. . . and Markets Spin Out of Control

Our society embraces competition.  It’s not just how we work, but also what we believe in.  Yet, in retrospect, the credit crisis of 2008 seems to suggest that there are times it doesn’t work at all.

The bankers, hedge fund managers and other investors who are theoretically supposed to monitor each other’s aggressive moves, relentlessly making sure that no one gets a competitive edge, seem in fact to have been collectively out of control.

John Cassidy in his account of the crisis, How Markets Fail, wrote:

“Consider what would have happened if [Chuck] Prince . . . chief executive of Citigroup from 2003 to 2007, had announced in 2005, say, that Citi was withdrawing from the subprime market because it was getting too risky. What would have been the reaction of Prince’s rivals? Would they have acknowledged the wisdom of his move and copied it? Not likely. Rather, they would have ordered their underlings to rush in and take the business Citi was leaving behind. Citi’s short-term earnings would have suffered relative to those of its peers; its stock price would have come under pressure; and Prince, who was already facing criticism because of problems in other areas of Citi’s business, would have been written off as a fuddy-duddy.”

Cassidy notes that Prince said to a Financial Times reporter in July 2007:  “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

We might argue that real leadership would have required just such an abrupt departure from the party, but bankers recently have been complaining that there was no one to stop them from taking the risks that led to the collapse of the market.

This is a startling shift from the argument of classical economics that markets are inherently self-correcting:  all the information is there and it all comes into play.  Markets can be relied upon to determine real values – so long as government refrains from getting in the way.

But Prince’s comments suggest that investors are often not really able to take in the information that’s available.  They are looking at each other, mesmerized by the “music,” compelled to keep time with everyone else.  Their behavior indicates that markets often don’t work in the way that our prophets of economic rationality have been proposing they do.

So where does that leave us?  Certainly we will have to pay attention to the work of behavioral economists who call attention to the psychological underpinnings of investor actions.  But that’s just the start of what is required to grasp the full scope of human behavior – and economic behavior too.  It can be profoundly irrational and self-defeating.  Moreover, there are collective forces that are sometimes impossible to control.

What we don’t know we know is the power of the group to shape the choices we think we have.