Tuesday, July 31, 2007

how to keep from losing our heads

It's possible to drive a herd of Buffaloes right off a cliff. First Nations people did just that in a place in Alberta called, appropriately enough, “Heads-Smashed-In Buffalo Jump”

Whereas, if a single Buffalo was chased it would dodge about and quickly change direction, a herd runs together and acts as if a slower more primitive organism is in charge. Individuals take their cues from the individuals around them. If everyone around you is running the same way you are less likely to change direction. So individual Buffaloes don't pull out, but run off the cliff together.

Herd behaviour is often self-reinforcing in this way. It forms the basis of behavior in financial markets and the stock market. An investor buys when he sees a trend towards climbing prices – a bull market. More people are buying so prices rise. The rising price means that people who sell make more money. And banks are more willing to make loans. With more money available more stocks can be bought so the price continues to climb. But at some point reality intervenes. The herd will reach a barrier and it has to change direction.

Something will eventually trigger enough lack of confidence that people begin to believe that the price of stocks will peak and start coming down. Enough people start selling and they bid the price lower. Lower prices mean that sellers are not getting as much money. And banks are calling in their loans because of the greater risk of default. Less money is available to spend and that forces prices down further. Whereas a bull market climbs gradually a bear market can drop precipitously. That's because as people receive less money their freedom of action diminishes and they lose options. They are motivated to quickly sell off as much as possible in order to cut their losses and gain more leeway. The herd of buffaloes is forced off the cliff because they have nowhere else to go.

Economics calls itself a science but it is really an ideology. Two of its fundamental assumptions are that each economic actor has perfect knowledge and acts rationally. But as we can see some markets, such as financial and stock markets, do not work this way. That's why no-one is able to predict the behaviour of financial markets with any degree of accuracy. Prices don't reflect reality because most of the time people don't know whether something is overvalued or undervalued. They follow trends like a herd. The very fact that we call a rising market a bull market and a dropping market a bear market shows an implicit recognition of irrational behaviour.

The other fundamental assumption of economics is that markets tend towards equilibria, But this is belied by the omnipresence of business cycles in the form of self-reinforcing booms and busts. Instability, not stability is the norm. During a boom demand chases supply as prices rise. During a bust, demand runs away from supply as prices fall.

We need to think and act less like bulls and bears and more like humans so that we can change direction before we reach our limits and run out of room to move. If prices don't reflect physical reality they will send the wrong messages to consumers and producers creating perverse incentives that reinforce destructive behaviours. This is exactly what happens when we allow big business to influence government policy.

There is no such thing as a perpetual motion machine yet we act as if the global economy is exactly that. If our economic behavior – our consumption and production - increase beyond the bounds of the Earth's capacity to support us then we are in a situation analogous to the Buffalo running off the cliff into the thin air. Our overproduction of stuff will cut the Earth out from under us.

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