How we’ve become accustomed to bubbles bursting the economy, instead of fighting them.

Summary: The financial sector has doubled in size as a %GDP since 1970, far exceeding its previous peak in 1929. The effects have been predictably broad and bad. One late stage symptom is the increased frequency of bubbles, perhaps even becoming our only driver of growth. To understand how this happens we should consult sociologists, such as one of the greatest of the post-WWII era: Daniel Moynihan. He describes how we’ve become psychologically adjusted to bubbles, rather than taking the political action to prevent them.

This is the follow-up to this morning’s Let’s ignore another warning from the BIS. Do we enjoy paying for burst bubbles?  For the 3,000 and 3,001 posts I’ve posted some unusually good material, timely and relevant to us all.

Daniel Patrick Moynihan (1927 – 2003) was one of the greatest sociologists of his day. His prescient observations (often too radical for his time, such as seeing the effects of single-parent families) put him in the top rank of sociologists, as did his applying these skills to become an ambassador and 4-term US senator.

Today we look at one of his major papers: “Defining Deviancy Down“, American Scholar, Winter 1993. I strongly recommend reading it, being rich with insights about America. It gives a sociological analysis describing how we (society) adjust to changing levels of deviancy. Moynihan discusses crime and out-of-wedlock childbirth as forms of deviancy.

We can apply his insights to finance — specifically, the development of asset price bubbles.

About financial bubbles

First, some context. Financial bubbles — unsustainable rises in investments and asset prices — naturally occur in free-market systems. Classroom simulations show how easily they happen. Right-wing bugaboos to the contrary, bubble occur without fractional reserve banking, and happen under the gold standard — as seen in 19th C Britain and America. While painful, they might even have beneficial long-term effects, as did the great 1840s UK railroad mania. But Larry Summers and others fear we’ve entered a new era of secular stagnation, with an illusion of growth from bubbles — shattered when they burst.

This post rephrases Moynihan’s text, changing the subject from social deviancy to financial deviancy. I skip over the theory he gives in the first half. Alterations to the text appear in red; additions in brackets.

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Introduction

In one of the founding texts of sociology, The Rules of Sociological Method (1895), Emile Durkheim set it down that “crime is normal.” “It is,” he wrote, “completely impossible for any society entirely free of it to exist.” By defining what is deviant, we are enabled to know what is not, and hence to live by shared standards.

From this viewpoint the fundamental facts of finance appear to us in an entirely new light. … bubbles must no longer be conceived of as an evil which cannot be circumscribed closely enough. Far from there being cause for congratulation when they drop too noticeably below the normal level, this apparent progress assuredly coincides with and is linked to some social disturbance.

… He does not imply that we ought to approve of bubbles — “pain has likewise nothing desirable about it” — but we need understand its function.

… It would not appear that Durkheim anywhere contemplates the possibility of too many bubbles. Clearly his theory would have required him to deplore such a development, but the possibility seems never to have occurred to him.

Kai T. Erikson {Wayward Puritans, 1965} contemplates both possibilities. Hence ‘the number of deviant offenders a community can afford to recognize is likely to remain stable over time.” … here is a theory that clearly implies that there are circumstances in which society will choose not to notice behavior that would be otherwise controlled, or disapproved, or even punished.

… It appears to me that this is in fact what we in the United States have been doing of late. I proffer the thesis that, over the past generation, since the time Erikson wrote, the amount of deviant behavior in American society has increased beyond the levels the community can “afford to recognize” and that, accordingly, we have been re-defining deviancy so as to exempt much conduct previously stigmatized, and also quietly raising the “normal” level in categories where behavior is now abnormal by any earlier standard. This redefining has evoked fierce resistance from defenders of “old” standards, and accounts for much of the present “wars about economic policy“.

The 3 ways to deal with too much deviance

Let me, then, offer three categories of redefinition in these the altruistic, the opportunistic, and the normalizing. …

The altruistic mode of redefinition is just that. {G}ood people to try to do good {by deliberately creating bubbles}, however unavailing in the end.

Our second, or opportunistic mode of redefinition, reveals at most a nominal intent to do good. The true object is to do well, a long-established motivation among mortals. In this pattern, a growth in deviancy makes possible a transfer of resources, including prestige, to those who control the deviant population. This control would be jeopardized if any serious effort were made to reduce the deviancy in question. This leads to assorted strategies for re-defining the behavior in question as not all that deviant, really.  {Regulatory capture is a powerful mechanism to achieve this.}

… Our normalizing category most directly corresponds to Erikson’s proposition that “the number of deviant offenders a community can afford to recognize is likely to remain stable over time.” Here we are dealing with the popular psychological notion of “denial.”

… {after years of warnings about the increasing incidence of bubbles as the New Deal restraints were removed} {t}he inevitable, as we now know, has come to pass, but here again our response is curiously passive. Bubbles are a more or less continuous subject of {discussion in economic and investment circles}, and from time to time it will be at or near the top of opinion polls as a matter of public concern. But it never gets much further than that. … Peaks continue to attract some notice. But these are peaks above “average” levels {of speculation} that thirty years ago would have been thought epidemic.

… There is no expectation that this will change, nor any efficacious public insistence that it do so. The {level of speculation} has been normalized. … it has done so at a level that induces denial.

Conclusion

The hope — if there be such — of this essay has been twofold. It is, first, to suggest that the Durkheim constant, as I put it, is maintained by a dynamic process which adjusts upwards and downwards. Liberals have traditionally been alert for upward redefining that does injustice to individuals. Conservatives have been correspondingly sensitive to downward redefining that weakens societal standards.

Might it not help if we could all agree that there is a dynamic at work here? It is not revealed truth, nor yet a scientifically derived formula. It is simply a pattern we observe in ourselves. …  we are getting used to a lot of behavior that is not good for us.

… As noted earlier, Durkheim states that there is “nothing desirable” about pain. Surely what he meant was that there is nothing pleasurable. Pain, even so, is an indispensable warning signal. But societies under stress, much like individuals, will turn to pain killers of various kinds that end up concealing real damage.

There is surely nothing desirable about this. If our analysis wins general acceptance, if, for example, more of us came to {outrage about the increasing financialization of the US economy} we might surprise ourselves how well we respond to the manifest decline of the American {economy}. Might.

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The cost we pay for ignoring bubbles

By now many studies showing that we have a gambling problem (the financial sector has grown too large). Here are two that describe different aspects of this serious problem.

Rethinking the Financial Crisis (2013) edited by renown economists Alan Blinder, Andrew Lo and Robert Solow, “a compilation of new research challenging the conventional wisdom on Wall Street about the efficiency of financial markets and the rationality of the investors who speculate in them.” See the summary “How the Financial Sector Consumed America’s Economic Growth“.

“Why does financial sector growth crowd out real economic growth? by Stephen G Cecchetti and Enisse Kharroubi, BIS, February 2015. This has justly gotten much attention (e.g., in Reuters sand The Economist). But, as Moynihan said, we’ll ignore it. The problem is structural, requiring our action to fix. We’ll pay dearly for our inaction.

For More Information

About financial bubbles:

1. Will 21st Century USA have a surprise boom, as did the 19th Century UK?
2. Larry Summers gives us the bad news. Worse, the only solution is more of the same.
3. The new tech bubble takes us to a new world. A mad world.
4. A guide into the weird numbers that run our world, describing both financial bubbles & climate change.
5. Let’s ignore another warning from the BIS. Do we enjoy paying for burst bubbles?
6. How we’ve become accustomed to bubbles bursting the economy, instead of fighting them.