Psychology, Economics, and Stock Bubbles

Examining the stock market bubble of the late 90s, Jane Galt wonders how it came to be, and comes to a conclusion that, basically, we did it because we're hard-wired to and thus it really was "irrational exuberance" that caused the problems.

She goes on to a rather interesting discussion on evolutionary psychology and how certain psychological mechanisms fed into the market mania and why people chose to invest heavily into severely overvalued stocks. The problem, though, is that a psychological explanation isn't much of an economic explanation, since psychology is with us all the time, but stock bubble mania comes and goes (among other reasons).

As Robert Murphy pointed out in his article "Psychology versus Praxeology",

"Psychology deals with theories to explain why people choose certain ends, or how people will act in certain settings. Praxeology, on the other hand, deals with the logical implications of the fact that people have ends and the fact that they act to achieve them."

So while Jane's explanation is interesting on the "why did these people act this way?" aspect, it doesn't tell us much about why a stock market bubble came to be in the first place. Surely all of the psychological aspects that Jane describes in her article exist in all of us, more or less all the time (or else her explanation wouldn't be very useful)- so the question becomes "why doesn't the stock market bubble all the time?" And when things go sour, why doesn't it just keep getting sour, since presumably the same psychological effects would kick in on the downside, and its a lot harder to be disappointed when you're betting on failure (what pops a bear bubble?).

The economic answer would be to analyze what it takes for people to act on their ends, and how then a bubble (prices rising in excess of value) could emerge. And, of course, I point back to the venerable and much maligned Austrian Business Cycle Theory (this is an Austrian site, after all). I believe that there are always risk-averse and risk-taking individuals in any market, and agree with Jane's basic point about individual investor psychology. But what restrains most of the irrationally exuberant, usually, is a lack of funds to chase the pie in the sky- these people are rational enough to understand that feeding, clothing, and sheltering one's self is more important than buying 1,000 shares of Widgets.com (the strong buy listed on the latest pop-investor show on MSNBCNN).

In macro terms, should there be a mass shift of irrational investors' cash into long-term investments (speculative ventures such as dot-coms), that would result in an equal reduction of cash/capital available for other purposes, such as consumer goods, consumer durables, shorter-term production goods, etc. The market is very good at and very quick to shift prices and signals to reflect the new reality- and if people don't see that money is going to less-optimal ends, they'll feel it in their wallets when they face higher prices for some goods, or when they look futilely for other goods that are removed from production. In such a case, new irrationally exuberant individuals will see the potential for a quick buck going against the trend, and psychology (via the market) works to correct the misalignment.

Therefore, in order to sustain such a misalignment, people must be 'fooled' into thinking there are more resources available than previously thought- that they can pour money into the pie in the sky, while eating their cake too (and buying their clothes, and paying their rent). In other words, a credit bubble must occur first- the means by which people can spend more than they have while still maintaining their standard of living.

When you have easy credit and easy money floating around, the natural corrective mechanisms of scarcity are removed, and then Jane's psychology can kick in and fuel the bubble. When the easy credit and easy money go away, the props holding up the bubble fall away, and reality crushes it back down to size. The amount of correction depends, of course, on how much the money supply is allowed to contract.

In all cases, though the cause of the bubble (and the pop) isn't the psychology, its the economics that enables it.

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I hope that I didn't imply

I hope that I didn't imply that I had the complete answer to stock market bubbles in a 2000 word post! ;-) I think you're right -- there are other conditions which must be present. But I do think the most important of these is time . . . time to forget the last bad event, and time to produce a mildly improbably long series of good outomes in order to really get the speculative juices flowing. COnsider that in 1925, the last really seriously bad market had been in 1893 -- the 1907 crisis having been averted by JP Morgan's timely efforts. Investors had forgotten, emotionally, that bad stuff happens to investments as well as good.

While credit, too, is important, I'd argue that by the time a bubble is really in swing, the credit is a creation of the bubble, not the other way around. By 1927, certainly 1928, people at the top were trying to halt the flow of money into margin loans. The problem was that raising the interest rates only made things worse -- it made America more attractive to foreign money, and made speculation the only investment with a sufficiently attractive return to justify the rates. Choking off credit to the speculators would have required sufficiently high interest rates to bring the rest of the economy practically to a standstill. This was even more true in 1999, when average people had far more assets they could tap for capital -- a margin rate of 50% didn't even dent the bubble.

Brian, It may well be at

Brian,

It may well be at least partially unfair to call the increased valuation of stocks, etc., found in bubbles irrational, unless rationality is taken to include a significant ability to predict the future.

There are three elements that tend to rationally increase the exchange valuations of goods.

First, a market traded good will have a market value that increases with its volatility, the degree to which its price fluctuates. This is easily seen in the valuation of stock options, but it is true for stocks and other goods as well. This is largely a probabilistic effect due to the fact that a volatile good can only lose up to 100% of its value, while theoretical percentage gains are unlimited.

Secondly, all future goods or goods which produce their values or services in the future, have present values which are discounted back from the future by some discount rate. This is true whether or not the goods are purchased by borrowed money at some interest rate.

When the FED and the banks expand credit and depress interest rates, the present value of all future goods must rise. The present value of goods that have a certain value 24 years in the future will double every time their discount rate falls by 3%. Other future valuation periods and discount rate changes are tied together by the rule of 72. Most goods derive their present values from an array of future times and values.

Thirdly, the end that stocks and other investments are supposed to serve is the increase or preservation of wealth or purchasing power. Before investments can be judged as irrational, the alternative means must be examined. In fact, there is nothing that can necessarily be guaranteed as an superior alternative in the face of a fundamentally uncertain future.

Regards, Don