Infectious Exuberance

America, from its inception, was a speculation,” begins the historian Aaron M. Sakolski’s 1932 classic, The Great American Land Bubble. George Washington himself was a land speculator, Sakolski notes, and by Washington’s time it was widely perceived that America would eventually be populated much more densely by vast numbers of immigrants, leading many investors to dream of rapidly rising land prices. Waves of speculative mania swept towns, cities, and regions from the 18th century onward, even along the vast and empty frontier. Up, up went the prices. And then, inevitably, down.

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Many culprits have been fingered for the housing crisis we’re in today: unscrupulous mortgage lenders, dishonest borrowers, underregulated financial institutions. And all of them played a role. But too little attention has been paid to the most fundamental cause, the same one that was at the root of the many booms and busts that Sakolski chronicled years ago: the contagious optimism, seemingly impervious to facts, that often takes hold when prices are rising. Bubbles are primarily social phenomena; until we understand and address the psychology that fuels them, they’re going to keep forming. And unless we apply that understanding to the bubble we’re trying to recover from, we risk calamity.

Bubbles are a lot like epidemics. Every disease has a transmission rate (the rate at which it spreads from person to person) and a removal rate (the rate at which those individuals recover from or succumb to the illness and so are no longer contagious). If the transmission rate exceeds the removal rate by a certain amount, an epidemic begins.

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Speculative bubbles are fueled by the social contagion of boom thinking, encouraged by rising prices. Sooner or later, some factor boosts the transmission rate high enough above the removal rate for an optimistic view of the market to become widespread. Arguments that this boom is unlike past bubbles—I call them “new era” stories—become more prominent and seemingly credible.

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In this sort of environment, skeptics have a hard time of it. No one has perfect information, and people—quite rationally—infer a great deal from the actions of others. As a bubble expands, some skeptics begin to disregard their own judgment because they feel that everyone else simply couldn’t be wrong. Contrarian voices become softer, which only makes it harder for the remaining skeptics to justify their views. Over time, the quality of information that can be gleaned from the behavior of others becomes worse and worse.

Few people seem immune to boom thinking. The recent bubble grew so large partly because the very people responsible for the financial system’s oversight came to share the general public’s rosy expectations. They may not have believed as fervently in the boom, but they still accepted the idea that it would not end badly. Builders kept building, and ratings agencies did not temper their sunny assessments of mortgage securities until after the crisis had begun.

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How can we inoculate ourselves against a recurrence of this whole awful cycle? Government officials today are rightly pushing regulatory reform to prevent lending abuses and reckless behavior among financial institutions. But that doesn’t address our psychological vulnerability to bubble thinking, which seems greater than it’s ever been. During the stock-market boom of the 1990s, the national psyche, long infused with a Protestant work ethic, seemed to undergo a transformation, and the idea arose that we could expect to make a lot of money by investing. At the same time, the proportion of Americans owning stocks and homes was increasing. We should be happy that more people are investors and homeowners today, but those latest to the game are often the least sophisticated players, most susceptible to irrational optimism—one reason why the most-recent stock and housing bubbles grew so large.

Irrational exuberance is bound to pop up from time to time; we can’t stop it altogether. But we probably can limit it, preventing some bubbles and keeping others smaller. Boom thinking is carried along by bad arguments and bad information. The key to keeping the transmission rate low and the removal rate high, if you will, is better dissemination of reliable information—something the government should focus on over the coming years.

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There’s another, more urgent reason to focus on the idea of social contagion today. Like booms, many busts are magnified by group thinking. And once busts become severe enough, they prompt changes in the national mood that ramify well beyond economic affairs. Benjamin M. Friedman, in his 2005 book, The Moral Consequences of Economic Growth, cites abundant historical evidence that when economic prospects look bleak—especially for long periods of time—intolerance, racism, and other reactionary impulses flourish. As more people experience hardship, trust between them tends to diminish, and the social fabric itself seems to fray.