In a book worth reading “Rail Roading Economics”, the author, Michael Perelman, writes on the herdlike behavior in capital investments.
“Let us return to the idea of Smith and Keynes that most investments are likely to fail. Nobody went further in this respect than Karl Marx. Marx repeatedly noted that new technology destroy capital values so rapidly that virtually no factory covers its initial investment costs. In one letter to Engels, he wrote:
More than 20 years ago I made the assertion that in our present society no instrument of production exists which can last 60 to 100 years, no factory, no building, etc., which by the end of its existence has covered the cost of its production. I still think that one way and another this is perfectly true.
Consider an industry where technology is advancing at a rapid pace. Marx cited Charles Babbage’s example of frames for making patent-net-a light woven cloth. The early frames had first sold for 1,200 pounds only to fall to 60 pounds within a few years.
The microcomputer revolution, which has caused the prices of computers to plummet at breathtaking speed, offers a more recent example of this phenomenon. We may think of this situation as a part of the paradox of market rationality: if investors are too rational, the economy will collapse.
Recall Keynes’s image of Buridan’s ass, which starves to death from being overwhelmed with the difficulty of making a decision. For Keynes, irrational animal spirits rather than rationality drive investment forward. For Smith, these animal spirits are doubly irrational, since most investors overestimate their chances. Keynes added that if enough investors are confident enough the economy might enjoy a boom sufficient to temporarily allow a good number of these irrational investments to earn a profit.
Here we encounter another layer of paradox. If too many investors are too rational, too visionary, in the sense of making investments capable of revolutionizing methods of production, the intensify of the resulting sequence of price revolutions can overwhelm the market, creating as much havoc as an excess of irrationality. Under such conditions, prices can provide as little information as they would under the influence of a wave of price-distorting speculation.
Remember that the informational content of prices should depend on a degree of stability, or at least predictability. Extraordinary price revolutions can unsettle all previous calculations.
Investors could sink funds in a project based on existing prices only to find out that an entirely new set of prices would be in effect once the investment were ready to produce goods for the market. The new prices might wipe out a substantial proportion of their investment in a short period of time, ensuring that the firm suffers devastating losses.
Once firms realize that the risks associated with such near-term price revolutions are substantial, they may fall back on a different type of rationality, choosing to refrain from investing altogether. After all, why should anyone undertake a substantial investment when a subsequent investment might wipe out the value of the initial investment before it can repay itself?
The microcomputer industry is littered with the corpses of failed companies, most of which were founded with the expectation of becoming the next IBM. We might also interpret the example of the Winchester disk drive industry, discussed above, in terms of the rapid devalorization of the capital stock, rather than as a failure of rationality. Taking note of this possibility reminds us that what might sound like absurd irrationality, as in the description of the disk drive industry as reported in the business press, might actually be the result of an excess of rationality.
In any case, once an industry experiences very rapid technical change, firms would not want to invest without some prior assurance that their equipment will not become obsolete soon after it is installed. If this reaction should occur, investment might be paralyzed. Consequently economic growth could be greater if the rate of introduction of new technology were restricted.
Sawyers asserts that such conditions actually did exist in the British maritime industry. “There were times, between the wars, when marine engineering was changing in such a rapid yet uncertain way that firms in the highly competitive shipping industry delayed investment in the replacement of old high-cost engines by the low-cost engines.”
So while economists build their models on the assumption that markets are rational, irrationality plays a fundamental role in the real economy. No investor can know the future, which depends in part upon the decisions of other investors. Each investor tries to guess future market conditions by guessing the behavior of other investors. These guesses occur within waves of optimism and pessimism.
This sort of arrangement leads to herdlike behavior. If the herd of investors becomes too pessimistic, the economy becomes paralyzed like Buridan’s ass. If investors become very optimistic, they can generate speculative bubbles. At the same time, within the speculative bubbles revolutionary innovations can develop, which can wipe out massive capital values. The rapid destruction of values, either by the bursting of bubbles or by technological revolutions, can unsettle the economy enough to create serious recessions or depressions. The dot-com bubble of the 1990s illustrates that both kinds of value destruction can occur simultaneously. Almost invariably economists avoid such complications by neglecting the role of long-lived fixed capital in their analysis.
This layering of paradoxes of rationality indicates that capitalism is a very complex system built upon a multitude of contradictions. Economists make a grave error in building their models on the assumption that everybody is rational and that economies almost inevitably move toward a stable equilibrium. In fact, just the opposite is the case. What prevents the economy from running off the rails every few decades is a combination of government regulation and anticompetitive behavior on the part of business.”