The madness of crowds in economic bubbles and recessions
By: Students Of Economics
Tags: Macroeconomics, International Relations, Business Economics, Economics

By Omar Barroso Khodr

Author’s note: By all means, I’m not an expert in economic crisis or recessions. As a 27-year-old economic analyst, I might be a bit too naive to understand the entire system, there’s plenty of maturities required for me to grow professionally. However, to have a fresh curious mind and the ability to look at things in an alternative way, I may be able to come up with a different explanation to help the intuition behind this. As a quick disclaimer, I won’t be able to predict none of the next recessions or when this one will be over, also this article is not to be taken as an investment suggestion. This is to be taken as purely for information purposes, with that said, let’s dig in.

Introduction

Economic recessions and crisis can be a fascinating topic to study and contemplate, despite the real word hardships that come with them. It puzzles many economists that recessions emerge from unexpected or random reasons, however, this is a careless assumption given that there exists interconnectivity of events that lead to distortions in the entire system. Economic recessions are not just a piece of ‘sexy news’, they have been recorded since ancient Rome. Although there are many technical models that are able to understand the dynamics of the economy, in some cases, the crisis is not caused by pre moulded assumptions. For example, we can notice how the recession we are currently going through was caused by an unforeseen pandemic, and how the previous one (the 2008 recession) was influenced by corruption in Wall Street, which created a speculative bubble in risky financial products. The similar correlation between most of the recessions is that they were caused by human errors, this was seen in the U.S. housing bubble that was being warned by economists like Robert Shiller, and the lack of legislation on Chinese wet markets warned by Nassim Nicholas Taleb in the book ‘Black Swan’. In the large scheme of things, our theoretical models have become obsolete, we might need to shift our focus more into the observation of human behaviour and psychology. In this article, we will make a brief analysis of how we can build our intuition behind this.

Technical Recession

Before we enter the fascinating discussion, we need to understand what is a recession, we often see this word in the financial news when things go wrong in the economy. However, there exists a technical meaning behind this term, and the explanation is not hard to understand. A technical recession is when an economy experiences two consecutive quarters of economic decline which is reflected by GDP (Gross Domestic Product) with conjunction with other key macroeconomic indicators like business confidence and unemployment. We can see from the image below the decline in GDP growth in Brazil in every quarter from 2015 until the first quarter of 2018. This period marked the longest period of recession in the Latin American country (to be more precise 10 consecutive quarters of GDP contraction).

At any rate, to justify an economic recession just by the technical terms can be a superficial analysis, in the case of Brazil, there were many qualitative factors that lead to the latest period of economic decline. From corruption schemes to government mismanagement, the causes of recession are more complex than the metrics. Below we can see that many other countries have experienced negative economic growth in the first quarter of 2020, due to the novel Corona Virus (Covid-19) pandemic. It’s just a matter of time for the latest GDP numbers in Q2 2020 to come out so we can establish a global technical recession.

The madness of crowds

When we mention economics, what generally comes to our minds? Money, financial markets, Wall Street, GDP, and wealth. However, we often forget a really important piece of information that dictates the entire course of actions of the system we live in: humans and their unexpected behavioural patterns. Yes, people’s behaviour has the power to change the way society operates, therefore it affects the economy. The intuition is simple, get for example the way electronic gadgets became so popular in our everyday lives couple of decades ago, it was absurd the idea that you needed to take your phone outside your house. Yet, due to advanced technological innovations and years of market research, we were able to create your convenient smartphones, based on your habits of playing games and listening to music in a portable device. A simple thing behavioural pattern became an essential tool in our everyday lives in the 21st century.

As much as we may seem modern, our behavioural patterns continue to be an ancient survival instinct, which is focused on the maximization of pleasure and security. Nevertheless, as individuals, we have different combinations of behavioural patterns based on our life experiences, personalities, culture, historical period, geography, and nationality. Put all that in this in-group and multiply by everyone who lives around you, and we get society. To forecast the habits and actions of this collection of individuals is a complex task, take for example the dancing plague that happened in 1518 in Strasbourg (modern-day France). The dancing epidemic happened after a single woman started dancing in the streets of Strasbourg, and a group of people started to follow her and dance until exhaustion for several days. It was estimated that 400–500 people danced for days for no reason whatsoever, they just followed the herd.

This bizarre set of events can tell us a lot about crowd behaviour in absurd situations, something that often happens when economic bubbles are around. The tulip mania which occurred in 17th century Netherlands proved to us how speculative economic bubbles can happen from random human behaviour. Perhaps the oldest economic bubble recorded in history, prices of tulip bulbs reached skyrocket high prices as ‘flower investors’ believed that tulips had the potential to become a rare and exquisite flower. With so much demand for tulips, prices became inflated until it became unbearable to pay, which lead to prices to collapse.

Many modern economic bubbles arose from ramifications in distorted human behaviour, where a certain group of people gambled in the possibility of one specific thing to create massive wealth until it becomes unstainable in the long-run and things turn haywire.

Behaviour through the Covid-19 Economic Recession

As the time of writing we face a new economic crisis, as much as the roots of this recession may exist due to a new virus, the fault rests in human error. The decrease in economic activity was supplemented by the emotion of fear, people nowadays avoid to casually consume in physical shops due to the apprehension of the disease. Other outside factors like the strict rules in social distance due also nudged us to change our consumer habits during the pandemic. All of these factors, also influenced the way supply chains, industries, businesses and offices have to operate as we face an invisible enemy. One classic example of supply and demand unbalance has been from the negative prices of oil that came out from the excess supply of millions of petroleum kegs being stored in plants. This ripple effect was caused by a decrease in driving habits, less since they don’t have the need to commute or to casually go places, the same factor occurred from the restrictions imposed in air traffic throughout the world which reflected in the demand for oil.

Other methods of behaviour are evident in the awareness of communication by governments and the press, the trade-offs are enormous when it comes to transparency, as we face real-time updates in the number of contagions and deaths this influences people in unforeseen ways. A couple of months ago we saw the bizarre panic from consumers with the excess purchase of toilet paper, not to count the empty shelves that happened across Europe and the United States. As we are biologically programmed in order to perpetuate our species, we do crazy things to stay in one piece, and this type of dynamics are reflected in economics. Take for example an investor who is adverse to risk, his first move when things heat up in the stock markets is to sell his shares, in order to avoid a greater loss. In the end, we all are scared to face the worst-case scenario, by that we choose to shield ourselves and this continues to change how business relations continue to evolve in 2020.

Political Risk & Emotional Baggage

Another challenge that generally appears in recessions is the political risks that exist in a certain country. Take the Brazilian recession we mentioned earlier, this period of stagnation was not exclusive to economic factors, it had deep roots in a long history of corruption schemes that the country faced since the early 2000s and 2010s (see the carwash scandal). These factors can be tricky to forecasters because they tend to make economic models obsolete since they were not made to compute subjective variables like corruption.

We can see this case being exposed in the ‘neo-cold war’ between the U.S. and China has emerged from a political marketing strategy of the Trump administration to promote more nationalist policies in the U.S. The current president Donald Trump used this strategy of manipulation to gain popularity among American voters. By the use of conservative debates like the slogan, “make America great again”, and promises to secure industrial and manufacture jobs, Trump was able to conquer the opinions of the working American class. This strategy put Trump in the white house and is similar to how in Brazil elected an extremely right-wing president like Jair Bolsonaro in 2018.

It’s impossible to forecast with perfect precision how crowds will behave, it’s obvious that if a country has a more developed society, there could be a more linear process to it, but this is still not a guarantee for success. One case comes from Iceland, which is considered one of the most developed countries in the world, in 2008 after a default of three of the major banks in the country, the entire banking sector collapsed. Speculation emerged in Iceland from the privatization of the banking sector in the 1990s and early 2000s, with the rapid growth of this sector, Iceland decided to raise interest rates to levels of 15% in order to attract international investors. This lead to an increase in Icelandic financial markets of 900% between 2003 and 2004. However, this nationalization of Iceland backfired with oligarchic types of policies like the reduction of the corporate tax rate from 48% to 18%. These incentives were perceived by the new banks which held plenty of power, with this ‘ace of trumps’ in their deck, banks did what they do best in these times: extended easy credit. Long story short, whenever economic times are ‘hot’ the population tend to act with more irreverence to finance their goals. This led to a speculative bubble in Iceland, with loans being distributed for exotic products like houses, cars, and foreign currency. From this mix of ‘speculative spices,’ we can just figure it out the path that Iceland took after a while rating agencies like Fitch gave a risky grade to Iceland which drove investors little by little until it became a total meltdown.

Conclusion & Opinions

We reached a maturity period in the economic sciences where it is clear that in order to understand this field better, we need to have a deeper comprehension of human psychology & behaviour. New subcategories, like Behavioral Economics, have shown us the power of understanding human adaptability in decision-making processes, which reflects in many other important things in the economy e.g. public policy, urban organization, and in-stock markets. However, to understand the dynamics of crowds, it can take more art than science, this is where we should mix economics with other fields such as biology, anthropology, sociology, history, communications, arts, and futurism. Some economic models can be effective under controlled variables in environments that can be manipulated with greater ease, for example, factories and firms. Although, when we add society to this spectrum, we are vulnerable to any kind of random fluctuations influenced by culture, politics, and the human condition in general.

The Covid-19 has brought and will continue to bring new behavioural patterns to the present-day society. As people spent time locked away, consumer and work patterns can change for good, and these changes will be established day after day. In this case, we must be attentive to the new trends that appear in digital platforms like in social media, and television. We can witness the new civil rights movement took a huge leap due to videos leaked online, and how this may have the capacity to change the course of the current U.S. elections. We have to be prepared for unexpected events as we live in a more interconnected world. And a piece of small advice for the ‘go’, if economic optimism arises after the pandemic, we should be prepared for a whole new set of bubbles to appear in the 2020s, things will not just become simpler when the Covid dilemma is eliminated.