Since hitting bottom in early March, the world’s
major stock markets have all risen dramatically.
Some, notably in China and Brazil, reached lows last
fall and again in March, before rebounding sharply,
with Brazil’s Bovespa up 75pc in May compared to
late October 2008, and the Shanghai Composite up
54pc in roughly the same period. But the stock
market news just about everywhere has been very good
Does this suggest that the world economic crisis is
coming to an end? Could it be that everyone becomes
optimistic again at the same time, bringing a quick
end to all our problems?
Speculative booms are driven by psychological
feedback. Rising stock prices generate stories of
smart investors getting rich. People become envious
of others’ successes, and begin to wonder if rising
prices do not portend further increases. A
temptation arises to get into the market, even among
people who are fundamentally doubtful that the boom
will continue. So rising prices feed back into more
rising prices, and the cycle repeats again and again
- for a while.
During a boom, people considering getting into asset
markets weigh the fear of regret if they do not
invest against the pain of possible loss if they do.
There is no authoritative answer about what the
“right” decision is, and no consensus among experts
about the proper level of exposure to these markets.
Should it be 30pc in stocks and 70pc in housing? Or
the reverse? Who knows?
The ultimate human decision must be based on the
relative salience of these discordant emotional
factors. In a boom environment, the emotional
factors are biased toward getting into the market.
But one must ask what would sustain such a movement
now. There seems to be no dramatic fundamental news
since March other than the price increases
themselves. The human tendency to react to price
increases is always there waiting to generate booms
and bubbles. The feedback is only an amplification
mechanism for other factors that predispose people
to want to get into the markets.
The whole world cannot recover all of the enthusiasm
of a few years ago from feedback alone, for there is
a giant coordination problem: we are not all
attentive to price increases at the same time, so we
make decisions to buy at very different times. As a
result, things happen slowly, and, meanwhile, more
bad news may be revealed.
The only way world confidence can return
dramatically is if our thinking coordinates around
some inspiring story beyond that of the price
In my 2009 book with George Akerlof, Animal
Spirits, we describe the ups and downs of a
macro-economy as being substantially driven by
stories. Such narratives, especially those
fuelled by accessible human-interest stories, are
the thought viruses whose contagion drives the
economy. The contagion rate of stories depends on
their relation to feedback, but plausible stories
have to be there in the first place. The narratives
have substantial persistence in that they affect our
The story that drove the worldwide stock-market
bubble that peaked in 2000 was complex, but, put
crudely, it was that bright, aggressive people were
leading the way to a new era of capitalist glory in
a rapidly globalizing economy. Such people became
new entrepreneurs and world travellers on the way to
prosperity. This narrative seemed plausible to
casual observers, because it was tied to millions of
little human-interest stories about the obvious
successes of those - friends, neighbours, and family
members - who had the vision to participate
enthusiastically in the new environment.
But it is hard today to re-create such a narrative,
given so many stories of trouble. The stock markets’
rebound since March seems not to be built around any
inspirational story, but rather the mere absence of
more really bad news and the knowledge that all
previous recessions have come to an end. At a time
when the newspapers are filled with pictures of
foreclosure sales - and even of surplus homes being
demolished - it is hard to see any cause for the
markets’ rebound other than this “all recessions
come to an end sooner or later” story.
Indeed, the “capitalists triumphant” story is
tarnished, as is our faith in international trade.
Here is the problem: there isn’t a plausible driver
of a dramatic recovery.
Starting an economic recovery is like launching a
new movie: nobody knows how people will react to it
until people actually get to see it and talk about
it among themselves. The new movie Star Trek,
based on yet another remake of a television show
from more than 40 years ago, surprised everyone by
raking in 76.5 million dollars on its first weekend.
That old story just got some excitement back with
this new movie. Similarly, we have to hope that some
of the same old stories that propelled us in the
past - the rise of capitalism and its
internationalization throughout the world economy -
can somehow be dusted off and revived yet again to
invigorate the animal spirits that drive economic
recovery. Our efforts to stimulate the economy
should be focused on improving the script for those
stories, making these stories believable again.
This means making capitalism work better, and making
it clear that there is no threat of protectionism.
But the rationale must be to get the world economy
out of its current risky situation, not to propel us
into yet another speculative bubble.