The paradox of gluttony in a malfunctioning economy

George W. Bush (remember him?) famously pointed out, early in the economic crisis, that as gas prices rose, fewer people drove their cars.  Bush saw this as delightful evidence that “the economy works.”  Jon Stewart added, shortly thereafter, that as more houses were going into foreclosure, people were sleeping on the streets “…the economy works.”

Bush was lending his voice to a philosophy taught in elementary economics courses and business schools across America, a philosophy that appears to have come to an end.

In his The Origin of Economic Crises, George Cooper, a leading British economist, says that the efficient market theory is deceptively easy to understand because it perfectly describes the goods market, but when it comes to the asset market, the laws of supply and demand can no longer be relied on to keep an economy in equilibrium.

Cooper imagines a scenario in a small, one-bank town: each day, the bank “marks to market” all its assets, meaning that it follows the standard financial practice of constantly reassessing the value of its assets as new information becomes available.  Imagine that the bank owns all 1 billion of its shares, which it values at $1 a share.  If, one day, a lone horseman comes in to town and purchases 100 shares in the bank at $1.01 a share (the bank is entitled to a little profit, right?), the bank might decide to mark up the value of its securities to reflect the new demand generated by the cowboy.  Now shares are worth $1.01.  The bank still owns almost 1 billion shares, so that extra penny a share has driven up the value of its total holdings by 1 penny x 1 billion = $10 million.  Like the wings of the butterfly that stir a hurricane on the other side of the world, one man spends $101 and creates $10 million in wealth.

Where this really gets ugly is that the new wealth inspires others to invest, because unlike the goods market (where people buy things based on the fundamental value, or benefit, an item confers to the purchaser), people buy assets based on their likelihood to go up.  So as the price of doughnuts goes up, fewer people buy them, causing the supply to increase and the price to come down…but as the price of Google goes up, people just buy more Google.  That’s what Cooper calls the “paradox of gluttony,” the paradox being that gluttony (a bad thing for the economy) begets more gluttony.

Cooper’s phrase is an inversion of Keynes’ paradox of thrift: as people save money to prepare for bad times, there’s less money in the economy flowing around, causing the bad times to come.  Fear of a depression becomes a self-fulfilling prophesy.  Sound familiar?

For more on Cooper’s ideas, see also: Financial Instability Hypothesis, the Forgotten Economic Theory