“Even when reason goes out the door, on the whole, we prosper.” Charles Mackay’s 1841 classic, “Extraordinary Popular Delusions and the Madness of Crowds,” has to be one of the best book titles ever penned. It is particularly fascinating on a morning when the Dow is below the magic 9,000 level and the Nasdaq is down by 1.4 percent.
The book examines what happens when irrationality overcomes good sense for large groups of people. It remains in print 161 years later because its insights continue to be as important in understanding stock markets as the mathematical models of Nobel-winning economists.
Are human beings rational or irrational? Psychologists say both, but economic theorists find it easier to assume the first. David Ricardo, the greatest economist of all time, pioneered finance theory 200 years ago when he examined the relationship between the price of an asset, such as a piece of land or a stock or bond, and the annual income it produced. His approach still predicts the value of my farm remarkably well and underlies the more sophisticated capital-asset pricing models taught to MBA students.
Ricardo also pioneered an approach to analyzing economic behavior that begins with the question, “What would a prudent (or rational) person do in this situation?” Virtually every theorist since Ricardo follows his lead. Indeed, the latest and greatest theory of what governments should do in the face of inflation or recession is called “rational expectations.”
Economic theory based on rational behavior by human beings who want to meet as many of their household’s needs as possible is powerful and has led to policies that made us as wealthy as we are. It can solve many problems and answer myriad questions. But it does not cover all possible situations.
It is particularly poor at explaining outcomes of those situations when reason loses out in human decision-making.
Mackay describes various historical episodes in which collective economic reason went out the door in modern European history. His accounts include the Dutch tulip bulb mania of the early 1600s and the Mississippi Company and South Sea bubbles in France and England. While the dot-com boom of the late 1990s pales in comparison to these historic bubbles, the lessons are the same.
One is that being in a crowd has a powerful effect on individual decision-making. Lynching prisoners, rioting after sports victories and putting all of one’s 401(k) into an “aggressive growth” fund are all examples of things that individuals do as part of a crowd and that they would be much less likely to do as individuals.
Any parent knows teen-agers are particularly swayed by whatever “everyone else” is doing, but we are not immune to it ourselves. Grandma and Grandpa may talk about the hardship that ensued after their small-town bank went bust in 1933, and parents may relate that stock prices wallowed in the doldrums for most of the 1970s.
Intelligent people take those lessons to heart. People think conscientiously about risk and diversifying their portfolio. But when a bubble goes on for a few years, when colleagues comment month after month on how their technology stocks are growing at double-digit rates, it is hard not to be attracted to the sirens.
We switch our 401(k) allocation from safety to growth to aggressive growth. We listen more intently to Saturday morning radio shows that tout the opportunities in emerging markets. Our ears perk up at news of how another IPO ended up with a first-day appreciation of a thousand percent.
Our quarterly statements start to show double-digit increases, also. As we sit in boring committee meetings or drive the truck down the same old route once again, it is hard to keep our minds from wandering to time-shares in St. Maarten or moving up to the lake year-round. Why not retire a couple of years early?
Alas, in the long run the old rules of thumb about price-to-earnings ratios usually have more validity than we thought. What went up must come down. And when prices seem to be coming down and down and down with little respite, bad news such as an accounting fraud can turn pessimism into panic.
Should we worry? Mackay’s accounts are implicitly comforting. Some people did lose their entire fortunes in the bubbles of the 17th and 18th centuries. But England, France and the Netherlands all prospered in the long run. Average income levels continued to grow.
Some Americans similarly are seeing great shells explode on the asset sides of their balance sheets. Some planned early retirements will become late ones, with part-time jobs continuing after retirement.
But the dot-com bubble was a mild one as bubbles go, and the underlying economic fundamentals are much stronger. Central banking is far from an exact science, but we have better institutions and policies to deal with the deflationary forces inherent in collapsing bubbles than existed even a century ago.
Life will go on, and we will continue to higher levels of living than our forebears.
© 2002 Edward Lotterman
Chanarambie Consulting, Inc.