Peer pressure and bubbles

What has the housing bubble told us about market efficiency, social psychology and economics? Quite a lot, I believe.

In the aftermath of the housing bubble, one thing is for certain: we can throw out the inane “Efficient Market Hypothesis.” It is disturbing that this rubbish has been held to for so long. But, after seeing two enormous bubbles within one decade, it is obvious to even the most novice investor that markets just are not efficient — neither stock markets, credit markets nor housing markets.

As I see it, the Efficient Markets Hypothesis was always a ploy by wannabe scientists in the economics profession who wished to impose the exactitude of Science onto a field of social science, more akin to psychology and history than to quantum physics and molecular biology.

Luckily, we have a countervailing market view due to the brilliant work of Daniel Kahnemann. The work he and Amos Tversky pioneered in Behavioral Economics garnered Kahnemann a Nobel Prize in the field of Economics. Economics is not a science. It is a field based on human interaction and is subject to the idiosyncrasies of human psychology and behavior.

In that vein, I would like to mention a famous study by psychologist Stanley Milgram which sheds some light on human behavior during bubbles. Let me say upfront that it is my view that media, pundit, housing industry and government cheerleading and good old fashioned peer pressure made it very difficult for the average person not to buy into the housing bubble hype while the bubble was still ongoing.

Three people take part in the experiment: “experimentor”, “learner” (“victim”) and “teacher” (participant). Only the “teacher” is an actual participant, i.e. unaware about the actual setup, while the “learner” is a confederate of the experimenter. The role of the experimenter was played by a stern, impassive biology teacher dressed in a white technician’s coat, and the victim (learner) was played by a 47 year old Irish-American accountant trained to act for the role. The participant and the learner were told by the experimenter that they would be participating in an experiment helping his study of memory and learning in different situations.

Two slips of paper were then presented to the participant and to the “learner”. The participant was led to believe that one of the slips said “learner” and the other said “teacher,” and that he and the actor had been given the slips randomly. In fact, both slips said “teacher,” but the actor claimed to have the slip that read “learner,” thus guaranteeing that the participant would always be the “teacher.” At this point, the “teacher” and “learner” were separated into different rooms where they could communicate but not see each other. In one version of the experiment, the confederate was sure to mention to the participant that he had a heart condition.

The “teacher” was given a 45-volt electric shock from the electro-shock generator as a sample of the shock that the “learner” would supposedly receive during the experiment. The “teacher” was then given a list of word pairs which he was to teach the learner. The teacher began by reading the list of word pairs to the learner. The teacher would then read the first word of each pair and read four possible answers. The learner would press a button to indicate his response. If the answer was incorrect, the teacher would administer a shock to the learner, with the voltage increasing for each wrong answer. If correct, the teacher would read the next word pair.

The subjects believed that for each wrong answer, the learner was receiving actual shocks. In reality, there were no shocks. After the confederate was separated from the subject, the confederate set up a tape recorder integrated with the electro-shock generator, which played pre-recorded sounds for each shock level. After a number of voltage level increases, the actor started to bang on the wall that separated him from the subject. After several times banging on the wall and complaining about his heart condition, all responses by the learner would cease.

At this point, many people indicated their desire to stop the experiment and check on the learner. Some test subjects paused at 135 volts and began to question the purpose of the experiment. Most continued after being assured that they would not be held responsible. A few subjects began to laugh nervously or exhibit other signs of extreme stress once they heard the screams of pain coming from the learner.

If at any time the subject indicated his desire to halt the experiment, he was given a succession of verbal prods by the experimenter, in this order:

  1. Please continue.
  2. The experiment requires that you continue.
  3. It is absolutely essential that you continue.
  4. You have no other choice, you must go on.

If the subject still wished to stop after all four successive verbal prods, the experiment was halted. Otherwise, it was halted after the subject had given the maximum 450-volt shock three times in succession. This experiment could be seen to raise some ethical issues as Stanley Milgram deceived his study’s subjects, and put them under more pressure than many believe was necessary.

Before conducting the experiment, Milgram polled fourteen Yale University senior-year psychology majors as to what they thought would be the results. All of the poll respondents believed that only a few (average 1.2%) would be prepared to inflict the maximum voltage. Milgram also informally polled his colleagues and found that they, too, believed very few subjects would progress beyond a very strong shock.

In Milgram’s first set of experiments, 65 percent (26 of 40) of experiment participants administered the experiment’s final 450-volt shock, though many were very uncomfortable doing so; at some point, every participant paused and questioned the experiment, some said they would refund the money they were paid for participating in the experiment. No participant steadfastly refused to administer shocks before the 300-volt level.

Credit Writedowns’ commentary: The Milgram experiment says a lot about human desire to obey and human capacity to heed a peer or authority despite massive contradictory evidence not to do so. Taken to the housing bubble, Milgram’s experiment implies that human beings may find it extremely uncomfortable to disregard the advice of well-known authority figures like Alan Greenspan or to buck the trend when everyone else is buying into the housing bubble.

On the whole, Milgram’s experiment explains why it is extremely difficult to take a contrarian economic or market point of view and stick to it in the face of massive implicit pressure to conform. The psychological pressure from one’s self and others is more than most of us can bear. And in markets, the bubble’s very rise is the ultimate indicator demonstrating the prevailing view and weighing on any contrarian, day after day, week after week. This was true during the
housing bubble from 2002-2005 and in stocks from 1998-2000.

I tend to look at these factors in markets as peer pressure more than obedience. However, Milgram said the following about his experiments:

The legal and philosophic aspects of obedience are of enormous importance, but they say very little about how most people behave in concrete situations. I set up a simple experiment at Yale University to test how much pain an ordinary citizen would inflict on another person simply because he was ordered to by an experimental scientist. Stark authority was pitted against the subjects’ [participants’] strongest moral imperatives against hurting others, and, with the subjects’ [participants’] ears ringing with the screams of the victims, authority won more often than not. The extreme willingness of adults to go to almost any lengths on the command of an authority constitutes the chief finding of the study and the fact most urgently demanding explanation.

Ordinary people, simply doing their jobs, and without any particular hostility on their part, can become agents in a terrible destructive process. Moreover, even when the destructive effects of their work become patently clear, and they are asked to carry out actions incompatible with fundamental standards of morality, relatively few people have the resources needed to resist authority.

Milgram experiment, Wikipedia

When one thinks of manias and bubbles, one could understand that a mass psychology takes hold during a bubble which lead many to actions which, in hindsight, are repugnant, duplicitous, and downright illegal. There is enormous peer pressure to at least conform, if not to actively reinforce or promote the bubble, legally or otherwise.

This is one reason that bubbles are so destructive.

  1. Mark Wadsworth says

    Skipping the middle bit and returning to the EMH, it depends whether you look long or short term. Long term, prices (whether of real estate or commodities) are fairly stable, it’s only in the short term that they have these wild swings.

    In the case of oil, the bubbles can come and go within a year or two. In the case of real estate, the cycles seem to be about 18 years long. So let’s not worry about oil, that sorts itself out, it’s the real estate bubble/credit bubble that you want to worry about, and that’s easily fixed via 1) sensible banking supervision, 2) land value tax and 3) liberalising planning laws.

  2. Anittah Patrick says

    I find your definition of science a mite reductive but will allow it given that your post, overall, is thought-provoking. I hadn’t considered the housing situation through the lens of the Milgram studies; thank you for that.

  3. Edward Harrison says


    Long-term th stock market is a good value barometer. But that long-term can be 20 years! The markets just aren’t that efficient over the short and medium-term.

    As for real estate, I agree 100% that real estate is an especially pernicious animal when it’s a bubble. I still struggle as to whether bubbles are endemic to the markets because of human psychology.


    Yes, my reductionist view of science is rather narrow. I do have to admit to having two PhD Biochemist parents so I have full respect for science. You seem to get the point I was making being about Economics not being science. I’m glad the Milgram experiment provokes some thought.

    Thanks for the comments.


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