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Scientific American has a piece up looking at The Science of Economic Bubbles and Busts. Not to quibble, but the very notion that the study of bubbles can now be described as a "science," which suggests a level of predictability, is absurd. Bubble psychology, and the larger field of behavioral economics, studies the mentality and actions of groups of often wayward souls, though defining wayward is always an adventure. In an ancient line from the markets, if these folks could really predict how bubbles worked, they'd be rich. They can't and they aren't.
The Scientific American overview wanders like a kid in a candy store, trying a little of this and a little of that. It talks about the "money illusion" and its locus of activity in the front of the brain as if that means something. It traffics in the set of memes, beloved of evolutionary psychologists and personal finance magazines, that our bouts of "irrationality" when it comes to money issues somehow trace back to the Paleolithic era, as if that had a prayer of ever being proved. In fact it represents the antithesis to the "strong" belief in efficient markets, with its roving bands of rational Spock-like investors, that seems to have gotten us in such a pickle: The "strong" case that we are all irrational and prone to instinctual reactions that somehow stem from an age when we spent a lot of time in trees. Need it be said? Market behavior is a complex blend of rationality and irrationality, of efficient and inefficient markets, of periods when animal spirits run freely and those when they hide beneath the bed. The markets are like the folks who constitute them: a profound and so far impossible-to-fix blend of free will and determinism; of noise and information; of intelligent decision-making and big boo-boos; of, yes, fear and greed, memory and forgetting. Scientific American falls for the classic snare: Markets, like history, look so very simple if: a) you're looking from the outside and b) you're examining them retrospectively. One of the trickiest things about bubbles is the fact that though we may suspect that value is disengaging from price, we never know when a bubble will burst and, until it does, we can't call it a bubble at all. Bubbles are manifestations of both market and political democracies. Behavioral economics aren't much help when there's broad agreement that some set of conditions is wonderful and should continue. Scientific American, for instance, scoffs at the irrationality of investors scarfing up dot-com stocks. How dumb were they? But what about those investors -- say Steve Case or Mark Cuban -- who got out in time? Were they irrational, as they lounge on their estates or watch their basketball teams play? Or what about investors in Amazon.com Inc. (NASDAQ:AMZN) and Google Inc. (NASDAQ:GOOG) that held on? And the psychology of mortgage holders, who took on clearly too much, is more complex, I think, than the magazine's notion that they were felled by a "money illusion." As Edmund Andrews points out in his new book on his personal travails, many mortgage holders were drawn in by the belief that they could refinance and keep the game going. True, that's the same psychology behind Bernie Madoff's Ponzi scheme, but it wasn't necessarily irrational. Risky yes; irrational no. Financial decisions are not just about money; they're about status, convenience, good schools, happiness, even, in Andrews' famous case, love. Besides, some mortgage holders clearly pulled it off. What no one knew, of course, was when the music would stop. And that's not apprehendable by any "science" of bubbles. Scientific American also seems to think it heartening that members of the behavioral school have jobs in the Obama administration. Well, it's not terrible: At least there's a diversity of views. But it certainly doesn't make the regulatory challenge before us any easier. The point here is not to mug Scientific American (and worthies like Yale's Robert Shiller, quoted in the piece, who know these complexities full well). For someone who has never heard of behavioral economics, the piece is a decent introduction. But it does represent an aspect of psychology well known in the markets: the tendency to overcompensate. We no longer "believe" in efficient markets, so we toss out all the hard-won gains that that model has produced over the last four decades. Instead, we construct in its place another model of human psychology, rooted in a similarly untestable reductionist set of theories. Which tells you just about all you need to know about the origins of bubbles. - Robert Teitelman See story from Scientific American Robert Teitelman is the editor in chief of The Deal.
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