Kindleberger bases his views on a pattern of irrationality. Market theory fails, he hypothesizes, because it is based on investor rationality. He argues, however, that while the investor by and large is rational that the market, being comprised of a large group of investors, witnesses a reduction of rationality as a result of mob psychology. His mob psychology theory goes through six stages, but the most important of which is the final one: "irrationality may exist insofar as economic actors choose the wrong model, fail to take account of a particular and crucial bit of information, or go so far as to suppress information that does not conform to the model implicitly adopted." (p.29). This component of the theory against illustrates the information gap between insiders and speculators. Insiders understand that economic rationality has been distorted. Speculators lack this understanding specifically because they are part of the lack of knowledge that causes the decline in rationality. They are not investing in a hot commodity because they have a deep understanding of the industry's fundamentals. They are investing because they feel there is a quick buck to be made.
The concept of rational actors is key to modern market theory. These bubbles occur because of the introduction of irrational actors - speculators - who know little of the dynamics of the market they are entering and often do not care to know. Why do these irrational actors enter the market? Simply put, for the opportunity to gain quick and easy profit. The market, by and large, is made up of knowledgeable and rational actors. The occasional irrational actor with a few bucks to throw around may enter the market, and may even do well, but their irrationality does not override the rationality that the vast majority of the market participants around them possess. Irrational actors are only able to influence the market under certain circumstances. These are the same circumstances that Kindleberger outlines. First, that a tight supply and increasing demand of a product creates a normal, rational demand. Rational investors begin to make money, driving the price up further. A handful of well-heeled irrational investors can enter the market at any point, but the tipping point for a mania to occur is when easy, cheap credit brings a mass of irrational investors into the market that is sufficiently substantial to dilute the impact of rationality. From this point, the market which is ostensibly comprised of rational investors begins to act irrationally, because the small component of irrational investors has become large enough to have genuine influence of demand and price. As an example, he uses the case of the 1830s railroad bubble in England, in which the early stages of the bubble were driven by rational investors - experienced businessmen - and the later stages after 1835 were driven by promoters selling shares to "a different class of investors, including ladies and clergymen." (p. 31) in other words, unsophisticated investors who cannot be expected to behave rationally. Yet market theory never adequately accounts for such irrationality and the actors involved seem to forever fail to deal adequately with the notion of irrationality intruding of their logical, rational markets. Indeed, Milton Friedman is discussed (p.97) as having advocated government information programs given that the government knows more about the bubble than the speculators. The speculators, however, not only don't know. They don't care. Failure to recognize that fact, is a problem for capital markets that exacerbates the disconnect between market theorists' understanding of manias and reality.
Interestingly, this core discussion of rationality/irrationality is rooted firmly in Kindleberger's beliefs about the nature of economic study. The study of economics, especially with regards to capital markets, is based on rationality. Rationality can, in general, be translated into numbers. Kindleberger received his schooling in the 1930s, before the advent of modern mathematical models. He specifically eschewed their use in writing Manias, Panics and Crashes. Mathematical models do a wonderful job of illustrating a crash, in terms of its patterns of price increases and the availability of capital. Yet they do little to address the issue why, which is at the core of Kindleberger's qualitative approach. This old-school approach to such a fundamental economic issue is perhaps why Kindleberger remains relevant today, thirty years after Manias, Panics and Crashes was first published.
This leaves that question of...
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