English economist John Maynard Keynes observed that “there is instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Our decisions to do something positive can only be taken as the result of animal spirits – a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.”
Despite abundant evidence that humans are emotively driven – prodded by desires, constrained by fears – conventional economic theory assumes that decisions are dispassionate. Though panic and euphoria have repeatedly bloomed and faded with slight provocations, markets are assumed by conventional economists to be “rational.”
Short-term stock price movements are random, but extreme movements in stock prices occur roughly 10,000 times more often than they would in a random process. This is evidence of irrational noise in trading. If traders were rational in basing their decisions purely on economic information related to listed firms, this repeated jitter effect would not exist. Instead, the jumpiness is simply jockeying for gains and loss avoidance, and in doing so exacerbating volatility. Israeli economist Yoash Shapira observed, that “financial markets are very noisy. Most of the ‘noise’ is due to human emotional factors.” As American billionaire investor Warren Buffett quipped, “If markets were rational, I’d be waiting tables for a living.”
The US central bank largely reined in the volatility of short-term interest rates from the mid-1990s. Instead of calming financial markets, it made the leaps and crashes more severe, and prolonged the duration to recovery.
The increasing concentration of wealth meant that fewer punters were able to move the market, and thereby the stampede of the herd instinct was more thunderous. The longer recoveries were the “once burned, twice shy” syndrome of large investors, who, by dint of increasing globalization, had a more diverse menu of international investment options. As American financial economist Robert Haugen noted, “a noisy stock market overreacts with great imprecision.”
◊ ◊ ◊
Capitalism runs as a confidence game. Its sparkle owes to optimism.
As often as not, being roseate is not only not warranted, it’s downright disingenuous. Capitalism is prone to deception in many ways, including self-deception.
The boom-bust bipolarity of capitalism owes to irrationality. Investors pile in on publicized opportunities in hopes of making money by doing nothing more than placing their bets. When an ill rumor spreads, investors panic to get out, thereby ensuring a crash.
The financial near-death experience of the 2008 recession was inspired by the collective delusion of ever-upward housing prices. The aftermath sent interest rates plummeting to historic lows.
That meant that those investing in savings were earning next to zilch. Many institutional investors, particularly pension funds, refused to cotton to the reality of the situation.
A pension fund provides retirement income to its investors. Most American pension funds, including those run by state and local governments, have long assumed a 7–8% annual return on their investments. This is practically impossible when 10-year US Treasury bonds yield just 2.4% on a 10-year commitment.
But there is strong incentive not to fiddle with the assumption of manna from heaven. The California state pension fund cut its assumed return from 7.5% to 7% at the end of 2016. That little maneuver cost the state $2 billion in extra contributions.
To adjust to a realistic rate of return would be tantamount to declaring insolvency: unable to meet financial obligations to pensioners unless contributors kicked in more they could possibly pay. Admitting actuality would crash the American economy. So, pension funds kicked their proverbial can of delusion down the road, merely postponing the inevitable crisis.
◊ ◊ ◊
Collective confidence, or lack thereof, is why capitalism is so severely cyclical.
Industrialization fundamentally changed the gyre of macroeconomic activity: upping the pace and intensity of economic swings.
In preindustrial times, abrupt price fluctuations were most often local or regional. Bad harvests and war were about the only triggers for broad economic malaise.
By contrast, industrialization brought monetary concerns to the fore. The sloshes and desiccations of financial flows became quicker and more pronounced, dependent upon the degree of surety that growth was in the offing. The confidence of moneymen determined an economy’s impending prospects.
Expanding trade from industrialization introduced bipolarity into economic cycles. The increasing integration of the international economy brought about by freer trade created a synchroneity of price movements across nations.
From the 19th century, bipolar economic booms and busts marked by stock exchange crashes and bank panics followed one another in pell-mell manner.
There are 2 capitalist cycles: business and finance.
The business cycle revolves around manufacturers, businesses, merchants, and consumers. The levels of production and consumption diverge when anticipation in production exceeds demand.
As consensus emerges that such divergence is an untoward harbinger, trouble looms by dint of pessimism. Investment slows, and with it, employment. With the price mechanism as the only arbiter of manufacture, and acting only as a lagging indicator, never as forward guidance, the business cycle naturally ramps up and runs down.
A distinct financial cycle also exists. The lucre gyre was long considered simply part of the business cycle, but its whirlpool comes from a different school of fish. Moneymen speculate to feed their greed.
Whereas businessmen ponder price to suss conditions, financiers fancy risk as their oracle. The prophetic powers of both are often ineffectual; but so it goes, as the market system essentially runs on rumor.
Animal spirits have a way of feeding a financial beast until it can run no more. Those who grab with the most gusto fall the hardest, while a measure of timidity proves prudent for men who live off monetary currents. Whatever the investment temperament, an ebb tide in the flow of money puts all financial boats in danger of the shoals.
Whereas entrepreneurs and firms profit individually, investors only rise to a feeding frenzy as a herd. While booms build slowly in the financial world, this collective dynamic ensures spectacular busts. This is because producers and consumers both rely upon easy terms of credit: producers to invest for future growth, and consumers to temporarily live beyond their means, and so fuel growth. When lending dries up the economy plummets.
The cyclical boom and bust nature of market-based economics show capitalism itself to be an irrational system.
◊ ◊ ◊
Economics is less a science than a boast. Economists typically act as intellectual cheerleaders: touting their beliefs through theoretical propaganda that does not fit the facts. To this end, economists have often couched their favored system as representing a physiocracy: a natural order. Capitalist economists are especially prone to promote their delusions that the market system is a wonder when industrialized capitalism has instead been an engine of inequity and self-extinction though the rape of Nature and massive pollution.
The inequitable prosperity achieved under capitalism was not worth the cost, as it was never sustainable. The price mechanism of the market system is inherently deficient because it does not account for the pollution of industrial production.
Industrialization was only possible because men were willing to ignore the inevitability of self-extinction that the machine age brought. The wonders of technology that afford the modern lifestyle were a Faustian bargain which traded the well-being of future generations for convenience today.
Capitalism was the short-sighted bet that a system of greed and institutionalized pollution was good for humanity. The insanity of that creed is the ultimate irrationality.