Economic Bubble from a Standpoint of a Psychologist: Causes and Decisions, part 1
© Alexei Shoustov, 2009
Edited by Lynn Hinkle
Economic Bubble from a Standpoint of a Psychologist: Causes and Decisions
Psycho-Economic Analysis - Putting the Economy on the Couch and Prescribing a Cure
Now that nearly everyone who works in the area of economics, banking and investments is in therapy, would it not make sense to put the economy itself on the couch and examine it using contemporary psychology? Working at the macro level instead of the micro level, studying the economy itself instead of studying such minutia as “Consumer choices of low-income populations in South Dakota” can help create a comprehensive model of the economic behavior of the world market, and perhaps lead to a long-term cure for the current insanity.
Psychologists can describe a nature of an economic bubble (such as Housing Bubble, Dot-com Bubble) from their perspective, predict people’s market behavior, measure people’s wants and show a way to prevent cyclic crisis. Why don’t economists ask psychologists to help them?
There are two crucial problems that are underestimated by those in the economic mainstream: demand forecast quality and different strength of the person’s drive to fulfill her or his different desires. Both are related to people’s psychology and cause a lack of confidence among economists.
In this paper I present a brief psychological interpretation of a bubble, possible scenarios of crisis, a psychological decision for the cyclic development problem, and a possible cure.
To begin, let us ask four significant questions:
1. What is the market from the standpoint of a psychologist?
2. Do all goods produced fulfill people’s wants?
3. How do people’s wants correlate with the goods produced?
4. How do individual abilities to predict future demand influence the market?
Market of drives
In school, future economists learn that markets exist because people have drives. [In this paper drives are perceived as over-all motivating states including both biological needs and all other (learned) wants that are not essential. Some drives are presented in the conscious experience of individuals while others remain unconscious. The difference among these forces is not important in the present analysis.] Once people lose their drives, the market will disappear. Most economists believe that it is impossible to predict change in what people want, so they forget about drives and give their attention to demand, goods and services. Goods and services are accountable as they exist in the objective world. It is possible to estimate demand through sales and people’s answers to marketing research questions. Sometimes, however, actual behavior is significantly different from answers on questionnaires and their ‘objective’ interest. This is why we hear about ‘irrationality’ of market behavior. Such a magic concept is common today.
It is certainly difficult to evaluate drives, and it is much more difficult then to count commodities. But is it sensible to look for a lost door key under a street light rather than the place where you probably lost it?
Psychologists cannot describe all of the drives of an individual person. However, we can use a theoretical abstraction. As in mathematics we are unable to draw a point without length, but we use a notion of a point with no length in a math theory. As in astronomy we are unable to measure the total amount of material in the universe, but we use an estimation of this total amount in a theory. Same here: we can imagine a ‘drives map’ of a person where all his drives at a particular moment are represented. This ‘map’ can rapidly change in response to environmental change. For example, when you walk in a forest and notice a bear 30 yards in the distance you immediately develop a strong desire to leave and this appears on your ‘drives map’ and displaces all other wants.
Changes in a market do not happen so fast. Observing the economical environment offers an opportunity to predict changes in people’s ‘drives maps’. These changes are strictly determined by each person’s individuality, which of course differs. Nevertheless, when describing a large group of people we often find that significant individual differences wear off. Changes of drives and market behavior of a nation, or a social class are much more predictable then is a behavior of a single representative of that group.
Let us use a notion of a Gross National Drives Amount (GNDA) which is a sum of ‘drives maps’ of all people at a certain moment. Consumer Confidence Index (CCI) is a possible way to measure GNDA changes.
Priority rate of a person’s drives
Every person has multiple drives experienced at the same time. There may be, for example, the drive for oxygen, food and information at one moment. It is possible to fulfill these drives simultaneously. You can breathe, eat a banana and read this article. These drives do not contradict each other.
There are some other combinations that are impossible to be fulfilled together. We have to choose the one that is more significant. If you have no bananas you go to a grocery store and buy some. It is impossible to get bananas and to save the dollar that you have to pay for them. Unless you are a thief, and then it is possible for you to save the dollar and get bananas. But it is impossible to feel safe at the same time.
We have to choose among those drives that contradict each other, while facing the environment. This choice is determined by our individualities. It is very difficult to figure out how any single person will act before behavior is actually displayed. Still, as noted above, when we have a large group of people it is much easier to say what kind of decision will be more frequent.
For most people, security is more significant then saving money and food is more significant then security and saving money. Most people go to a grocery store and buy some bananas, they do not steal them. We may notice that people give some rates of priority to specific drives that contradict each other. These rates are determined by forces within the individual, which are slow to change. So rates are comparatively invariable.
Let us imagine that we are able to figure out all the drives of a person represented in the ‘drives map’ and rates of priority that are given by that person to those drives. Then we divide all the drives into three groups: High Priority Rate Drives (HPR Drives), Middle Priority Rate Drives (MPR Drives) and Low Priority Rate Drives (LPR Drives).
Our hypothetical person goes out to a market to fulfill some of his drives in exchange for some money. First his choice is to work, thus earning a salary, which is a stronger desire then wanting to save time and energy by not working. After getting his paycheck, he compares everything he is able to buy for the money he earned and collates it to his ‘drives map’. As a result he makes a decision to buy some of the goods that are available. (By the way, it is absolutely clear that his decision is determined both by conscious and unconscious reasons, but it does not influence our conclusions.)
Those goods that fulfill a person’s HPR Drives are the HPR Goods. The goods that fulfill MPR Drives and LPR Drives are MPR Goods and LPR Goods.
Notice that having a dinner is an HPR Drive for most people. Further, having a dinner at a luxury restaurant is an LPR Drive for most people and an MPR Drive for top-managers of big companies. Expensive branding of an HPR Good may move it to the group of LPR Goods.
HPR Drives are related to a person’s vital, biological needs. MPR Drives are more culturally determined. They serve to support a person’s lifestyle. LPR Drives are often caused by environmental influences, such as advertisements, reference groups’ behavior, and accidental correlation of environmental factors with a person’s unconscious desires. There is no certain delimitation among the three categories of drives and no strong correspondence to vital needs and lifestyle. All of a person’s drives lay on an imagined continuum. Some definitely belong to one of three categories, others may be perceived as marginal.
It is comparatively easy to create a new LPR Drive of a person using advertisement techniques. It is possible to convert an LPR Drive into an MPR Drive but quite difficult to convert an MPR Drive into a HPR Drive. At the same time, refusing to fulfill an LPR Drive is quite easy for everybody.
When a person has enough money to fulfill his HPR Drives by purchasing HPR Goods, he is likely to buy MPR Goods and even LPR Goods. If his opportunities shrink he may choose between two alternatives. One is to change something in his money-earning behavior to support his goods consumption structure (work more or more efficiently, or work at another place). A second alternative is to cut his drives, beginning with the lowest priority, or LPR Drives.
Every person has the potential to change behavior. Every active person has a limit of behavior change. Reaching the limit, living within his means, requires him to cut drives. If cutting LPR Drives is not enough, a person has to change his lifestyle, eliminating MPR Drives and experiencing serious stress. He will demonstrate dissatisfaction in some ways. If he faces cutting HPR Drives, he will take to the streets and participate in protests.
For example, Greenpeace activists perceive the protection of nature as either a marginal HPR/MPR Drive, so they protest continually.
Real Goods and Undesirable Goods
Returning to the relationship between drives and goods (services) we understand that the demand can be considered as a behavioral realization of people’s drives. What does a person do at a market? That person tries to compare personal drives and substitute something wanted less for something wanted more. The market fulfills its purpose only when a consumer appears whose desire for an object or service is stronger then his desire to keep the money that the salesman wants in exchange. If there are no sales, then there is no market. Any objects or services become Real Goods only when ultimately purchased by consumers. If some objects did not find a customer (and are written off by a salesman) it means that these objects did not become Real Goods. It is possible to perceive them as Undesirable Goods. But these objects’ Value Added (VA) is accounted by economists in a Gross National Product (GNP) immediately after every stage of production! So we understand that GNP includes both VA while producing Real Goods (that have been or will be bought by final consumers) and VA while producing Undesirable Goods (that have been or will be written off).
The traditional answer of the economists to this problem is that the cost of a product that was written off is put into the price of a product sold. So there is no problem at all.
I doubt it. It could be no problem if all production cycles stay within one financial year. In this case losses from producing Undesirable Goods meet profits from producing Real Goods and reveal the efficiency of the enterprise.
It could be no problem for long-term cycle enterprises if there is no growth of the Undesirable Goods production from year to year. In this case losses from producing Undesirable Goods of the previous financial year substitute losses from producing Undesirable Goods of the current year that are not yet apparent. Profit from producing Real Goods demonstrates the efficiency of the enterprise.
We live in the world of economic growth that includes Undesirable Goods production growth. Below I am going to show that the production of Real Goods rose much slower then the production of Undesirable Goods. This means that each year the amount of VA while producing Undesirable Goods exceeded Undesirable Goods VA of the previous year. Losses of the current year that contain previous year’s Undesirable Goods VA do not include the growth in a newborn Undesirable Goods VA. This difference is accumulated in a bubble. The enterprise (producer or seller) seems to be comparatively successful while its balance sheet does already contain Undesirable assets. So the enterprise’s assets are overvalued.
How could this gap stay invisible? There was enough money to cover expenditures for producing both Real Goods and Undesirable Goods. This money was emitted based on the GNP growth. And GNP includes Undesirable Goods VA that is hidden for a while in a bubble that is increasing in size.
People who are involved in production of Real Goods pay an inflation tax to support other people who are involved in production of Undesirable Goods. Sooner or later it results in a crisis.
This has a significant impact on the efficiency of the national economy. Traditional GNP does not show it. GNP with 10% growth may consist of 40% growth of Undesirable Goods production and 20% reduction of Real Goods production. Money creation and people’s belief in permanent growth hides the problems for a while. Do you know what happens later?
Demand forecast quality
Now let us talk about investors’ individual abilities.
What does an investment boom mean? It does not mean that those who invest want to get more houses, cars, computers and steaks in the future for themselves. It means only that they want more money in the future to get anything they would like to have. And they suppose that other people would like to have more houses, cars, computers and steaks in the future. They give their money to those companies that begin to produce these houses, cars, computers and steaks. If these investors are successful prognosticators of future demand, the efficiency of the enterprises is high. If these investors are not very good at predicting future consumer’s behavior, this investment money goes to the wrong companies, which start to spend resources, energy and labor to produce Undesirable Goods.
People have different ability levels to predict future demand. When we look towards the future it is difficult to understand whose forecast will become more precise. But, when we look towards the past, we can recognize investment results of some people as successful and the results of others as catastrophic. Other people have different results in different cases. Still it is possible to imagine that all people could be divided into groups according to the medium quality of their forecast about the future demand of consumers. There would be 10% who would be considered to be the best, 10% to be the worst, and those in the eight other deciles.
Psychologists do not yet know why some people are good prognosticators while others are bad. It may be something that is connected both with knowledge and intuition. There are no sure ways to test or to develop this ability. What we know is that some people start new enterprises and they produce good profit, even in crisis times (like Steve Jobs and his I-Pod and I-Phone). Others suffer bankruptcy with all or almost all of their projects.
Let us compare two types of the national economy. Within the first there are only best prognosticators of future demand who are able to invest money in the national economy. Within the second everybody is investing. It is clear that the first one is much more efficient then the second. Why? Because the enterprises opened by the best prognosticators produce only Real Goods that will be bought by the consumers. These enterprises do not spend resources, energy and labor to make something people will not buy. Enterprises opened by bad prognosticators (or enterprises whose stocks were bought by bad prognosticators) produce terrific amounts of Undesirable Goods. If these Undesirable Goods have short production-sales cycles, enterprises bankrupt soon. If these Undesirable Goods have long production-sales cycles (like real estate, cars), the enterprises suck more and more money created and survive until the other crisis.
Precise demand limits
Nobody whose demand forecast is usually precise is able to make unlimited investments. It is important to observe market information, analyze changes and decide what would be the ideal amount of goods and services being produced for the market at every period of time. The person’s field of attention is limited, no matter what is used to reach conclusions - conscious analysis or intuition.
What does it mean? It means that cheap money gives a chance to those who are not so good at predicting demand.
When banks fulfill the money call of the best prognosticators (most reliable), they are able to give some coins to those who are a little bit worse. If their central bank decision makers are fans of GNP growth, they have enough money to support investors with lower and lower demand forecast efficiency.
Expensive money makes banks loan only to the best demand prognosticators. Cheap money gives banks the opportunity to earn much more money from interest by loaning to everybody. Inflation tax does not matter - they make money from the air using the fractional-reserve banking.
Bad prognosticators who produce Undesirable Goods with long production-sales cycles inflate a bubble. When it bursts total trouble mood comes to society. Mistakes are remitted. Everybody has to bring a brick to a new ‘Growth Pyramid’. The investment race has to be started again!
The reader may believe that growth is good for everybody. Yes, it is. Real Goods production is fine. But, the same cannot be said about the equivalent rate of growth of Undesirable Goods. When money becomes cheaper, production growth of the Undesirable Goods exceeds production growth of the Real Goods.
Why do people give bad prognosticators a chance to spend their resources? Why do people involved in production of Real Goods always pay to save the others who are involved in a production of Undesirable Goods? Maybe there are other ways to provide an economy with sane (and sustainable) growth.
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