One thing about blogging. You don’t have to be a pundit. You don’t even have to be right. You can just say what you think. Well, here’s what I now think about financial bubbles:
Robert Shiller, the Yale Economist who studies bubbles, asks the question, "Why do people regularly fail to see that a soaring market is a bubble, an illusion, until it bursts?" He borrows a phrase from a speech Alan Greenspan gave – "irrational exuberance" for the title to his book on the topic. And he looks to works on mass psychology to find the answer. Well I’m not looking at the group psychology literature for the answer. I think it’s simpler than that. What he and Greenspan are calling "irrational exuberance" is not irrational. And the place to look isn’t at herd psychology, it’s the simple individual psychology of Sigmund Freud, in particular, the work of his daughter, Anna Freud, on what came to be called ego psychology. But the authors of the psychology aren’t important. What’s important is how it all works.
The DOT.COM bubble: Personal Computers became possible in 1974, but didn’t hit the ground running until 1981 with the IBM PC. The Internet, at least HTML Web Pages became possible in 1994, but became widely used in 1997-1998. There was nothing irrational about the exuberance. The possibilities for the Internet were there for all to see, including investors. The DOT.COM bubble was driven by these possibilities, though the companies being invested in couldn’t get the Internet to where it is today fast enough, but there was nothing irrational about the Internet.
The HOUSING Bubble: The HOUSING bubble started around 2000. Times were good and there was a lot of encouragement for home ownership. But there was something new, sort of unnoticed Banks and Mortgage Brokers were willing to lend money with low [or no] down payments and easy payback schemes. The size of the market of home owners was suddenly expanded. Home Construction soared and house prices soared with the boom. Investing in the housing boom was rational. It would’ve been irrational to pass it by.
The OIL bubble: Any fool could see that oil reserves are finite and they are now "over there" – no longer in Texas. OPEC had us under their thumb. Oil is really "liquid gold." We’d even started a War in hopes of gaining access to more of it. Of course prices should go up. It’s surprising it hadn’t already happened. It made sense, and the rise in prices started with the Invasion of Iraq.
My point is that in each case, the explanation for the rapid rise in prices was perfectly rational. We believed it, and investors jumped on the bandwagon. The exuberance wasn’t irrational – it was based on truth – the exciting possibilities of the new Internet, the new army of home buyers, and the finiteness of the oil reserves.
Rationalization is the mental mechanism by which a desire is hidden under a logical argument. It’s the favorite of adolescents who have come into their adult minds and can rationalize anything [driving their parents crazy with their endless love affair with rational argument]. It’s the nature of the mature mind to try to understand things cognitively. The Freudian view of human mental life is of more primitive wishes being in conflict with civilized social and rational thinking – "Me First" versus "Us Together." And what better place for such a conflict to play out than the Marketplace? I think bubbles form because the exuberance [enthusiasm] for a given market is too rational, not because it is irrational.
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