Market contagion, financial crises and a Girardian economics (longer read)

–That people act in an imitative fashion under conditions of high economic uncertainty is not news: Panic selling, spiraling inflation, overheated art markets, and speculative frenzies (I sell when you sell, buy when you buy) are some of the many instances of imitative economic behavior.[1] 

What’s bothered me, though, is the relative lack of reference in the economic literature to René Girard’s theory of mimetic contagion (mimetic desire in his terms). Why? Because Girard’s framework has major implications not identified by economists writing on market contagion and associated crises.

Brief description of a Girardian economics

From a purely Girardian perspective, financial and economic uncertainty begets ever more uncertainty, as more and more people imitate each other in a desperate rush to figure out what to do. At some point, classes of people are arbitrarily identified (scapegoated in Girard’s terms) as the cause of the crisis, widespread violence ensues against them, and new financial and economic institutions emerge from the hostile, violent conditions.

Most economic contagion models do not go that far in predicting violence (to be clear, predicting does not mean advocating).[2]

Contagion modelers typically argue that the way to break the cycle of imitation is the availability of and accessibility to more accurate information. Thorough-going Girardians will have none of that. They insist the underlying and overwhelming problem is pervasive uncertainty for which there is no recourse to “certainty” to solve. Appeals to “market fundamentals” or “getting back to normal” stabilize temporarily, and that is at best only. Such appeals do not and cannot resolve the baseline uncertainty that corrodes each and every stabilization effort.

In a Girardian economics, the more uncertain things are, the more wealth we desire to buffer against that uncertainty; but the more wealth we have, the more desire we have for even more wealth. The specification of wealth itself becomes increasingly problematic as uncertainty persists. Once wealth “ceases to be identified with the instituted money, [economic agents] no longer know behind which mask it is hiding.  Stocks, real estate, gold, foreign currencies, primary commodities, etc. attract the anxious attention of individuals looking for likely refuges from the ‘terrible oscillations of chance’,” the economist, André Orléan, has written.

This leads to what Girard calls a crisis of undifferentiation. Uncertainty becomes everywhere intensified; economic behavior grows more and more uniform; and ever more wealth becomes desired as “what is wealth?” becomes increasingly difficult to answer. Markets undergoing crises of undifferentiation—epidemics of contagion where everyone ends up imitating each other—are instances where we do not know enough to distinguish, in econo-speak, satisficing from maximizing or the second-best from the Pareto-optimal, and where no one is clearly right but where everyone hopes they are.

Girardian features of the 2008 financial crisis

This resulting sense of free-fall and groundlessness is neatly captured in the comments of bankers and investors just before and during the 2008 collapse of Lehman Brothers. “It feels as if we are 15 minutes away from the end of the world,” the head of equities at a large U.K. bank told the Financial Times about the lead up to the first major U.S. bailout.

“The market has changed more in the past 10 days than it had in the previous 70 years,” reports a senior executive at a European investment bank in 2008. “We have no idea of the details of our derivative exposures and neither do you,” conceded a senior Lehman Brothers official at a meeting of bankers and regulators just before it collapsed. “The crisis continues because nobody knows what anything is worth,” said one informed observer. The chair of Morgan Stanley Asia concluded, “We have gone to the edge of an abyss that few thought was ever possible”. I can find no reports of financial experts appealing to “underlying” market fundamentals during these weeks.

According to Girardians, people under these conditions—these crises of undifferentiation—respond by scapegoating. Scapegoating provides the certainty to move on. Reports from and about the last quarter of 2008, with the collapse of Lehman Brothers, the bailout of Freddie Mac and Fannie Mae, and the further bailouts of AIG and Citigroup, were replete with terms such as “panic,” “herd instinct,” “mob mentality,” “mob rule,” “witch hunting,” “finger-pointing,” “lynching,” and “show trials” along with the ubiquitous referencing of “scapegoats” and “scapegoating” (all terms from contemporaneous reports in the Financial Times).

Many commentators, of course, believed they were in fact correct in their blaming this one or that one for the crisis. Girardians argue, in contrast, that the choice of scapegoat is completely arbitrary, where pervasive uncertainty drives economic behavior. We saw some of this arbitrariness in the belief that if no one is to blame, then every one shares the blame. At that time, we were, for instance, told with respect to the financial crisis that “there is enough blame to go around for every one” and “we are all to blame for the meltdown.”

In heated financial markets where everyone is buying or selling at time t+1 because, well, most everyone was buying or selling at time t, there is no way to validate that selling save by stating it is what everyone else was and is doing. This point was famously made by Chuck Prince, former head of Citigroup, when he told the Financial Times in mid-2007, “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

But where’s the blood?

Its focus on an ensuing violence, however, is what sets a thorough-going Girardian economics apart from other contagion models. A full-blown Girardian economics, at least as I understand it, would hold that imitative behavior goes beyond scapegoating. It turns into mob behavior, not as a reporter’s hyperbole but in actuality. People scapegoated are killed, and it is only after widespread violence that people respond in revulsion to their behavior by forging new social and economic conventions so that such violence “never happen again.” In this view, new economic and financial institutions arise only after panic and mob-like behavior and the post-hoc rationalizations for what all the preceding “really” meant.

We certainly heard calls from politicians and regulators alike for “never again,” when it came to the 2008 financial crisis. So too, a manager or two committed suicide or disappeared from the scene. But it is an odd sort of crisis when those harmed on such an unprecedented scale did not take screaming to the streets. In 2008, we witnessed food riots over crop prices but no real violence over this massive wealth destruction. Which prompts the question:As René Girard asked me when I presented my version of a Girardian economics at his Stanford seminar, “Where’s the blood?”

I suppose some of it is there if we look for it. Already well documented, murder and suicides and violence do go up during a severe economic downturn like the one to which this financial crisis led. This, however, scarcely qualifies in Girardian economics as mob behavior essential for the rise of new social convention and institutions governing finance and economics.

So what happened?

In July 2009, former Treasury Secretary Henry Paulson testified before Congress on his involvement in the financial crisis. He admitted he had been deeply concerned about frightening the public if he expressed his real fears about the financial system unraveling: “[W]hen a financial system breaks down, the kinds of numbers that we were looking at in terms of unemployment was [sic] much greater than the numbers we’re looking at now. People in the streets, and of course, around the world—it was very significant and I remember talking about it…”.

But people did not take to the streets. Why?

Girardians, as I understand them, would resist two popular “answers:” (1) government interventions worked, and/or markets went back to fundamentals; and (2) it is too early to say how things are working out. Girardians would have expected considerable violence during and after events of September/October 2008, and there is no chance, in their view, that such reforms to the financial system as there were would ever make things more “certain” in the absence scapegoating and ensuing violence.

My answer

There are at least four ways in which a crisis of economic undifferentiation could be delayed, albeit not averted, when comes to market contagion. More, if I understand Girardians, these four ways are the value added to contagion models of the financial crisis already proposed by mainstream economists:

If you can’t reduce pervasive uncertainty, the next best alternative is to impede the resulting rivalry (“increase the costs of rivalry”);

If you can’t reduce the rivalry, the next best alternative is to impede the associated imitative behavior (“increase the costs of imitation”);

If you can’t reduce the rivalry or imitation, the next best alternative is to foster and prolong differentiation (“decrease the costs of differentiation”); and

Lastly, if you cannot do any of the above, the alternative is to slow down or wait out the crisis of undifferentiation (“increase the costs of undifferentiation”).

These actions are, I believe, what have been happening by way of the financial and economic reforms undertaken since 2008. Their effect has been to delay the consequences of the financial crisis by sidelining the scapegoating. Let’s examine each in more detail:

Increase the costs of rivalry.

In the Girardian framework, markets are mechanisms to increase the transaction costs associated with rivalry, not decrease them, as conventional economic theory would have it.

Markets are what keep us from killing each other for the goods and services we desire. They transform us into price takers rather than commodity thieves. What happened in the lead up to the 2008 financial crisis was just such increased thievery (e.g., insider trading and predatory lending). Many existing and proposed reforms—most notably, increasing capital adequacy reserves in banks and lending institutions—have been intended to make the excesses of rivalry too costly to undertake.

But increasing the costs to rivalry poses a dilemma from a Girardian perspective. To increase their costs may lessen that rivalry, but the higher costs serve as an incentive for increasing the wealth needed to cover (buffer against) the now-higher costs associated with rivalry. For Girardians, it is no surprise that firms, such as Goldman Sachs and JPMorgan Chase, were driven to return to wealth-making faster than would have been expected given the economic conditions and liquidity shortages said to exist at the time.

Increase the costs of imitation.

The principal feature of the lead-up to the 2008 financial crisis was that costs of imitation were too low. Behavior, as many pointed out, became positively correlated, when finance theory insisted such behavior should have been uncorrelated through risk dispersion.

Instead of diversification and risk spreading, hedge funds and others ended up acting in very similar ways. Either “[t]oo many funds bought the same assets” or the “problem was that, while these assets are heterogeneous, the owners were not. In tough times they behaved the same way….Diversification was therefore fake”. “Far from promoting ‘dispersion’ or ‘diversification’ [financial] innovation has ended up producing concentrations of risk, plagued with deadly correlations,” according to a Financial Times’ correspondent at the time.

Calls for “increased transparency” are routinely given as the solution to this problem. Risk cannot be concealed or obscured if financial processes are transparent, so this argument runs. From a Girardian perspective, such calls are self-defeating. Greater transparency would reveal the financial system is transparently complex and in many ways visibly beyond human comprehension when it comes to measurable risk and unmeasurable uncertainty. At worst, everyone sees the system for what it is, a house of cards impossible to shrink through “better risk management” or shrink-wrap with “better macro-prudential regulation.”

Either way, calls for greater transparency would lead people to becoming even more rivalrous as they hunt for ever greater wealth to protect or buffer themselves.

Decrease the costs of differentiation.

Now things get really interesting. You saw everywhere in the 2008 financial crisis the insistence of major participants that each differed from the others and that they were not—repeat, not—all alike.

Hedge funds insisted they did not start the financial crisis but that banks and investment houses did; the latter institutions insisted they were not all the same, some were better (or accused of being worse) in managing securitized assets; not all securitized assets were the same—that is, all toxic; more, not all toxic assets were equally valueless; still others argued that it depended on the valuation procedure used and few agreed which was the better one; no over-arching agreement, moreover, because the regulators themselves did not agree….; and so on.

Against a Girardian background, this sustained insistence on differentiation, even as finance and banking were in the midst of uncertainty, is especially important to note. Circumstances remained, at least in the minds of the finance sector, differentiated in major forms before and through the crisis. Very different social conventions emerged with respect to financial transactions, and the conventions evolved and innovated at that time as they diffused through institutions and among their participants. While accusations of “You’re all the same!” reached near fever-pitch, banking and finance services were still far from being homogenous and uniform, even during the crisis and the Great Recession that followed.

In other words, the blame game remained cheap throughout the 2008 crisis: The costs of differentiation were lower than one would have expected in a full-blown crisis of undifferentiation. I return to this point in a moment.

Increase the costs of undifferentiation.

A last strategy is to wait out the financial collapse in the hope that the longer people hold out before the crisis of undifferentiation becomes total, the more likely undifferentiation will not be total nor the contagion completed in full-blown scapegoating. One way to make undifferentiation “cost more” is to fuel the rumor mill about the who, why, how, when and where of the financial crisis, since it takes time to settle a rumor. (Small beer, but beer nonetheless.)

Since 2008, we have had an incoming tide of books and publications that keep all manner of whodunit suspicions and fevers alive. Rather than narrowing down identification of those who are “really” to blame, we have a surfeit of candidates said to have caused or contributed. In fact so many that some take the 2008 financial crisis to have been overdetermined. Instead of knowing who is to blame, we are encouraged to conclude, “With all that was going on, it would have been a miracle if the financial crisis didn’t happen!” Error here has many fathers when reliability is orphaned.

–In short, scapegoating has become difficult to complete during and since 2008, thereby diffusing the prospect of violence and the rise of new financial institutions: . . . so far, Girardians underline. Yes, scapegoating has begun, some violence has been witnessed, but there has yet to be polarization around one scapegoat or defined set of them. Or from the other direction, what polarized agreement that has occurred has been more around phenomena—notably, rising inequality—than on specific groups or classes of agents.

Yet even if the financial crisis were not the one predicted by a purely Girardian economics—how could it be a crisis of undifferentiation and scapegoating without the violence?—it is remarkable how well the four types of interventions just described fit the course of events as we know them today.

Which raises a last caveat. The 2008 financial crisis is a handy case study, not only because it’s part of living memory, but also because the literature that followed helps track the aftermath in terms of the four strategies discussed.

A more pertinent, policy-relevant case study would be the COVID-19 pandemic, one that tracks not only the spread of the epidemiological contagion, but the associated spread of mimetic, imitative reponse over space and time. It’s clear that wearing masks and social distancing have become core differentiation strategies at least up to the time of writing (August 2020), but we’re in medias res here too.

Endnotes

[1] Conlisk (1980) wrote about the widespread importance of imitation in economic behavior. Topol (1991) focused explicitly on mimetic contagion in investment behavior. Scharfstein and Stein (1990) and Banerjee (1992, 1993) modeled herd behavior among investors. The critical-mass (“tipping”) models of Schelling (1978) and Akerlof (1984), as well as the “informational cascades” model of fads and cultural change developed by Bikhchandani, Hirshleifer and Welch (1992), captured the notion that, under uncertainty, economic agents end up copying each other’s behavior. Most famously, Nobel Laureate in Economic Sciences, Robert Shiller (e.g., Shiller and Pound 1989; Shiller 1989, 2006) writes about and focus on contagion models in investment and the strategic role of imitation among investors. He argues, for example, that the subprime mortgage crisis and the 2008 financial crisis that followed had a great deal to do with “the contagion of market psychology” that led to bubbles under the boom conditions of the turn of the century (Shiller 2008). More recently, Shiller (2019) has focused on the role of narratives in the spread of and response to market contagion and crises.

[2] Not all economists who rely on the Girardian framework focus on violence as the instigator of new economic arrangements. Scholars such as Jean-Pierre Dupuy, Mark Anspach, Paul Dumouchel, and André Orléan, among  others, have applied aspects of Girard’s contagion model to economics and related topics. In my view, the most notable application is that of economist, André Orléan, in his The Empire of Value: A New Foundation for Economics (translated by M.B. DeBevoise, 2014, The MIT Press: Cambridge, MA.). Violence is not a key feature of his analysis of money and the 2008 financial crisis in that book. (See also Orléan 1988, 1989, 1992a,b, 1998.)

References

Akerlof, G., 1984. A theory of social custom, of which unemployment may be one consequence. In An Economic Theorist’s Book of Tales. Cambridge University Press, Cambridge.

Banerjee, A., 1992. A simple model of herd behavior. Quarterly Journal of Economics 107, 797-817.

————— 1993. The economics of rumours. Review of Economic Studies 60, 309-327

Bikhchandani, S., D. Hirshleifer and I. Welch, 1992. A theory of fads, fashion, custom, and cultural change as informational cascades. Journal of Political Economy 100, 992-1026.

Conlisk, J., 1980. Costly optimizers versus cheap imitators. Journal of Economic Behavior and Organization 1, 275-293.

Orléan, A., 1988. Money and mimetic speculation. In P. Dumouchel, editor. Violence and Truth. Stanford University Press. Stanford, CA.

————, 1989. Mimetic contagion and speculative bubbles. Theory and Decision 27, 63-92.

————, 1992a. The origin of money. In F. Varela and J-P Dupuy, eds. Understanding Origins. Kluwer Academic Publishers. Netherlands.

———— (co-authored with Robert Boyer), 1992b. How do conventions evolve? Journal of Evolutionary Economics 2, 165-177.

———–, 1998. Informational influences and the ambivalence of imitation. In: J. Lesourne and A. Orléan (Eds.) Advances in Self-Organization and Evolutionary Economics. Economica: London.

Roe, E., 1996. Sustainable development and Girardian Economics. Ecological Economics 16, 87-93. The article is the principal source for this blog entry, though material from the original has been updated substantially.

Scharfstein, D. and J. Stein, 1990. Herd behavior and investment. The American Economic Review 80, 465-479.

Schelling, T., 1978. Thermostats, lemons, and other families of models. In Micromotives and Macrobehavior. W.W. Norton and Company, NY.

Shiller. R., 1989. Stock prices and social dynamics. Fashions, fads, and bubbles in financial markets. In Market Volatility. The MIT Press, Cambridge, MA

————, 2006. Irrational Exuberance. 2nd Edition, Paperback, Broadway Business.

————, 2008. The Subprime Solution:  Today’s Global Financial Crisis Happened, and What to Do about It. Princeton University Press: Princeton, NJ.

————, 2019. Narrative Economics: How Stories Go Viral & Drive Major Economic Events. Princeton University Press: Princeton, NJ.

Shiller, R. and J. Pound, 1989. Survey evidence on diffusion of interest and information among investors. Journal of Economic Behavior and Organization 1,: 47-66.

Topol, R., 1991. Bubbles and volatility of stock prices: Effect of mimetic contagion. The Economic Journal 101, 786-800.

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