Money, capitalism, etc. are technologies, not science, not theory and not biology. Get it?
Reply | Report Abuse | Link to thisTalk about having a political agenda. The author took an interesting subject and turned it to an apologists' view of government intervention. Who knew government existed to save us from our irrationality! When government policies distort prices in the marketplace we make decisions based on that false information. The author fails to note in the housing bubble example that it was the government who lowered interest rates and created the climate for the boom, and then raised interest rates and created the climate for the bust.
Reply | Report Abuse | Link to thisWhat's a "rational" man supposed to do?
One more thing. Thaler's comment about needing a PhD in economics to get a mortgage is hyperbolic BS. No where did the author address the issue that basic financial skills are not taught in our schools. It is truly amazing how rational one becomes when one is given the tools! The author points to how irrational we are when it comes to decision making, but fails to address how education changes that equation.
What's up with that?
So in a way, government created this "irrationality" in the first place.
Devils Advocate at 07:02 AM on 06/26/09
Reply | Report Abuse | Link to thisMoney, capitalism, etc. are technologies, not science, not theory and not biology. Get it?
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Mainstream economics is the empiricist jumble that you have identified. Austrian economics, however, is a science of the laws of economics.
One of the silliest articles on economics I have ever read. An increase in the money supply is not immediately felt by all participants at the same time. nor could it ever be. Inflation is not an equal opportunity destroyer of value. Those who are first in line to receive inflationary dollars receive them and can spend at near full value long before they are fully debased. Measurable inflation doesn't show until much later when the economy has fully absorbed the additional supply of money. So let's follow the scenario as it happened.
Reply | Report Abuse | Link to thisIncreases in the money supply lowered the cost of capital in both the tech and housing bubble. Decision makers then bid up the cost of infrastructure, plant and equipment and real estate. The makers of industrial goods such as Applied Materials in the tech bubble and construction firms in the housing bubble made a healthy run during this period of expansion. Employment numbers grew, pay went up and new spending was stimulated. But the expansions were only temporary. They were based on misleading assumptions which were triggered by the government's loose money policies. After the money supply fully cascaded through the economy, we realized that we weren't richer. The expansions weren't sustainable and resources were diverted into costly black holes. We actually ended with less than when we started.
The homeowner who used his home like an ATM for seconds and then thirds on his mortgage is reflective of this process. His new loan for the boat was prudent so long as housing prices were rising. What caused housing prices to rise? Cheap money.
THIS IS EXACTLY WHAT HAPPENED IN BOTH THE TECH BOOM AND HOUSING BOOM. The government wasn't and isn't the solution, it was the problem.
During the economic bubble growth, the common sense gets depleted. When the common sense drops below certain value, we call it irrational jubilance, then the bubble bursts. It is not so much of a psychology issue but more like a behavioral modification by the media. The behavior modification also occurs when the rewards are high compare to the performance. For example, the performance bonus in financial sector lost the word performance and only bonus remained. They award bonuses for poor performance by arguing it could have been worse. When the market is growing beyond rationality, they come up with new words to justify and the one I like is the famous 'new economy' during IT boom. In the current bubble burst, the media comes of with the new words such as 'second derivative' and somehow became experts in calculus. When they say that the second derivative is slowed down, they do not say it is forced to slowdown by adding a trillion dollars to the economy by borrowing. It is a simple human behavior that if I loose a job, I can borrow and keep paying my bills for while until I get another job. What happens if I don't get job? Even if I get a job, I have to pay off the debt I made during the unemployment period. So, my personal finances will remain poor until I pay off the debt I borrowed during the unemployment period. How can a country's economy will improve until they pay off the trillion dollars they borrowed. Instead they turned the market place into an organized gambling place. Obviously, there are more loosers than winners like in any casino places. But the casino owners will win. Good luck at the new casinos!
Reply | Report Abuse | Link to thisThe whole concept of economists being driven by Physics envy was stolen from Charlie Munger (Warren Buffett's business partner and Vice Chairman at Berkshire Hathaway). He wrote about this in Poor Charlie's Almanac several years ago.
Reply | Report Abuse | Link to thisThere is nothing magical, mystical, irrational or crazy about economic bubbles, booms and busts--they are always and forever the result of the expansion of the money supply. It really is that simple.
Reply | Report Abuse | Link to thisMonetary expansion ruins the price mechanism--the coordination mechanism of the economy. Once the price mechanism is ruined, economic coordination is impossible, and the result is the discoordination of investment, leading to bubbles in certain sectors. These bubbles inevitably burst when the monetary expansion ends, and the result is a recession.
Monetary expansion is a necessary and sufficient condition to cause the boom and bust. There is nothing that humans' rationality or irrationality can do about it. When the price mechanism is distorted, the market will produce a bad outcome. This is not a market failure, since it was the government that ruined the price mechanism with its monetary expansion.
This, in a nutshell, is the Austrian Theory of the Business Cycle. This is not some fringe nutty theory--FAO Hayek won the Nobel Prize in Economics precisely for this theory. Yet, today, economists prefer to philosophize about imperfect humans rather than understand this very simple idea. This might be due to some irrationality on the part of economists, who would rather an explanation that pins the blame on humans' shortcomings rather than the clear explanation that shows it is economists' central planning that is at fault.
If you want to try to understand ABCT, you should maybe start with these powerpoint slides: http://www.auburn.edu/~garriro/ppsus.htm
I then suggest you read Hayek's The Use of Knowledge in Society. Follow that with Hayek's Monetary Theory and the Trade Cycle, and then his The Pure Theory of Capital.
It is simply amazing that someone would write an article about booms and busts without even mentioning this.
An interesting piece, Mr Stix, and some suitably enraged commentary upon it. You should take these reactions as a compliment. If you cannot satisfy 'em, you might as well enrage 'em.
Reply | Report Abuse | Link to thisI particularily enjoyed Carlton22, the Old Testament prophet who shrieks of God and GOLD! Wonderful. It reminds me that Alan Greenspan, who confessed that everything he thought he knew was wrong, was for a long time a close associate of the goldbug novelist and philosopher, Ayn Rand.
May I quibble about one factoid in your piece: 'Kahneman won the Economics Nobel Prize in 2002'. No he did not. No one has ever won a Nobel prize for Economics. Alfred Nobel left no money for an Economics Prize. it was the Swedish Central Bank that decided in May 1968 to remedy this obvious error by sneaking in to the ceremony a prize for economics 'in memoriam of Alfred Nobel'. A low trick designed to fool journalists, which it has done ever since.
You di d not deal with how long it might take for economics to die - I suggest you refer back to the discrediting of astrology in late sixteenth century England.
the_heat_is_on, we have all seen the the success of empiricism in the former Soviet Union where government economists attempted to rationally assign 25 million different prices. We now see the same economic illiteracy holding sway under Obama. Politics does not trump economics. As marekknowak previously said, "Please educate yourself: www.mises.org".
Reply | Report Abuse | Link to this.
Reply | Report Abuse | Link to thisIt is the rule and not the exception that governments cooperate to create bubbles such as our still collapsing housing bubble. Regulators manipulate interest rates.(Remember how we had the lowest interest rates in 40 years!) The chief economist was giving interviews to the Wall Street Journal that we had seen the housing bottom in 2007! Those entrusted to protect us were more concerned to protect their jobs as they sidestepped their repsonsibilties. When the housing head was cut off, they explained that borrowers and lenders got greedy! Truth is, buyers and lenders trusted the regulators. I guess that's a very stupid illusion. Now our governement is creating unbelieveably huge amounts of unbacked currency to save us all. Like a flood to extinguish a house fire, the cure will be a greater disaster , The non participants will be forced to suffer now. Why does our government wish to destroy us? Where's the phychological study about that? The Fed can only guess at the consequences of the current emergency measures! Many respected economists predict a potential tidal wave of inflation. As for all the behavior economics BS, I (a real estate broker for 21 years) warned buyers away from this market in '03! In '05 I was pleading with anyone who would listen that we are heading for an increasingly heavy fall we continue to see housing prices continue to rise. I found agreement with local bankers and mortgage brokers and other real estate brokers. Beyond the local, on the street savy, their was silence or optimism. Even problems with Fannie Mae and Freddie Mac in '04, '05, '06, and '07 were not being reported in the main stream media. WHY??? Economic Regulators and Economists and most Politicians, and evidently the writer of this article, were too removed from this ugly creation to be of service to the people. We do not see our politicans. The economists who see them don't seem to understand what's happening. Are they all in classrooms?Teaching? The behavior economists will have to begin to hit the streets and ask those on the front lines what happened. The writer of the above article should do the same. We have another, bigger, bubble brewings. But I suppose you can't see it coming either.
Reply | Report Abuse | Link to thisGary: "SciAm News Flash: People Aren't Always Rationale!" Duh. You think?
Reply | Report Abuse | Link to thisIt would have been nice to read a quality article about the underlying causes of the recent (and past) bubbles and busts, but clearly this wasn't it.
Clearly this past bubble had a life history. It started when the Federal government interfered in the real estate market by pressuring banks to give mortgages to people who couldn't afford them. It was allowed to grow unchecked when the Federal government failed to regulate 'derivatives' that were created by banks in an attempt to somehow share the risks created by all the unsustainable mortgages. And it continued to balloon when the Federal government kept base interest rates unreasonably low in an attempt to keep the whole house of cards from collapsing.
This wasn't herd dynamics. This was a few people in government whose social engineering was gamed by society (we're smarter than you give us credit for!) and ultimately got caught up in very unintended consequences. Pretending that this is all about evil bankers (thank you Barak) or stupid people (thank you Gary) teaches us nothing, and indeed merely sets the stage for the next round of social engineering and unintended consequences.
Pleasepleaseplease, can we have a REAL article about what went wrong and what we could do to fix it?
The behavioral argument of Shiller and Akerlof is only half right. The other half lies in complexity theory, in particular, the fact that individuals copy successful behavior as a strategy for success. This leads to power law distributions rather than normal (Gaussian) distributions.
Reply | Report Abuse | Link to thisSee my review of Shiller and Akerlof on Amazon.com, or my Economic Journal paper, (2007), "The Dynamics of General Equilibrium."
I think this analysis is right on the mark. All this stuff about people being "irrational" is way overblown. The crisis flows from the way markets aggregate individually rational choices.
Reply | Report Abuse | Link to thisThis has become the standard catechism of the free market fundamentalists. It is empirically implausible for reasons I outline in my review of Thomas Sowell's book (http://www.amazon.com/Housing-Boom-Bust-Thomas-Sowell/product-reviews/0465018807/ref=cm_cr_pr_link_next_6?ie=UTF8&showViewpoints=0&pageNumber=6) or Richard Posner's book, A Failure of Capitalism. By the way, neither Posner nor I argue against capitalism, but rather against free market fundamentalism.
Reply | Report Abuse | Link to this@the_heat_is_on "Science relies on empiricism to develop meaningful knowledge. Austrian economics is based on praxeology and rejects empiricism" Yes, but do you know why they reject the bastardization of mathematics? Have you gone any further then wikipedia? Doesn't really sound like it.
Reply | Report Abuse | Link to thisThe recurrence of boom periods, followed by periods of depression, is the unavoidable outcome of repeated attempts to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.
Reply | Report Abuse | Link to thisThe breakdown appears as soon as the banks become frightened by the accelerated pace of the boom and begin to abstain from further credit expansion. The change in the banks' conduct does not create the crisis. It merely makes visible the havoc spread by the faults which business has committed in the boom period.
~Ludwig Von Mises
The reasons for Marx’s belief that periodic and increasingly severe economic crises are inevitable under capitalism and cannot be avoided. Is the simple fact that the driving force of the system can be summed up as a compulsion to accumulate capital.
Reply | Report Abuse | Link to thisCompetition between capitalist concerns forces each firm to attempt to expand its share of production by converting surplus value into capital. This process of capital accumulation tends to increase the demand for labor and so to push up wages. To minimize wage costs more sophisticated and expensive capital equipment is introduced with the aim of increasing the productivity of each worker and hence the amount of surplus value (profit), extracted. An unwanted consequence of this increase in the amount of fixed capital per worker or “rise in the organic composition of capital” is a downward pressure on the rate of profit.
The immediate cause of slumps is not this long-term tendency but short run fluctuations in the rate of profit. Of course every actual slump has particular causes of its own but certain general causes are always present.
In the course of a boom the demand for labor rises, output increases and so does capital accumulation and hence the demand for additional machinery and equipment. Unemployment falls and as it shrinks so does the most important check on rising wages. Earnings are pushed up and so the rate of profit tends to be diminished. “But as soon as this diminution touches the point at which the surplus value that nourishes capital is no longer supplied in normal quantity, a reaction sets in: a smaller part of revenue is capitalised, accumulation lags, and the movement of rise in wages receives a check.” (Marx).
The result is a recession, which is first felt in the heavy industries making “capital goods” – “Department I” as Marx calls them. The loss of earnings of workers in this department due to lay-offs, reduced overtime and so on causes a fall in demand for the commodities that working people buy and so spreads the recession to the sector of industry making these goods. Marx calls this sector “Department II”. The effect is cumulative and the depression worsens. Whether or not wage rates are cut- and typically they are – actual earnings and hence demand falls progressively.
Unemployment rises until the wage gains of the boom have been cancelled out and the rate of profit starts to rise again. A new boom is then in the making. This is a very much simplified picture which leaves out a number of features of importance, notably price fluctuations in the boom-slump cycle.
Nevertheless it represents the essence of Marx’s crisis theory. Three additional points have to be considered.
The first is that though the crisis appears as a crisis of “overproduction”, of falling demand, it is not demand as such that is deficient. It is purchasing power. As Marx wrote: “The final cause of all real crises always remains the poverty and restricted consumption of the masses as compared to the tendency of capitalist production to develop the productive forces in such a way that only the absolute power of consumption of the entire society would be their limit.”
This fact is the basis of various reformist schemes that seek, in one way or another, to prevent or alleviate slumps by giving away purchasing power to workers. The possibilities and limitations of these will be examined later.
The second point is why crises should tend to get worse This is where the long term tendency for the rate of profit to decline is important. To the extent that it is realized, it lowers the profits “ceiling”, and so the “space” between that “ceiling” and the “floor” created by working class resistance. Thus, in the absence of offsetting factors, crises should become ever more frequent and more severe. This is the basic reason why Marx believed that wages could not increase indefinitely in a capitalist society.
Finally there is the fact that there is a sector of production, called by Marx “Department III”, that makes neither “wage goods” for sale to workers nor “capital goods” for accumulation. It includes both “luxury goods” for sale to the rich and, more important, various goods for the state which are, strictly speaking, not commodities in Marx’s sense at all, since they are not produced for a market.
This sector is relatively unaffected by the factors making for boom and slump in Departments I and II. Its size is of great importance in modifying the boom-slump cycle. How does the theory measure up to reality? The liberal economist Lord Beveridge concluded: “Fluctuations of industrial activity in Britain in periods of an average length not very different from those of the modern trade cycle can be traced over the whole time for which data of construction industries are available, i.e. from 1785”.
The average length of the cycle, on Beveridge figures, is around 10 years. Clearly the boom-slump cycle is built into capitalism. When the severity of the crisis is considered this picture is modified. There was a general but uneven tendency for crises to become more severe until the 1880s. Thereafter slumps became milder until after the first world war. The slumps of 1921, 1929 and 1938 were much more severe than those of the 19th century, though that of 1938 was interrupted by the second world war.
Finally, since 1945 there have been a number of mild recessions, none of which deserve the name of slump. These facts have to be explained before it is possible to reach a reasoned conclusion on the claim that the post-war economic expansion proves that capitalism has been drastically modified and is now slump free.
Three main features of the system that have not yet been examined have a bearing of the issue. They are the growth of monopoly and state monopoly capitalism, the export of capital and the expansion of Department III production.
Two of these have had, at various times, a medium run stabilizing influence on capitalist economies. None of them can permanently stave off the system’s inherent tendency to crisis.
Re: Mr. Heat & his charming definition of praxeology (& seconding other comments as to political manipulation of markets, recently & historically):
Reply | Report Abuse | Link to thisEmpirical methods in science build valid theories, after testable observations.
Praxeology is such a tested concept, defining core decisions in economics not theoretical in an ivory-tower sense.
Did Einstein fly into outer space to test the Special Theory of Relativity?
Mr. Heat might read a book or two.
Baffling that this excursion into brain topology deftly ignores past market interference through government policies, the saintly efforts of legislators & central bankers at regulation.
Always nice to know what our brains are doing electrochemically speaking.
Until we, as citizens, outgrow our infantilized acceptance of politicians efforts to (pretend to) shield us from risk, markets will crash, along with the buying power of our currency, generation after generation.
One obvious example of the lack of rationality, is paying commercial staff commission. As such, these commercial empoyees of financial institutions think about their own pockets and not the long-term interests of the bank, its depositors and shareholders. If you don't know how to calculate risks, go and learn from a bookmaker...
Reply | Report Abuse | Link to thisThere have not been enough firings so far...
I suspect there is a flaw in this argument. This article supposes men are (imperfectly) optimising some kind of personal utility functions.
Reply | Report Abuse | Link to thisWhen you read Galbraith on the Great Crash or live through one or two speculative bubbles and interview traders, you realise that they follow common implicit rules. For example when in a bubble you know you have very little time to make a lot of money. “Moral hazard” is rational. A few days ago, a trader managed to raise oil prices by 3 or 4% in one hour. However he was not alone: his colleagues had expected something. Their collective move increased oil prices by something like 10% (see 'Rogue broker' blamed for oil spike / Financial times July 3rd).
We are social beings and we spontaneously create, and follow, social rules. Students of complexity say that organisation “emerges”.
What seems irrational when a human being is taken separately becomes rational when he is seen as a member of a society, of a “team”. It is rational to follow social rules (e.g. London stock exchange’s “my word is my bond”), because in doing what is good for the group we do what is good for us; And because it is more efficient to do so than following our own selfish interest.
As long as economists and policymakers don’t give up the fiction of a rational man and don’t start reading sociology, it seems likely we’ll keep on having crises.
I suspect there is a flaw in this argument. This article supposes men are (imperfectly) optimising some kind of personal utility functions.
Reply | Report Abuse | Link to thisWhen you read Galbraith on the Great Crash or live through one or two speculative bubbles and interview traders, you realise that they follow common implicit rules. For example when in a bubble you know you have very little time to make a lot of money. “Moral hazard” is rational. A few days ago, a trader managed to raise oil prices by 3 or 4% in one hour. However he was not alone: his colleagues had expected something. Their collective move increased oil prices by something like 10% (see 'Rogue broker' blamed for oil spike / Financial times July 3rd).
We are social beings and we spontaneously create, and follow, social rules. Students of complexity say that organisation “emerges”.
What seems irrational when a human being is taken separately becomes rational when he is seen as a member of a society, of a “team”. It is rational to follow social rules (e.g. London stock exchange’s “my word is my bond”), because in doing what is good for the group we do what is good for us; And because it is more efficient to do so than following our own selfish interest.
As long as economists and policymakers don’t give up the fiction of a rational man and don’t start reading sociology, it seems likely we’ll keep on having crises.
Not true. the collapse happens when there is no more profit to be extracted from a particular market.
Reply | Report Abuse | Link to thisThe reasons for Marx’s belief that periodic and increasingly severe economic crises are inevitable under capitalism and cannot be avoided. Is the simple fact that the driving force of the system can be summed up as a compulsion to accumulate capital.
Competition between capitalist concerns forces each firm to attempt to expand its share of production by converting surplus value into capital. This process of capital accumulation tends to increase the demand for labor and so to push up wages. To minimize wage costs more sophisticated and expensive capital equipment is introduced with the aim of increasing the productivity of each worker and hence the amount of surplus value (profit), extracted. An unwanted consequence of this increase in the amount of fixed capital per worker or “rise in the organic composition of capital” is a downward pressure on the rate of profit.
The immediate cause of slumps is not this long-term tendency but short run fluctuations in the rate of profit. Of course every actual slump has particular causes of its own but certain general causes are always present.
In the course of a boom the demand for labor rises, output increases and so does capital accumulation and hence the demand for additional machinery and equipment. Unemployment falls and as it shrinks so does the most important check on rising wages. Earnings are pushed up and so the rate of profit tends to be diminished. “But as soon as this diminution touches the point at which the surplus value that nourishes capital is no longer supplied in normal quantity, a reaction sets in: a smaller part of revenue is capitalised, accumulation lags, and the movement of rise in wages receives a check.” (Marx).
The result is a recession, which is first felt in the heavy industries making “capital goods” – “Department I” as Marx calls them. The loss of earnings of workers in this department due to lay-offs, reduced overtime and so on causes a fall in demand for the commodities that working people buy and so spreads the recession to the sector of industry making these goods. Marx calls this sector “Department II”. The effect is cumulative and the depression worsens. Whether or not wage rates are cut- and typically they are – actual earnings and hence demand falls progressively.
Unemployment rises until the wage gains of the boom have been cancelled out and the rate of profit starts to rise again. A new boom is then in the making. This is a very
the comment (submitted twice for emphasis) by martynstrong is not, as Bill Gates says all the time, the stupidest thing I've ever heard. But it is close.
Reply | Report Abuse | Link to thisMarketing is what we need to improve....
Reply | Report Abuse | Link to this___________________
Andrwe
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Maybe i'm wrong but there seems to be a flaw in the rationing of this article.
Reply | Report Abuse | Link to thisThe main argument for the crisis is "money illusion", but what arguments are there presented for "money illusion" itself? This so called experiment assumes that earning 50% more money is an illusionary gain when prices also increase with 50%. It would be interesting to know what was the time span between the two observations, but in real world this doesn't happen over night. The subject who earned 50% more money could very well purchase the goods cheapper from somewhere else or just consume less of those goods and still have some extra money as a gain. Maybe the authors of the experiment could provide some evidence from real life situations where indeed people are earning more money, but damn inflation strikes everywhere and in an instant all prices are up from jam and bread to luxury holidays.
Another argument for "money illusion" actually won the Nobel Prize for Economics, it says in the article. Basically someone assumed that "feeling sad about losing" something equals to "feeling happy about gaining" the same something then proved it wrong by surprisingly finding that the feeling of losing is actually stronger. Somehow they showed that pain really hurts, though i dont't get why they wanted to compare it with feeling happy.
Then coming back to this article providing arguments for why the crisis happened i can say it was most disappointing to read it in Scientific American.
The instability of the system is due to the way the central bank and the monetary system works. Money is debt-based: money is only created when loaned, and vice versa. When more loans are created than repaid, the money supply expands. When the FED manipulates interest rates down, the money supply expands, creating BUBBLES. When 2 people bid for the same house, the price goes up. They were both encouraged by the low interest rates to borrow (newly created money). This is how bubbles form.
Reply | Report Abuse | Link to thisWhen more loans are repaid than created, the money supply contracts. A slight slowdown causes the money supply to shrink which further accelerates the popping of the bubble. Therein lies the instability.
The central bank (FED) is a cartel and its existence is against free market principles - it is a government licensed monopoly to print money. No surprise, the Federal Reserve Act was written by 7 reps of the biggest Wall St. banks of 1910.
A PHYSICIST has modeled the equations that describe the monetary system. He found that the debt-based fiat monetary system is inherently unstable:
http://www.whattheproblemis.com/documents/ra/Money_parasitism_Vladimir_Nuri.pdf
For further reading:
http://mises.org/books/fed.pdf
http://mises.org/mysteryofbanking/mysteryofbanking.pdf
When too much money is concentrated into too few hands the poor can no longer function, so the economy collapses.
Reply | Report Abuse | Link to thisGary, I've been a reader of SA for nearly 30 years. I've enjoyed every article. Further, I've never posted a comment like this for any reason. So, this is a first for me on many levels. Your article was something I'd expect to read in Time or NYTs. It wasn't simple however I didn't learn much. I'm a financial advisor so I do some reading in this area. For a journalist it was a good article. For a scientist it was too simple.
Reply | Report Abuse | Link to thisWhile this article covers a very wide range of topics related to human risk decision making, it makes a number of fundamental errors. The first is that emotion and reason are two separate systems. The latest research shows they are not. The second is that price is ALWAYS relative and always influenced by the prices of the day before. I could go on but in short, while seemingly very informative and certainly inclusive of some leading thinkers, the article is mis-leading in terms of what can be deduced from neuroeconomics - which really does explain much more of the WHY than the WHAT of Behavioral Economics or Finance.
Reply | Report Abuse | Link to thisI was glad to see Dick Thaler mentioned in the article. I had a class with him 15 years ago in which, with simple in-class experiments, he showed the flaws in just about every major assumption of classical ("rational") economics. I have never forgotten that class. Thanks, Dick, if you're reading!
Reply | Report Abuse | Link to thisOne of the thing Dick worked on with Amos Tversky was the concept of "fairness." We all think we know what "fair" means, but their work showed how arbitrary and variable the rules of fairness are. Later work, by others, has shown that various animals have concepts of fairness as well, so the idea is almost certainly deep-seated in our irrational animal spirits, not part of "higher" human thought. I recommend reading some of this work, as it gives a lot of insight into what's "fair" in places like the Middle East and Northern Ireland... or even what a "fair" price of gasoline would be and a "fair" return on investment for oil or pharma companies.
Recent works of Prof. R. Ashley (Virginia Tech University, US) and Prof. C. Kyrtsou (University of Macedonia, Greece) reveal new findings on financial modelling. The new idea here is that heteroskedasticity (time-varying variance, extreme fluctuations) arises endogenously. This new notion is of great interest since if phenomena such as sudden changes, large peaks and fat tails in financial and economic series can be attributed to complex interactions or intrinsic dynamics, then alternative interpretations of anomalies and rich policy implications come to light.
Reply | Report Abuse | Link to thisFor further reading:
Ashley, R., (2007): On the origins of conditional heteroskedasticity in time series, Working paper, department of economics, Virginia Tech.
Kyrtsou C (2008) Re-examining the sources of heteroskedasticity: the paradigm of noisy chaotic models, Physica A, 387:6785–6789
The state of the global economy is tragic for some that are directly affected by loss of employment and housing (repos) but news like this is somewhat refreshing for a change.
Reply | Report Abuse | Link to thisSome even says your misfortune is an opportunity for another...people that are not affected by job loss finds themselves in a quite good position where prices are dropped substantially; e.g cars, housing, clothes, etc...
http://economycrisis.biz/
The state of the global economy is tragic for some that are directly affected by loss of employment and housing (repos) but news like this is somewhat refreshing for a change.
Reply | Report Abuse | Link to thisSome even says your misfortune is an opportunity for another...people that are not affected by job loss finds themselves in a quite good position where prices are dropped substantially; e.g cars, housing, clothes, etc...
http://economycrisis.biz/
Check out this paper by a PHYSICIST:
Reply | Report Abuse | Link to thishttp://129.3.20.41/eps/mac/papers/0203/0203005.pdf
He modelled monetary systems, and concluded that the DEBT-BASED FIAT currency system coupled with FRACTIONAL RESERVE BANKING we have, is INHERENTLY UNSTABLE.
In contrast, a FIXED or relatively fixed money supply (e.g. gold or other commodity standard), or a NON-DEBT based fiat currency system, are inherently stable!
What is a DEBT-FIAT system? Watch this:
http://video.google.com/videoplay?docid=-2550156453790090544
Here are those links again, clickable:
Reply | Report Abuse | Link to this<a href="Paper showing debt-fiat currency system is unstable">http://129.3.20.41/eps/mac/papers/0203/0203005.pdf</a>
<a href="Video explaining debt-fiat currency">http://video.google.com/videoplay?docid=-2550156453790090544</a>