Gold and the Wacky Human Mind

The voting machine that is the market deemed an ounce of gold to be worth $1,600 a few days ago and then, whoops, two days later, that same market, the collection of rational minds that trade in the metal, valued that same ounce to be worth less than $1,400.

Keep in mind: These prices are in dollars that are not backed by anything other than Uncle Sam’s less-than-creditworthy promise.

Economists of the rational-expectations school and believers in the efficient-market hypothesis must be scratching their heads. These deep thinkers contend all information is known in the market. There are no such things as bubbles and busts.

Wikipedia explains rational expectations,

“it is assumed that outcomes that are being forecast do not differ systematically from the market equilibrium results. That is, it assumes that people do not make systematic errors when predicting the future, and deviations from perfect foresight are only random.”

Yep, that sounds exactly like you, me, and your idiot brother-in-law. Nobody makes mistakes when predicting the future.

Yeah, right.

At the same time, Eugene Fama, father of the efficient-markets hypothesis, says, “I think most bubbles are 20-20 hindsight.” When asked by John Cassidy at the New Yorker to clarify whether he thought bubbles can exist, Fama answered “They [bubbles] have to be predictable phenomena.”

Fama is no Nobel laureate, but he did co-author a textbook with Nobel Prize winner Merton H. Miller, and he himself has won plenty of prestigious awards for his theoretical work.

These guys can theorize all they want to, and win awards doing it, but what they have to say has nothing to do with how markets act and react.

This week’s Laissez Faire Club author, Alec Macfie, was an economist lecturing at the University of Glasgow back in the 1930s. He had a better head on his shoulders than today’s fuzzy-minded theoreticians who evidently haven’t taken the time to look out of their campus office windows to see how the world really works.

Macfie explores the ups and downs of the business cycle as well as investment booms and busts in his elegantly written Theories of the Trade Cycle. He not only, among other things, provides a clear synopsis of Hayek’s Austrian Business Cycle theory, but he also makes use of psychology to solve the business cycle puzzle. Investor errors are revealed in a crash as entrepreneurial errors are revealed by recessions. In Macfie’s view, the term error should be substituted with “excesses of optimism and pessimism.”

He explains that in a bull market the possibility of potential profits is spread by suggestion and is overemphasized. Investors hear the potential but not any opposing rational criticism. “A man acting under the influence of suggestion is like commander of a submarine observing his enemy through a periscope. He sees his easy prey and is impelled toward it, but his periscope cloaks from him the surrounding dangers,” writes Macfie.

But how could investors or entrepreneurs go from bullish to bearish so quickly to create huge drops in assets prices? A. C. Pigou, a renown English economist at the time, sheds some light on this, explaining, “An industrial boom has necessarily been a period of strong emotional excitement, and an excited man passes from one form of excitement to another more readily than he passes to quiescence.”

So for investors there is no inbetween, they go from bullish to bearish in the blink of an eye. Just what is it that sets them off? “It is, of course, common knowledge that we tend to manufacture rational explanations for conduct which springs largely from our unconscious urges,” Macfie explains. “Every politician, every elector, exemplifies this.”

Manufactured rational explanations or rationalization is constant in individual finance, according to Elliott Wave’s Robert Prechter. Individuals use reason to succeed in economic endeavours. However, in finance, individuals rationalize the decisions they have made that amount to simply herding with other investors. Rather than make their own valuations, investors depend upon others’ valuations. Rather than having knowledge about markets they remain ignorant. Rather than using objective value, investors value subjectively.

Bubbles and crashes are consistent with nonrational risk aversion, but not with rational assessments of risk. Still, people are hyper risk sensitive and often resort to bailout first and analyze later. “Thus, it is the instinct of each herd member to flee from danger that supplies the force behind the stampede,” writes Professor Macfie, even though that force maybe be a mere suggestion.

And while an individual will achieve prosperity acting in the economic sphere, that same person will chase booms and busts in finance. Why? According to Prechter, speaking at The 2013 Socionomics Summit in Atlanta, these decisions are made with two completely different parts of the brain. We use the rational part of our brain, the neocortex, to make economic decisions and maximize utility. However, investment decisions are made in the limbic system, that is driven by emotion, making us follow the herd.

Does any of this make sense from an evolutionary standpoint? Actually, yes, according to Prechter, “Prosperity keeps humans alive in the short run. Setbacks keep the species alive in the long run.”

The pummeling of gold was certainly a setback for those who are betting against the central bank controlled new world order. But one should realize that central bankers are no more than academic theoreticians lucky enough to get a government job. Their views of how the how the economy and markets work have no basis in reality.

Yes, the gold herd was spooked a few days ago. But the yellow metal has been around a lot longer than Ph.D. economists and will prove more durable in the end.

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