Some would say that we are living in a time of unprecedented prosperity. The longest expansionary period and bull run in America's post-war history is unfolding right before our eyes, and many (including some economists) conclude that we are in a new era, one that does not recognise crashes and depressions, one where the business cycle is dead, one where the stock market will continue to boom forever and ever, amen. Hence the surprise involved when the Nasdaq experienced a major correction in mid-April this year. At the risk of sounding like the dismal scientists that we are often labelled, I beg to differ. I argue that the meteoric rise of the US high-tech stock market and its subsequent crash was not only inevitable, but ultimately predictable, and it was not so far afield that we would have needed binoculars to see it.
To illustrate, let us draw from an elementary concept in the economics of strategic interaction - that of game theory. Consider the most oft-quoted game in game theory: that of a prisoner's dilemma. Two individuals, Laurel and Hardy, commit a crime, and are caught. If they both co-operate and deny the crime, they will be convicted of minor charges (as there is insufficient evidence to convict for a major crime) for a month. If one admits to the crime whereas the other denies, the one who confesses will be let off after a week, whilst the other will have the book thrown at him and languish in jail for a year. If they both admit to the crime, they will spend the next 6 months behind bars.
What is the solution, as predicted by game theory? Amazingly enough, both of them will admit to the crime, even though they might both be better off denying it. Why this non-co-operation? Because no matter how chum the two mates are, when it comes to the crunch, they both have an incentive to cheat, in order to try to pull off a Houdini and get charged for only a week. After all, cells aren't exactly rooms with a view.
There is one reason why they might co-operate, though. In the simple game described above, both Laurel and Hardy will never see each other again, nor play the same game. If the game becomes a repeated one, however, there is then strong enough incentive for both to want to cooperate, as the punishment of deviating carries the weight of future games along with it, and the consequent punishment of deviation.
How does this relate to stock markets? I submit that the 'bubble' that existed in the highly-charged tech-industry market can be easily understood as a rational, calculated decision made by you and I. The market is a game, where if we both buy long, we reap a co-operative outcome that yields a higher payoff than if we sell short. After all, the increased wealth effects that we all feel by owning stock are definitely better than feeling poor. Market participants were stuck in a repeated game, and the hence the Nasdaq continued its gravity-defying run - in other words, we enjoy the mutually beneficial outcome.
How did all this change? The thing that keeps the co-operative outcome in such a game is the threat of being burnt if we don't - after all, perceptions were that the bull run would have lasted into the foreseeable future. Much of this had been fuelled by the exceptional performance of Internet and technology - so-called New Economy - stock. What it takes, therefore, in a market that is larger than you or I, is that enough people switch from seeing the game as one lasting forever to one that just might be over before this coming Saturday. The game no longer enjoys an infinite horizon, and we have the non-co-operative result. This switch leads to a choice of both selling short on our part being viewed as optimal, and our raging bull turns into a whimpering bear.
What might have caused this dramatic change? It's hard to say for sure. Economists, as their name suggests, aren't fortune-tellers. But I venture to say that it might be the saturation of the market. Everyone from Al the repairman to Joe the cab driver was into 'investing'. Venture capitalists stopped funnelling their cash into dot-coms that had no money, no profits, often no offices, but a fancy name and a great idea. The honeymoon period had ended, and newspaper articles of the time suggested just suggested just that.
The lesson here for us today is simple. Despite all the advances in economic science, we are still far from our conquest of business cycles. After all, if it were that easy, economists would be out of a job.