Are Markets the Problem or the Solution?

Our most important public debates today center around the question: Are markets the problem or the solution?

Did the free market create the financial crisis, or did government intervention prevent the market from doing its work?

Can the free market solve our health care problems, or should it step out of the way and let government tackle it?

Beyond that we find another series of questions. Are markets efficient or ineffective? Do they act fairly to distribute goods and services or are they skewed to favor one group or another? Do they have a life of their own or are they simply the expression of the nature of those who participate in them?

Recently I was rereading Niall Ferguson's essay on what happened to the financial markets last fall. I have linked the article before, and am still impressed by its clarity and concision. It is worth another link. Here.

Examine this thought. Ferguson wrote: "Zoological imagery is an integral part of Planet Finance. Optimistic buyers are 'bulls;' pessimistic sellers are 'bears.' The real point, however, is that stock markets are mirrors of the human psyche. Like Homo sapiens they can become depressed. They can even suffer complete breakdowns."

I agree that it is no accident that animal imagery is so important to the financial world. Yet, it is not just about imagery.

Bull and bear might also be used as animal totems, each of which symbolizes a tribe. And let's not forget the gold bugs... another tribe with its own totem.

Once you join one of these tribes, it is very, very difficult to change sides. Markets seem to have something to do with the way humans behave in groups.

Now, ask yourself this: If the market mirrors human behavior, does it mimic normal human behavior or does it indulge the extremes of possible human behavior? Does it naturally revert to the mean or the norm... or is it destined to swing from one extreme to another, like a human psyche suffering from bipolar illness?

What applies to the individual also applies to groups. Humans always join groups, whether they be communities, tribes, or crowds. Sometimes they are swept along on a wave of madness because everyone in the group is thinking a certain way. And sometimes they retreat into despair because everyone else is feeling down.

But, these are not normal behaviors, for individuals or for groups. Groups that indulge mass euphoria or mass despair soon become dysfunctional.

To put it another way, when a group becomes prey to excessive optimism the market, by its nature, will bring it back to earth. Unfortunately, the descent may end in a crash.

It is worth mentioning that most people and most markets do not get caught up in these extremes. Possibilities are not truths.

When Ferguson analyzes the way that markets mirror the human psyche, he refers to Charles Kindleberger's description of market manias.

I am tempted to call the swing between market mania and depression an expression of bipolar illness, but I think it is more accurate to say that it mirrors a human mind that is addicted to drugs.

Kindleberger's five phases are: displacement, euphoria, mania, distress, and revulsion.

Compare this to what happens when someone becomes addicted to drugs.

The individual starts down the road to addiction when he experiences something new and apparently profitable. Often enough, he takes it as an initiation rite. Taking the new drug makes him part of a new group.

The individual and his companions will next experience a type of euphoria, as though they are special and have found the answer to all of their troubles. As long as they are together and as long as they are taking their drug, they feel liberated from suffering.

Eventually, they will come to the point where the drug ceases to perform its magic. They will decide that they can regain their euphoria by taking more and more of the drug. This is a manic stage where the addict retains his hope that his new strategy of extreme indulgence will restore his fleeting euphoria.

As it begins to dawn on the addict that the drug is ceasing to work, he will start seeing that his habit and his new friends are costing him dearly. Then he will enter a stage of distress and disillusionment. He will keep taking the drug to avoid those feelings of despair.

From there it is often only a matter of time before he ends up in the gutter and reaches rock bottom. At that point he might be ready to begin the work of recovery.

If the market has been behaving like a group of addicts, then what is the drug? According to Ferguson it is cheap money or better, free money. The supplier, again according to Ferguson, was the Federal Reserve, and the users where the inhabitants of Planet Finance.

So, one day last Fall it seemed that someone had simply removed the supply of drugs. And the market, like an addict going into a forced withdrawal, began to crash.

Then, the Federal Reserve opened the monetary spigots with even more cheap money. And people were wondering how a problem that had been created by cheap money was going to be solved by cheaper money?

If we want to work the analogy, we can say that some addicts would not survive a fast withdrawal. It may feel heroic to allow someone to go through extreme withdrawal, but some people simply do not survive the experience.

The more important point, I believe, is that while human beings and markets can go through addictive cycles, these cycles are not the truth of the human psyche or of the markets. They are aberrations, unpleasant possibilities that define some of the extremes of human conduct.