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Page last updated at 10:07 GMT, Thursday, 16 October 2008 11:07 UK

How Brains might have foretold the big crash

Thunderbirds' sell-out toy Tracy Island was another bubble

Michael Blastland
What have risky loans and Thunderbirds' Tracy Island got in common? Everyone wanted them because everyone else wanted them. It's how bubbles are made and why we are always doomed to see them burst, says Michael Blastland.

Say what you like about the new pariahs, bankers' reputations are shredded anyway. The libel laws might as well be suspended.

And why? Because they were greedy and stupid, obviously. The reasons are transparent and judgement quick. Thus is the moral high ground suddenly over-crowded. How easy, how comforting to know that vast error was simple.

J M Keynes wrote that buying shares was like a bonny baby competition, in which you don't choose the baby you think prettiest, but the baby you think other people will think prettiest

This is no defence of bankers. But it can be argued that the easy explanation is inadequate and, left unchallenged, will hasten the next crash. Unfortunately, a better explanation incriminates us all.

This argument - of a link between the suits who blew it and the rest of us - is made by way of babies, Christmas toys and ants.

It works like this.

One of the first habits we acquire is to glance at mum before deciding how to react to what's around us. It is called social referencing. How do I know if I should be afraid or eager? I check the reaction elsewhere.

That characteristic equips us well. To find out what others think before we act makes sense: they might know something.

Watching the buyers

Even if they know nothing, other people who think a thing worth having will make us more inclined to want it too. The kid who craves those new, weird trainers, wants them in part because every other kid wants them. Never mind that they wreck his feet.

It's a habit that feeds fashion and influences more than just the clothes we wear. It is what makes markets of all kinds not simply a matter of a seller with a product at a price and a buyer with a budget, but a buyer who has an eye on other buyers, who are themselves looking over their shoulders.


This year's top 12 toys - each a bubble waiting to happen

The economist J M Keynes wrote that buying shares was like a bonny baby competition, in which you don't choose the baby you think prettiest, but the baby you think other people will think prettiest. Or even the baby you think other people will think other people think prettiest.

So the market can become detached from any supposed objective quality in the product, not through stupidity, but through the everyday circular psychology of living and choosing among others.

To illustrate this, some economists have turned to ants. Place two equal piles of food outside the nest, and the ants find both, but nearly all prefer just one. Pile A is all the rage. This is because one trail is soon reinforced by others and becomes dominant.

Herd mentality

Then they suddenly switch. Now pile B is all the rage. That's because a few lost their way and wandered to pile B, others picked up this trail and reinforced it, the fashion changed.

Similarly, people in all kinds of markets often tend to converge on one belief. On Wednesday, the top 12 toys for this Christmas were unveiled. But who can say which will be this year's Furby or or Blanket Time Iggle Piggle - sell-out toys from Christmases 1998 and 2007 respectively? At least Brains, Thunderbirds' resident bespectacled thinker, might have had an inkling of how bubbles are blown and burst after Thunderbirds' Tracy Island toy sold out in the run up to Christmas 2000.

This year's must-have Christmas toy will often run out because no one knows what it will be in advance. Everyone will want it but only because everyone wants it, and that's apparent only late on in the year.

It will happen again and not because there'll be a new generation of fools, but mainly because we find comfort, reassurance and momentum in groups

Parents may tut-tut at the quality all they like. Newspapers may complain of profiteering at children's expense. But there need be no conspiracy.

The principle - that our choices are influenced by others and we often tend to herd together - applies to innumerable areas of human behaviour. What we do depends on what others do, and what they do depends on us. Thus can we even find ourselves all doing something that no individual thinks wise or best, like paying with the shirts off our backs for a new house.

From here, it is a short step to the banker assessing risk. Risk is often not an objective fact either. Even the most prudent lending can become risky in a vicious downturn. Even a 110% mortgage can turn out OK in a boom.

So how do bankers decide what's excessively risky? They might pretend they have a formula, but mostly they do what we all do, and look to other people's behaviour, or at an index of risk which can be no more than the sum of other people's beliefs.

Outsiders' protests

They look at other banks making similar decisions, and they look at us. And if everyone else is betting with confidence, they will too. Their expectations shape the facts as they see them. Market confidence, so they think, is their insurance.

Eventually, of course, belief alone isn't enough, and there are always a few outsiders protesting that not all is as it seems, a view that one day, like the ants' preference for pile B, suddenly prevails.

But if the initial belief was inherently and obviously stupid and led to inevitable destruction, no one would fall for it. They might have been greedy, but so stupidly greedy as to cut their own throats?

Engraving from 1720 satirising the investors in the South Sea Bubble
South Sea Bubble is perhaps British history's most famous pop

Unlikely. The circumstances were in principle not unusual. They arose from social referencing in the strange, small world of new financial products.

We repeat this kind of behaviour in one form or another with astonishing frequency and "stupidity" doesn't begin to help us understand it. Bubbles that pop have been a feature of economic life ever since a boom in red mullet in ancient Rome. Railways, loans to Latin America, seaside piers, South Seas trade, Asian currencies, tulip bulbs, American real estate, the internet, you name it, getting carried away on the tide is in our blood.

A remarkable feature of this tide - often noted - is how we use our intelligence to explain that the latest boom is different, why last time was plain stupid, but this time some new fact has changed the rules. Seems to me that process has started already.

Then, as this year's Nobel prize-winning economist Paul Krugman has said, people believe the new stories because everyone important tells them. People tell these stories because everyone important believes them. Holding the consensus view becomes a litmus test of being taken seriously. What ultimately drives disaster is circularity.

Or as Charles MacKay put it in his 19th Century classic Extraordinary Popular Delusions and the Madness of Crowds: "How imitative and gregarious men are, even in their infatuations and crimes."

So think the whole episode stupid if you will. After all, right now, everyone else thinks so too. And they must know something.

It will happen again and not because there'll be a new generation of fools, but mainly because we find comfort, reassurance and momentum in groups.

But when? Some say 10-15 years. In my view, it is here already, driven in part by the facts, true, but also by what people think others now believe, an excessive collective mood that could cause real damage. This time, it's called pessimism.

Michael Blastland is the author with Andrew Dilnot of The Tiger that Isn't - Seeing Through a World of Numbers.

Below is a selection of your comments.

All the financial wizards have done is chase the headline of the day: when things were booming, they bought into risky lending and CDOs because, on that day, these financial instruments were performing well. Now that the headlines tell us that many institutions are suffering as a result of this short sightedness, they are hoarding cash and lending to no one. The sad thing is, many of these "experts" then blame the headline rather than their abandonment of logic for the mess they find themselves in.
Dave, Cheltenham, UK

This article also explains why Coldplay are so inexplicably popular.
Charlie Farmer, London, UK

The ants are an example of an information cascade. Ants follow the chemical trail left by other ants, trails are quickly reinforced, but only a small number of ants will have "done the research". The modern financial markets are in an example of a collapsing information cascade. CDOs hid the risk of the debt they were made up of, a large amount of money wound up sloshing around in this market, everyone was using mathematical models that tried to extrapolate short term behaviour into a long term trend. This was doomed to failure because it was a chaotic system with too much instability in it because no one knew anything about the market and merely followed what everyone else was doing via their models. I also suspect that it's a termodynamic collapse, wealth moving freely between nodes in the network creates a functioning ecomomy, we've lived through 20 years of the most significant wealth concentration in modern times, that hoarded wealth does nothing in the economy, and reduces the number of decisions and transactions that can be made. i.e. the economy seizes up.
Gordon, Norwich

But one thing has changed this time around - hypercommunication. This bubble will be like every other bubble, except that it'll take in far more people and probably happen far more quickly because the information for social referencing will use email, chat, phones, blogs and all the other modern ways to communicate...
Graham , Ramsgate, Kent

What complete and crystal clear sense. It reminds me of the passage in Catch-22:

"...Let somebody else get killed."

"But suppose everybody on our side felt that way."

"Then I'd certainly be a damned fool to feel any other way. Wouldn't I?"
Mark Riles, Reading, England

A well observed piece of writing with a nice twist at the end. I worked in residential property, in London, in the 1980s when the housing market was booming. I was in my 20s and recall vividly graphs showing the historic upwards shift of house prices, followed by a "dashed line" projecting upward trend. When I would ask folk, recalling my economics classes and concepts such as Utility Maximization, people would just scoff at me.

This time around I have watched the housing market with wonder once again and seen the bubble grow. I wonder how can this be? It breaks the laws of economics. Then I realised about 12 months ago people were not buying property with a mortgage that paid for that property after a fixed period, they were buying property with interest-only mortgages. They were doing this to keep the payments down and thus stretch their Utility Maximisation curve. They were relying on growth to reduce the debt relative to the loan. They were driven in many cases by fear, the fear that if they did not get on the ladder in some form they would never be able to.
Paul Zarb, Kinross, Kinross-shire

For a great example of how people can make decisions together which no-one individually thinks are right, try the Abilene Paradox. There's a summary on Wikipedia.
Peter , Salisbury, UK

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