Story Time for the World Economy

NEW HAVEN - Since hitting bottom in early March, the world’s major stock markets have all risen dramatically. Some, notably in China and Brazil, reached lows last fall and again in March, before rebounding sharply, with Brazil’s Bovespa up 75% in May compared to late October 2008, and the Shanghai Composite up 54% in roughly the same period. But the stock market news just about everywhere has been very good since March.

Does this suggest that the world economic crisis is coming to an end? Could it be that everyone becomes optimistic again at the same time, bringing a quick end to all our problems?

Speculative booms are driven by psychological feedback. Rising stock prices generate stories of smart investors getting rich. People become envious of others’ successes, and begin to wonder if rising prices don’t portend further increases. A temptation arises to get into the market, even among people who are fundamentally doubtful that the boom will continue. So rising prices feed back into more rising prices, and the cycle repeats again and again – for a while.

During a boom, people considering getting into asset markets weigh the fear of regret if they don’t against the pain of possible loss if they do. There is no authoritative answer about what the “right” decision is, and no consensus among experts about the proper level of exposure to these markets. Should it be 30% in stocks and 70% in housing? Or the reverse? Who knows? So the ultimate human decision must be based on the relative salience of these discordant emotional factors. In a boom environment, the emotional factors are biased toward getting into the market.