Imagine if all of the sudden the blood in your body just stops flowing normally. It does happen very often as a result of some external shock. We perceive that something we do not like is about to happen and as a result we do not let our body function in its normal way. The same thing happens with money. The credit just stops flowing as a result of an exception, and expectations usually justify themselves. This situation is called, a credit crunch.
In 2008 the entire world got into deep crisis. The world's best economists, political scientists, sociologists, were trying to come up with an answer as to what could have possible triggered such crisis at a time when the world's biggest economies thought that they had the issue of recessions taken care of. They thought that the Great Depression had taught them enough lessons to never let crisis of such scale ever happen again. Ben Bernanke, Time's magazine “Man of the Year” for 2009, the head of the Federal Reserve Bank of the United States of America, in responding to some analysts claims that the Federal Reserve, with its bad monetary policy, had turned an ordinary recession into the greatest economic depression in history (the Great Depression) stated: “You're right, we did it. We're very sorry. But thanks to you, we won't do it again” (Kupelian, par. 20).
Indeed the study of the Great Depression had given such confidence to the world's best economists that they would never let such thing ever happen again. Robert Lucas, a professor at the University of Chicago, a university known as the birthplace of the world's most famous economic liberals that promote laissez-faire attitude toward the markets said that the “central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades” (Krugman, par. 4). However, after the crisis hit economists gave explanations which were totally contradicting to the statements they had just made before the crisis hit.
How do crisis develop? Analyzing from an economics perspective, the first stage of financial crisis is displacement. Investors from the powerful countries breathe in a good opportunity for investment in an emerging market and they start investing. Examples of this are Mexico, which by the 1980s gave signs that it's about to adapt a really liberal approach to its market. Later on they became part of the North American Free Trade Agreement. This sent a signal that Mexico is about to prosper. When a country enriched with natural resources shows that it is ready to open up and become one of the countries “livin the good life”, means small investments will bring huge profits, in a very short period of time.
As was noted in the beginning of this paper, expectations are self-justifying. Everybody expects a certain market to do well, and so it happens. Why does this happen? Well, this is how the expectation itself aids the event predicted. Say everybody expects Kosovo's economy to grow at a tremendous rate. Investors worldwide spent most of their time in front of a screen watching the news, seeking good opportunities for investment. If the predictions show that Kosovo is about to have great economic results they will invest their money here. Hence the economy will grow. The expectation itself, even though it may not be based on any relevant data, will have an effect on the event predicted. Shpend Ahmeti, the head of GAP, one of Kosovo's most popular think-tanks states that “expectations are everything in financial markets. Expectations that a certain company or industry will perform well in the future will lead to more investment in that company or industry” (Ahmeti). The philosophical term for the phenomenon is self-fulfilling prophecies.
Self-fulfilling prophecies happen in all areas of life. You wake up in the morning with a feeling that you are not going to have a good day, or maybe the horoscope tells you so. You may not realize that you're actually working toward making it a bad day, and so it turns out to happen that you will have a bad day. You are fulfilling the prophecy you believed in when you woke up. The idea that all prophecies are self-fulfilling has opened many philosophical debates as to why do things happen the way that they do? Does free-will exist? Is everything predetermined, or written in a great book as some claim, or does everything happen by chance? How much does our free-will, if such a thing exists, affect the reality?
When the belief that a certain market is about to emerge much capital starts flying in. This stage is known as euphoria. Alan Greenspan, the former head of the Federal Reserve Bank called it an irrational exuberance in a speech he gave about the stock market boom where he raised a very important question:”how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?” (Greenspan, par. 41) What Alan Greenspan warned about was that the markets are not perfect. When too much money is thrown into a certain sector or market it will create a bubble, and when the bubble in pumped in more air that it can handle, it will burst. This is one of the causes of the recent financial crisis. According to Shpend Ahmeti,
The recent financial crises were caused primarily by the bubble on the real estate market. People were overinvesting in this sector, and bubbles eventually do burst. People get greedy when they see that a certain sector is generating large profits. Housing market does not have the informational efficiency that the financial market does; hence it took longer for economists to see the problem (Ahmeti).
What happened was that the expectation was manifesting itself into reality. Everybody expected the real estate to market to grow and so they added liquidity to it. The overinvestment caused the increase in supply to exceed the increase in demand. However, this was not the real issue. When the prices reached their peak, they would not come down at such a fast pace if it wasn't for the “offsetting” expectations. Again, it's all about expectations. For some time even though the real market value of real estate was going down this was not reflected in the prices because nobody was really worried about it. However, once everybody was talking about that the possible decline in prices they started selling. This stage is known as revulsion. As Noble prize winner economist Paul Krugman noted,
The funny thing is that once you take the possibility of self-fulfilling crises seriously, market psychology becomes crucial—so crucial that within limits, the expectations, even the prejudices of investors, become economic fundamentals—because believing makes it so (Krugman, p. 110).
If people did not expect prices to go down they wouldn't. If there were some kind of false propaganda that the real estate prices would continue to go up, even though the market situation tells otherwise, they would continue to go up. People would see it as a good investment opportunity, hence the demand would continue to increase, maybe exceeding the increase in supply, and hence the prices would continue to go up. However, expectations win once again.
A great example of self-fulfilling prophecies is speculative attacks. When we talk about speculative attacks there is one name that pops in everyone's mind: George Soros. The legend of George Soros and his Quantum Fund is very popular among economists but also to the general population. What George Soros understood was that if enough people believe something is going to happen they will work towards making it happen. Soros made more than a billion dollars in matter of weeks speculating on the British pound. How did he do that? First of all, he borrowed a great deal of British pounds which he sold in the foreign exchange market. He then speculated that the value of the British pound will drop. He would “give interviews to financial newspapers declaring his belief that the pound would soon be devalued, and so on. If all went well, this would generate a run on the pound by other investors” (Krugman, p. 123). And so it happened. People started selling the British pound, making its value drop because of the huge supply. Prophecy fulfilled. All that Soros had to do was buy his pounds back and give them to its creditors. It's like borrowing a jacket, selling it for fifty Euros today and buying it back for thirty after a month after its value had dropped. You give the jacket back to whoever you borrowed it from, and you had made a quick and easy twenty Euros.
Speculators like George Soros have been the center of debate after the financial crisis contaminated the entire globe. It did not do much harm to Great Britain, because the confidence in the British government is not the fragile. However, when the speculators attacked currencies such as that of Malaysia they brought the whole economy of a country down. But what worries IO's (International Organizations) such as the International Monetary Fund is not the economy of poor country, but the effect it has on the economies of the countries that finance these institutions. With globalization all countries are just parts of a bigger whole which they would damage if they are not doing well enough.
The self-fulfilling panics would not happen if it wasn't for another problem, a game. The game is known as the prisoner's dilemma. Prisoner's dilemma is a situation when “a group whose members pursue rational self-interest may all end up worse off than a group whose members act contrary to rational self-interest” (Kuhn, par. 1). Examples of prisoner's dilemma are many. For example, all teachers do grade scaling or curving if the class average is too low. Hence, it is in student's best interest not to study too hard, but they do so from the fear that others will. Even if the group of students get into an agreement that they will not study too hard and benefit from scaling, most if not all the students will study from fear that others will not respect the agreement.
How does the prisoner's dilemma apply to the financial crisis? Well the basic assumption in economics is that people are rational and they try to maximize their utility. When the expectation is that the real estate prices will decline people's rationality tells them that they need to get out of there, sell their property. That is what any reasonable person considers a smart thing to do. However, being rational is not in their best self-interest. If everybody had acted contrary to their self-interest, everybody would benefit from it. But as was explained, the prisoner's dilemma does not even fail in a class group, let alone the whole participants in the real estate market.
Ahmeti, Shpend. "Financial Crisis." Personal interview. 26 Jan. 2009.
Greenspan, Alan. "The Challenge of Central Banking in a Democratic Society." Speech. Francis Boyer Lecture. American Enterprise Institute, Washington D.C. 4 Feb. 2009. FederalReserve. Federal Reserve Board, 6 Dec. 1996. Web. 4 Feb. 2009. <http://www.federalreserve.gov/boarddocs/speeches/1996/19961205.htm>.
Krugman, Paul. "Fighting Off Depression." NYTimes. New York Times, 4 Jan. 2009. Web. 4 Feb. 2010. <http://www.nytimes.com/2009/01/05/opinion/05krugman.html>.
Krugman, Paul R. The return of depression economics and the crisis of 2008. W. Norton & Company: New York, 2009. Print.
Kuhn, Steven. "Prisoner's Dilemma." Stanford Encyclopedia of Philosophy. Stanford University, 22 Oct. 2007. Web. 4 Feb. 2009. <http://plato.stanford.edu/entries/prisoner-dilemma/>.
Kupelian, David. "Bernarke: Federal Reserve caused Great Depression." Web log post. WND. World Net Daily, 19 Mar. 2008. Web. 4 Feb. 2010. <http://www.wnd.com/index.php?pageId=59405>.