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Of irrational exuberance, bulls & bears

August 07, 2007 12:00 IST
There is a trend to apply psychological explanations in place of basic economic logic to explain macroeconomic phenomena. One example concerns the boom-and-bust business cycle. A conventional explanation follows John Maynard Keynes' in portraying booms and speculative bubbles as the outcome of "animal spirits" released by capitalism.

While herding or schooling is normal among some animals, it is uncommon among humans that tend to define themselves as individuals. Since participation in groups occurs only when consistent with the pursuit of life purposes, it works against mindless or reactionary impulses consistent with herding. As such, the temptation to a knee-jerk reaction when considering risks and investments tends to be overcome by introspection or learning from earlier mistakes.

There is a tendency to greet new technologies promising large potential returns with exaggerated optimism. But widespread hysterical behaviour ("irrational exuberance") with price increases detached from all underlying economic conditions is far from the norm.

Indeed, asset bubbles are rare because markets usually involve many different people drawing different conclusions from the same information. An offsetting balance between "bulls" (optimists) and "bears" (pessimists) reflects the contrarian nature of some people and the subjectivity in human values and goals.

The economic explanation for a boom that involves many people making similar errors of judgement over a long time is that they were misled by widespread misinformation. As it is, the data that is most widely available to all investors is the cost of credit expressed through interest rates.

If central banks make credit artificially cheap and inflate the money supply, they provide investors with financial means to throw money at highly speculative ventures. In turn, this leads to speculative excesses and the rapid growth of asset values since investors tend to miscalculate their future costs. Without the monetary expansion or new bank-financed credit, other transactions throughout the rest of the economy must fall in an offsetting manner.

In the end, artificially low interest rates engineered by central bankers set up conditions for a boom that inevitably leads to a bust. As rising prices force monetary policy to be tightened, many businesses financed with cheap credit find it difficult to pay higher interest rates and are forced to liquidate.

More psycho-babble is found in the notion that price increases for important commodities like oil might lead to expectations of higher overall prices that are self-fulfilling. According to this interpretation, a transparent central bank policy has an important impact on real economic data. In particular, a clear announcement of central bank policies can have a calming effect on inflationary expectations so overall prices will not rise.

But this psychological explanation for how and why consumer or producer prices rise is misguided. Economic theory and historical evidence indicate that an inflated money supply is the primary and fundamental cause of rising prices.

If the central bank does not inflate the money supply, there can be no general acceleration in prices regardless of what the so-called inflationary expectations might be. Even if a sudden and sharp increase in the price of energy or food induced people to expect higher inflation, an unchanged money stock will not allow it to happen!

Another psychological fallacy is that consumer sentiment and the level of consumption drive an economy. The notion is that increased spending induces businesses to invest more and hire more workers. But this argument fails the first test of elementary logic. Since consumption is the outcome of production, production cannot be seen as the consequence of consumption.

While rising consumer demand can induce businesses to increase investment and hire more workers, such gains are sustainable only if the spending reflects rising productivity. Higher productivity supports economic growth by allowing workers to earn more and save more so that more can be the increased investment in the capital structure.

On its own, increased consumption cannot directly benefit workers because it cannot lead to increased productivity necessary for real wages to rise. Instead, it is better to add to savings so more can be invested. As such, abstention from consumption leads indirectly to higher incomes for labourers.

While psycho-thrillers make good bedtime reading, serious economists should steer away from them when explaining market events.

The author is Research Scholar at the Centre for Civil Society, New Delhi and Professor of Economics at Universidad Francisco Marroquin, Guatemala

 

Christopher Lingle in New Delhi
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