Financial manias and panics: a socioeconomic perspective

American Journal of Economics and Sociology, The,  Oct, 2002  by Brenda Spotton Visano

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Introduction

THE HISTORY OF FINANCIAL CAPITALISM is replete with high-profile episodes of widespread euphoric speculation and its converse, distress and panic. From the eighteenth-century South Sea and Mississippi Bubbles appearing at the earliest stages of security investment to the most recent excitement focusing on high-tech stocks, avarice and opportunity have combined to create remarkable instances of "moral epidemics" in the markets for financial equities. While not the only expressions of psychological intoxication of large numbers, stock manias and crises or panics, are among the most significant in their power to reallocate wealth in unintended ways in a relatively short time period.

Financial manias and panics have attracted economists concerned with the efficiency of asset markets and interested sociologists studying the "crowd mind." Though the same phenomena are being researched, there remains a surprising lack of intersection between the two disciplines of economics and sociology in their endeavors to understand better these exceptional, yet regular, occurrences.

Sociologists focus effort on describing the "crowd mind" and identifying patterns of interaction. Explanations of the nature of fads and fashion hinge on the individual's desire to experience a sense of identity and unity. The reason that participants in fads and fashion choose any particular object or activity at any given time is essentially a random one. By sociological criteria alone stock market manias remain virtually indistinguishable from amusement fads or clothing fashion, and financial panics indistinguishable from other escape mob incidences. Unlike more transitory fads and fashions, however, financial manias and panics have real and lasting economic consequences.

Economists, on the other hand, seek materially based explanations. The orthodox notion of a speculative bubble, for example, captures mathematically a process of bidding up to excess an asset's price, motivated by self-fulfilling expectations of capital gains. A financial crisis is "a disturbance to financial markets, associated typically with falling asset prices and insolvency among debtors and intermediaries, which ramifies through the financial system, disrupting the market's capacity to allocate capital within the economy" (Eichengreen and Portes 1987:10). Most economists attribute such crises to revulsion from prior bubble-like excess.(1)

Yet, what constitutes excess? Attempts by orthodox theorists of speculative bubbles to define excess objectively as market price deviations from an assets present discounted value of expected lifetime Earnings--its fundamental value--fail as a practical tool. Crucial problems of statistically measuring the true fundamental value plague empirical research, spur endless debate, and prohibit any final word.(2) Differentiating "crises" from lesser episodes of distress presents similar challenges. Finally, anecdotal accounts and media reports suggest that there is something extraordinary, at times appearing very much like a mania or showing every sign of panic--developments excluded by the assumption that individuals act to maximize wealth alone.

If one accepts that on occasion waves of optimism or pessimism have captured the minds of stock market investors, one accepts the presence of a unique crowd mind. Accepting this, in turn, implies that one must reject the critical economic assumption that investors are exclusively and individually maximizing wealth. Yet, given the fact that stock market manias and panics measurably influence the value and distribution of wealth, we desire an explanation of the phenomenon that nevertheless can account for objective, material influences.

As a means of furthering our understanding of financial instability, this paper proposes an economic explanation of instability that permits the intrusion of collective dynamics. Alternatively viewed, it posits objective economic grounds for the sociological dimensions of stock market manias and panics. As such, this paper strives to lessen the gap between the sociological and economic realms of discourse in its attempt to move a step closer to a better understanding of the essential nature of extreme financial instability.

This paper explores the sociological aspects of financial instability caused by economic speculation in a revolutionary innovation. It empirically orients the reader by including brief references throughout to some of history's highest profile episodes of mania and panic. The analysis builds on an economic hypothesis suggesting that the diffusion of revolutionary innovations as analyzed by Rosenberg (1976, 1994) qualifies in important and promising ways Schumpeter's (1939) explanation of cyclical instability and Kindleberger's (1989) analysis of excessive speculations. An environment of uncertain promise introduced by the prospects of an innovation creates optimism that is primed for a unique and potentially explosive speculative excitement. To better understand extreme speculative enthusiasm, an adaptation of Simmel's (1957) theory of fashion to the emergent norm framework proposed by Turner and Killian (1987) first explains the gradual swell of speculative excitement. Once generated, the enthusiasm continu es, as Schumpeter suggests, until the innovation's objective potential becomes apparent and estimable. If the contemporaneous degree of optimism proves unfounded and prices prove too high to sustain, a reversal of fortune ushers in distress that may inspire panic. A crisis and panic, contrary to implications of extant economic theory, does not necessarily follow a period of speculative enthusiasm. This paper suggests, instead and in light of Lang and Lang's analysis of collective dynamics, that certain objective market conditions create a panic in a distressed environment.