A speculative bubble is a social epidemic whose contagion is mediated by price movements. News of price increase enriches the early investors, creating word-of-mouth stories about their successes, which stir envy and interest. The excitement then lures more and more people into the market, which causes prices to increase further, attracting yet more people and fueling “new era” stories, and so on, in successive feedback loops as the bubble grows. After the bubble bursts, the same contagion fuels a precipitous collapse, as falling prices cause more and more people to exit the market, and to magnify negative stories about the economy.
But, before we conclude that we should now, after the crisis, pursue policies to rein in the markets, we need to consider the alternative. In fact, speculative bubbles are just one example of social epidemics, which can be even worse in the absence of financial markets. In a speculative bubble, the contagion is amplified by people’s reaction to price movements, but social epidemics do not need markets or prices to get public attention and spread quickly.
Shiller begins with what appears to be an acknowledgment of the central problem with our “markets first” approach to public policy, namely that placing financial markets at the center of larger social structures makes markets a primary mechanism for the contagion of risk which then jumps the market barrier to cause social epidemics. It’s not hard to think of examples in which price acts as a form of contagion that causes social crises – the food riots in 2008 triggered by soaring prices in commodity markets are the most obvious.
But he goes on to miss this point entirely, instead retreating to a discussion that severs the links between market bubbles (which in his telling affect primarily those transacting in the market itself) and social epidemics without a market component. I’ll leave the discussion of his bizarre reading of history to others, and will only note that this distinction is exactly the problem with the assumptions of finance-centric political economy, which seems to view markets in isolation even as policy decisions embed them more and more deeply into society. This sets up the fundamental problem – when global and increasingly speculative financial markets are the unseen connective tissue that links much of the world, so that more and more of the world is affected by trading outcomes without participating in them, then externalities will be the rule, not the exception. But Shiller completely ignores this and instead argues the opposite.
The less subtle problem with Shiller’s argument is his truly bizarre reasoning in support of financial markets as a moderator of social epidemics. First, his case for the constraints on markets:
The recent and ongoing world financial crisis pales in comparison with these events. And it is important to appreciate why. Modern economies have free markets, along with business analysts with their recommendations, ratings agencies with their classifications of securities, and accountants with their balance sheets and income statements. And then, too, there are auditors, lawyers and regulators.
All of these groups have their respective professional associations, which hold regular meetings and establish certification standards that keep the information up-to-date and the practitioners ethical in their work. The full development of these institutions renders really serious economic catastrophes – the kind that dwarf the 2008 crisis – virtually impossible.
Apparently, we’re back in the world of magical thinking where reputational concerns and self-regulation through “certification standards” for business analysts, ratings agencies, accountants and others will be sufficient to keep financial markets from spinning into catastrophe. Sure, each of these professions failed spectacularly recently, and none have borne any costs for their failures, but hey – they have certification standards!
Worse still, Shiller ignores the social context again. If we haven’t addressed the problems in financial markets, but the world remains dangerously reliant on them for everything from food prices to retirement security to municipal finance, then I’d say (paraphrasing Shiller) this combination means that really serious economic catastrophes – the kind that may well make the 2008 crisis look like a warm-up – are a near certainty.