When I started this blog (way back on that other page), I finished the intro with questions on why and when bubbles start and burst and whether or not they will continue to occur, before setting off on a meandering journey through the social sciences. To summarize my findings I would say that:
Given the power of social proofs , it seems highly likely to me that herding plays a major role in how a bull run becomes a bubble. As speculators attempt to suss out the Keynesian beauty contest , members of the general public begin to enter the market. Their lack of knowledge makes them vulnerable to miscalibrated experts (mavens ), messages in the media (connectors ) and talented salesmen - collectively, the 20% of the population who do 80% of the work , according to Gladwell.
After the tipping point , the bubble, fuelled by our built-in inability to adequately frame context , has the big mo on its side.
But eventually, the biggest investors start to get anxious, remembering the backwards induction argument (from the Brunnermeier video earlier on) and realising that no-one knows when this bubble is going to burst. They decide to liquidate their position. The connectors start to spread the word and the salesmen suddenly stop offering 125% mortgages and the whole process reverses.
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| POP! |
Why did this whole thing started in the first place? It could well have been a big act of risk homeostasis - maybe insurance has suddenly taken on a major role (like before The South Sea Bubble in 1720) or Black and Scholes have developed this great new way of pricing options contracts that mean institutions have more cash available or maybe JP Morgan have developed a brand new derivative instrument that enables securitization (just like prior to the housing bubble in the early 21st century).
This, of course, is re-enforced by centuries of human intuition that leads us all to think that because we can't remember an example of when this kind of disaster happened before, there's probably not much chance of it happening again!
This all suggests that once enough time has passed after the 2007 housing market crash, investors will convince themselves that the next major bubble is in fact not a bubble at all, screening all available information with another process that has served mankind well for thousands of years - confirmation bias .
Forever blowing bubbles? I think that this is somewhat inevitable, unless of course the financial world stops ignoring an entire branch of science that contains countless examples supporting the idea that we are only rational within limits; contradicting the very foundation of economic theory - efficient markets hypothesis .
To wrap up, I'll leave you with another couple of quotes from Dan Gardner's book:
"We are only 'boundedly rational' - rational within limits. The fact that we are often rational is the reason why conventional economics often works; the fact that there are limits to our rationality is the reason why conventional economics occasionally falls on its face"
"It's easy to fall into dispair. If the economic turmoil we are experiencing is rooted in psychology, what can we do about it? Human nature can't be changed. Is there nothing we can do to lessen our vulnerability to economic mania?
In fact, there is. Human nature may be unchangeable but much of the environment in which people live is of our own making. It can be changed. 'If we want to prevent things like this from happening again, we have to create tools that are designed for humans and not Homo economicus,' says Cass Sunstein, whose book Nudge, co-written with Richard Thaler, is about how to do just that"
