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Irrational exuberance and the madness of crowds

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The title of this article combines comments by Alan Greenspan about the stock market boom of the 1990s (”irrational exuberance”) and the title of a book by Charles Mackay. The book, “Extraordinary Popular Delusions and the Madness of Crowds”, is a short but interesting one, covering those aspects of human psychology, sociology and politics that lead to what are known as bubbles. A bubble is loosely defined as what happens when the price of a particular class of item breaks away from fundamentals and, in effect, goes up because everyone expects it to go up.

We’ll rewind a bit here and take a look at the way markets usually work; all markets, not just financial ones. Company A produces a product; it could be a car, a toaster, a cake or a life insurance policy. In order to sell its product, Company A must price it at a realistic point. Too low and it will lose money on each product it sells. Too high and nobody will buy it except the rich and the insane (often the same demographic).

Note that to keep it simple here I’m excluding things like loss-leader promotions, where products are deliberately sold below cost to stimulate demand for related items.

Anyway, in a stable market the price is set at the margins, where the ability and willingness of the buyer to buy is matched by the ability and willingness of the seller to sell. This is a nice little negative feedback loop that keeps prices competitive, assuming competition is permitted within this particular market sector. Shortages of supply – whether real or deliberately created by withholding stock – can lead to increases in price, but higher prices will only be met if the demand is present and if Company A isn’t undercut by Company B.

And, most crucially of all, demand is moderated by the ability to pay. As the old example goes, the demand for Ferrari’s among 12-year-old boys is pretty much infinite, but that doesn’t have any effect on the market (at least until they grow up) because they have no ability to pay.

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