The Inevitability of Booms and Busts

It seems that the Mises Institute is tilting at windmills in its hope to end economic booms and busts by reenacting the gold standard and outlawing fractional reserve banking. As long as human beings are making decisions about the prices of goods and services--i.e., as long as you and I, dear readers, are investing and consuming--we will be experiencing the crazy ups and downs. We can turn back the repeal of the Glass-Stegall Act, but we can't outlaw human nature.

This month's Atlantic Monthly published a couple of very impressive articles about how our wonderful, wacky humanity is the root of the problem. "Pop Psychology" describes experiments done by economists where a dozen participants are each given a certain amount of "securities" (for example, a certificate that yields a 24-cent dividend every 4 minutes) and cash (the real stuff, negotiable instruments). The experiment is limited to 15 rounds of dividends, so after an hour of trading the participants get to keep whatever money remains from their trading activity and dividends.

It is a trivial exercise to calculate the economic value of the security: during the first round it is $3.60 (15 times $.24), in the second round it is $3.36, etc. Anyone who believes that the trading price of the securities for these 60-minute securities in the 12-person market will largely reflect their apparent economic value, though, does not understand human behavior. (And truth be told, I must count myself among the misinformed/astonished.) What drives the market price of the securities is not their apparent economic value, but the desire of the participants to buy low and sell high. So what happens 90% of the time in these experiments is that the profit-seekers drive the price of the securities skyward--until the 15th round, at which point the market crashes.

Sound familiar?

So now you know why reverting to the gold standard will never end the cycle of booms and busts; we can change the banking system, but we are powerless to stop the tide of human behavior. I pointed out in a previous post that the cycle of expansion and contraction has occurred both when currency has been pegged to the gold standard and when it hasn't. I would be overstating the case to see that good banking policy is inconsequential; good policy might reduce the amplitude of the swings. At the same time, we do need to recognize that there is no policy that can relegate booms and busts to the dustbin of history.

In the second article, Henry Blodget (of Wall Street notoriety) examines the conduct of participants in the recent real estate and credit bubble, and finds it to be completely unremarkable. Of course home purchasers kept bidding up the price of real estate; they wanted to keep making profits. Investment bankers wanted to keep earning their bonuses. Politicians wanted the good times to keep rolling. Mortgage lenders wanted to keep earning origination fees. It takes a village to raise a child, and I guess it takes a village to cause a stampede in the real estate market.

In the wake of the inevitable bust, there has been much finger-pointing, but far too little self-examination. Perhaps we will learn our lesson for a generation, but eventually people will start saying "It's different this time, prices really can keep spiraling upward" and the next boom and crash will happen.