The following is an excellent excerpt from the book “THE GREAT UNRAVELING: Losing Our Way in the New Century” by Paul Krugman from Part One ” Bubble Trouble” in Chapter 1 “Irrational Exuberance” and I quote: “Seven Habits of Highly Defective Investors” – Fortune, December 29, 1997 – “I like the theory of efficient financial markets as much as anyone. I don’t begrudge Robert Merton and Myron Scholes the Nobel Prize they just received for showing how that theory can help you price complex financial instruments. But unless you spent the past five months in a Tibetan monastery, you must have noticed that markets have been behaving pretty strangely of late. As recently as June the “miracle” economies of South-east Asia could do no wrong–investors cheerfully put billions into local stock markets. By October those same investors were in full flight; after all, everyone could see how corrupt and badly managed those economies were. When the IMF and the World Bank held their September meeting in Hong Kong, everyone congratulated the hosts on their economic policies, which had insulated them from the turmoil to the south and maintained prosperity through the handover to China. A month later Hong Kong had not only crashed but had briefly brought Brazil and much of the rest of the world down with it.
What is the market up to? Well, I recently had a chance to listen to the market, or at least a fairly large part of it, when I attended a meeting of money managers. Collectively they control several hundred billion dollars, so when they talked, I listened. Mainly I wanted to know why such smart men and women–and they must be smart because if they aren’t smart, why are they rich?–do such foolish things. Here’s what I learned: the seven habits that help produce the anything-but-efficient markets that rule the world:
1. Think short term. A few people in that meeting tried to talk about the long term–about what kind of earnings growth U.S. corporations might be able to achieve over the next five years. This sort of thing was brushed aside as too academic. But wait: Any economist will tell you that even a short-term investor should look at the long run. This year’s stock price depends on this year’s earnings plus what people think the price will be next year. But next year’s price will depend on next year’s earnings plus what people next year expect the price to be the following year. . . . Today’s price, then, should take into account earnings prospects well into the future. Try telling that to the practitioners.
2. Be greedy. Many of the people kept talking about how they expected a final “meltup” in prices before the big correction and how they planned to ride the market up for awhile longer. Well, maybe they were right, but if you really think stocks are overvalued, how confident should you be about your ability to time the inevitable plunge? Trying to get those extra few percent could be a very expensive proposition.
3. Believe in the greater fool. Several money managers argued that Asian markets have been oversold, but that one shouldn’t buy in until those markets start to turn around–just as others argued that the U.S. market is overvalued, but they didn’t plan to sell until the market started to weaken. The obvious question was, If it becomes clear to you that the market has turned around, won’t it be clear to everyone else? Implicitly, they all seemed to believe that the strategy was safe, because there is always someone else dense enough not to notice until it really is too late.
4. Run with the herd. You might have experienced that a group of investors would have been interested to hear contrarian views from someone who suggested that the U.S. is on the verge of serious inflationary problems or that Japan is poised for a rapid economic recovery, or that the European Monetary Union is going to fail–which would have offered a nice challenge to conventional wisdom. But no: The few timid contrarians were ridiculed. The group apparently wanted conventional wisdom reinforced, not challenged.
5. Overgeneralize. I was amazed to hear the group condemn Japanese companies as uncompetitive, atrociously managed, unable to focus on the bottom line. But surely it can’t be true of all Japanese companies; guys who managed to export even at 80 yen to the dollar must have at least a few tricks up their sleeves. And wasn’t it only a couple of years ago that Japanese management techniques were the subject of hundreds of adulatory books and articles? They were never really that good, but surely they are better than their current reputation.
6. Be trendy. I came to the meeting expecting to hear a lot about the New Economic Paradigm, which asserts that technology and globalization mean that all the old rules have been repealed, that the inflation-free growth of the past six years will continue indefinitely, that we are at the start of a 20-year boom, etc. That doctrine is basically nonsense, of course–but anyway I quickly determined that it is, as they say in Buffy the Vampire Slayer, “so five minutes ago.” All the rules have changed again: Now we stand on the brink of a dreadful epoch of global deflation, and despite its previous track record of engineering recoveries, there is nothing the Fed can do about it. You see, it’s a new new economy.
7. Play with other people’s money. If, as I said, the people at that meeting were very smart, why did they act in ways that seem so foolish? Part of the answer, I suspect, is that they are employees, not principals; they are trying to make money and careers for themselves. In that position, it is hard to take a long view: In the long run, even if you aren’t dead, you probably won’t be working in the same place. It is also difficult for someone managing other people’s money to take an independent line. To be wrong when everyone else is wrong is not such a terrible thing: You may lose a bonus, but probably not your job. On the other hand, to be wrong when everyone else is right. . . So everyone focuses on the same short-term numbers, tries to ride the trends, and buys the silly economic theory du jour.
Listening to all that money talking made me very nervous. After all, these people can funnel money into a country’s markets, then abruptly pull that money out–and create a boom-bust cycle of pretty spectacular proportions. I don’t think they can do it to the U.S.–in Greenspan I trust–but I am not 100% sure.
One thing that I am sure of is that the Asian leaders who have been fulminating against the evil machinations of speculators have it wrong. What I saw in that room was not a predatory pack of speculative wolves: It was an extremely dangerous flock of financial sheep.”
(IN READING THIS BOOK AND WHAT LED UP TO A LOT OF THE PROBLEMS TALKED ABOUT IN CHAPTER 5 TITLED “THE BAIT” CONCERNING THE PROBLEMS THAT PRESIDENT GEORGE W BUSH AND VICE PRESIDENT DICK CHENEY CREATED WHEN THEY TOOK OVER THE PRESIDENCY, LEADING FROM A MONEY SURPLUS TO A DEFICIT IN THE 8 YEARS OF THEIR ADMINISTRATION AND THE ROLE THAT FED CHM ALAN GREENSPAN PLAYED IN IT. A CONSTANT DOWNSLIDE OF A BAD-RUN GOVERNMENT AND A MEDIA THAT LET THEM GET AWAY WITH IT. THERE WERE A FEW EXCEPTIONS AND ONE OF THEM BEING THIS EXCELLENT-WRITTEN BOOK WRITTEN BY PAUL KRUGMAN,who writes a twice-weekly column for the op-ed page of the New York Times. A winner of the John Bates Clark medal for the best American economist under the age of forty, he teaches at Princeton University.”
THE FOLLOWING IS FROM THE JACKET COVER AND I QUOTE: “In this long-awaited work, award-winning economist and columnist Paul Krugman challenges us to take on George Bush and the radical right. Drawing from his New York Times columns, he chronicles how the boom economy unraveled: how exuberance gave way to pessimism, how the age of corporate heroes gave way to corporate scandals, and how fiscal responsibility collapsed. Krugman asks how it was possible for a country with so much going for it to head downhill so fast and finds the answer in the agenda of the Bush administration.
Krugman began writing his New York Times column in 2000 and quickly demonstrated that he is one of the most well-informed and trenchant commentators in America. One would have to go all the way back to John Maynard Keynes to find an economist so wiling to take on the issues of the day in accessible terms, and his political allies recall the age of the great Muckrakers or Walter Lippmann and Louis Brandeis. From Krugman’s account of the secret history of the California energy crisis to his devastating dissections of the Bush administration’s dishonesty on everything from tax cuts to the war on terrorism. Krugman tells the uncomfortable truth about how the United States has lost its way amid economic disappointment, bad leadership, and deceit. This unprecedented work of social and political history sets the first years of the twenty-first century in a stark, new light.”
LaVern Isely, Progressive, Overtaxed, Independent Middle Class Taxpayer and Public Citizen Member and USAF Veteran