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June 2009

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10:33am Sunday June 7, 2009 (link)

I was thinking about financial booms and busts the other day. I believe that crashes are just the price of bubbles. Which is why I'm suspicious of any statement that the 1929 stock market crash "caused" the depression. The crash was just the end of the bubble, and the depression was the prolonged unwinding of excess debt and poor investments. Prolonged by government attempts to reflate the bubble, among other things.

So the real problem here isn't unwinding debt and so on. We know that happens eventually. Systemic effects (dominoes crashing into one another) are important, but overrated in my opinion. The real problem is manias and bubbles. Why do we do this to ourselves?

Two points:

1. No living thing (there's a general argument for you!) can ignore windfalls. If for whatever reason, the grass is greener this year, if you are a rabbit, you eat more of it. And have more kids, which survive in greater numbers. If you were some "sustainable" cautious rabbit that only had 2 kids and only ate what it usually ate, you'd lose out to the greedy ones. Nature selects for optimists that grow more or less as fast as they can.

2. We are social animals and there's a huge cost to being an outsider. Living alone is deadly -- you have no one to help you if you get into trouble, no one to look out for you, no one to hunt or gather with, and no one to share food with if you don't do well today. One mistake and, like solitary animals, you may be finished.

Similarly, we worry about our status in the group. Being unpopular means getting beat up a lot, getting no help, having to give up your food/mates to the stronger members. Also very bad news from an evolutionary standpoint.

So as social animals, we crave status (or at least acceptance) by the group. This is why group-think has such a power over us, from fads and manias to adulation of heros and kings, to religious movements, wars, and revolutions. We think of ourselves as rational beings, but it's just a gloss over those social instincts.

As long as we are human, we will have these crazy bubbles from time to time. Because as animals, we don't ask why times are good, we just try to take advantage of it. And because as primates, if everyone else is buying houses, we will too.

Regulators are just as caught up in this as the general population. They don't want to do the unpopular thing, and they don't want to kill off a boom. No one does, except cynical "doom and gloom"-ers. Wishing it were otherwise is just futile.

Instead we should be asking, "when the inevitable booms and crashes happen, how do we avoid systemic risk?" I don't think we're asking that question as we deal with this crisis. All the debate I read is about more regulation, as if there weren't enough already.

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