|Steve, thanks for trying to clarify. Unfortunately, I still fundamentally disagree with your approach. I think it is an attempt to substitute psychologizing (not even psychology!) for economics, and provides no real value and quite a bit of harm! Let me highlight some of the problems.
First, a focus on emotions would have to accomplish one of two things for it to be relevant at all. It could explain an event that couldn't be explained due to changes in incentives or economic context. Or it could be used to measure the intensity of such an event. Let's look at both.
Any attempt to introduce emotion as the driving force for an economic behavior is a rejection of economics. Economics provides us a method of analyzing how certain "causes" incentivize changes. These "causes" are things like prices, opportunities for profit, or expectations of the future context. The causes are just aspects of the economic context that create incentives. We can then analyze the incentives and explain how changes in them incentivize changes to the economic behavior of individuals. We can see how an artificial increase in cost, say by a minimum wage law, incentivizes some companies to reduce their work force in order to maximize their profit or avoid suffering losses.
When emotions are introduced in explaining economic behavior, they are introduced as an alternative to economic incentives. They attempt to explain the changes to economic behavior by appeals to some outside, mysterious force unconnected to economic incentives. And that means rejecting economic explanations. It's the equivalent of explaining natural phenomena by saying God did it. It looks like an explanation, but actually acts as a substitute. And whenever you use this kind of "explanation", you are implicitly claiming that that particular economic behavior cannot be explained through economics, just as the natural phenomena explained by a god is thought to be unexplainable through science.
In practice, emotions are used to describe the boom and bust cycle. The boom is explained by claiming that people get caught up in the emotions and propel the boom further and further. That assumes that there are no economic incentives in play, which there are plenty. The bust is explained as an inexplicable panic or change of emotion, also unconnected to economic incentives. Both are viewed as mysterious external forces that disrupt normal economic forces, and both implicitly assume that there can be no economic explanation. The introduction of emotions is used to substitute a sort of mass psychologizing for grounded economic theory.
And of course, any introduction of emotions as the "cause" of economic behavior smuggles in the presumption of irrationality. If the economic behavior cannot be explained by reference to economic incentives, it means that people are not acting appropriately based on the incentives. They are acting irrationally. And that's a strong argument for government controls and regulations, to save people from themselves.
So introducing emotions not only rejects economic reasoning, but it hinders it by implicitly assuming there is no economic justification, and you don't need to look any further. It also is universally used as an attack on free markets (they are inherently irrational and self-destructive) and offers support to government interference (we have to be saved from ourselves). No added value, and a lot of harm along the way.
I should probably note that economics does not attempt to explain changes in individual preferences (i.e., demand), by economic incentives or anything else. Demand is an input. You could try introducing emotions as a cause for changes of individual preferences, but it adds no value in economic reasoning. But this is not what is being argued when it comes to things like the boom and bust cycle. The arguments isn't that individuals across the board suddenly change their preferences.
So let's go on to the second place emotions are brought in. The intensity of the reactions. The big problem here is that economics does not and cannot provide a formula for what the optimal reaction is to a change in economic incentives. There's nothing that tells us that a minimum wage increase must result in X number of people being fired. In fact, it could be that not a single person loses their job even with all else being equal. Economics is not quantitative. It is qualitative. It doesn't tell us what the results will be, but identifies the incentives or changes in incentives. So how does introducing emotions add value here? It doesn't. Saying that people are "overreacting" is not meaningful in this context. It is not scientific. It is simply introducing the presumption of irrationality again with the presumption that economic behavior is somehow disconnected from economic incentives.
Strong emotions can change economic indicators without representing irrationality or diminished reason.I don't know why you think this is true. If rationality and economic incentives suggest you act in a particular way, and you act in a different way due to "strong emotions", aren't you acting irrationally or with diminished reason? If your strong emotions are in sync with your reasoned opinion of the best course of action, hasn't the introduction of "strong emotions" simply obfuscated the issue?
The one thing that you said that makes the most sense is the idea that people rationalize their urges and sometimes ignore consequences that should be expected. Whether it is the con man, or the government, or just the individuals themselves who generate these rationalizations, it's obviously true. People are clearly willing to believe that housing prices will never drop, or we're in the middle of a "new economy" that will never have a downside, or that Pets.com is a good long term incentive. And it would be foolish to believe that in economic matters, emotions don't have any impact on people's choice. It's certainly true that people will often ignore or downplay risks when they are emotionally committed to something. But most of the time when individuals decide to rationalize risks away, they are making an individual value preference.
If we pretend we're in "normal" economic times, and I want to buy a house, I may decide it's important even if I could barely afford it and there's a risk that I might lost my job. I'm choosing to value the house more and value the security and lack of risk less. That's not a topic of economics, though. During the housing boom, though, it's different. As the incentives are stacked up for buying a house, I would be more likely to buy one. While there are risks as well (including a housing bust), I have ample evidence that the risks are minor. Prices keep going up! The amount of land on earth is limited while population keeps increasing! The government has already proven they are willing to do anything to keep the prices high! And if I don't do it now, I'll lose big time! These are all strong incentives. Where does the introduction of emotions help explain the situation?
Here are some of the factors: How many people are experiencing an emotional shift at once?I don't see this as important. Take housing. A strong incentive during the boom is that everyone else is buying houses, so the prices are going up and you expect it to continue. When the bust happens, it isn't due to a sudden inexplicable emotions change in state. It happens for a variety of reasons, including prices not going up as much as they were (a problem with any boom, as inflation can't increase at the same rate for long without hyperinflation), and the drop in expectations of how valuable the real estate would be. Those trigger less buying, which lowers price even more, causing further reactions. When people start realizing the trend, they start recognizing the risks they had assumed were minimal before are becoming much more likely, and they add to the trend. Add in widespread unemployment and the destruction of major financial institutions, stimulus spending, and a government bent on socialism, and you have a recipe for substantial changes in expectations.
It's not the sudden emotional shift of lots of people. It's the change in rational evaluation by those people. It's not the fact that everyone is excited about the housing market that makes people hop into the market, it's the fact that the incentives become so strong.
In most economic situations for each person that is happy about the days transactions, another is unhappy - there is an averaging going on in human activities because of different circustances and different beliefs.This is a bizarre statement. Economic transactions are when two parties think they can trade for mutual benefit. If I buy a gallon of milk at the store, both parties win. Both sides are happy. There is no "averaging out" to zero. Even the stock market, which has the appearance of zero sum, requires that every transaction is mutual. If the price changes, later, it may seem that one side won and the other lost, but it was entirely mutual at the time. Those who buy wanted to own the stock, and those who sold wanted to get rid of it. Both would have preferred a better deal (who wouldn't!), but they both got what they wanted. If I sell some of my stock today because I want cash, and someone else buys it because they preffered stock over cash, we both win. We're both happy.
There is also an averaging of the intensity of emotions. Some people are in a panic because of individual circumstances, like a loss of their job.No, there isn't. In normal situation if I lose my job and panic, that does not mean someone else out there won big and is ecstatic. There's no reason why any of this would "average out" whether in normal or abnormal economic situations. The economy is not zero sum, so there is no winner for every loser.
Places where emotion would be a factor would involve large portions of the population effected at once, the intensity of the emotion being high, and under it all is that reason is telling them of a sudden change. What they know (or think they know) is suddenly changed and this leads to a sudden change in emotion.Agreed, but once again the emotion provides no value to the theory except to imply that it is irrational. Imagine if every time you did something, I said "Oh...that's just Steve acting out on his emotions!". Of course there's an element of truth there! Your actions probably are aligned with your emotions. But it only serves to question your rationality. If instead I said "Oh, Steve just rationally concluded that was the best course of action and acted on it", wouldn't that be better?
I am seeing emotions as a product of reasoning regardless of whether the reasoning was done correctly or not, and regardless of whether the information the reasoning was based upon was correct or not. So I don't see this as an irrational state - just a more highly motivated state. It will have a higher percentage of people acting in opposition to reason and it will have a higher percentage of people completing a sequence of actions... that's the nature of highly motivated action when looking at a large number of people.I don't understand why you don't view this as irrational if it makes people act "in opposition to reason". Why do you think there's a distinction here? My claim is that by introducing emotions into the argument, you're creating a presumption of irrationality. You keep arguing that you're not, but then go on to point out that the resultant actions are in opposition to reason! If you're trying to make a subtle point, you're not doing a good job.
Mostly, I'm saying that there is a multiplier effect when large numbers of people feel the same way at the same time.You haven't shown any actual multiplier or hinted at one that I can tell. So far it sounded like you were saying that if lots of people are emotional, then it will have a large effect. But that's true if lots of people rationally conclude they should behave in a particular way. Anything multiplied by a lot of people is big because a lot of people are acting that way. But you seem to be suggesting that there is a further multiplier somehow. Whereas I would say that when people recognize the new economic reality (that people are not continuing to buy houses at ever increasing prices), they rationally adjust their behavior accordingly. There is no need to have a theory of run-away emotions that distort the market.
When you talk about economics, psychology drops out - it is assumed to be averaged out.I don't think that's right at all. I think you have some strange understanding of economics where it attempts to predict quantitatively how people will act. It's like the Isaac Asimov Foundation trilogy, where individual preferences "averaged out" allowing predictions. But that's all nonsense and not how real economics works.
Booms and busts and other mania type of phenomena need that extra factor to be understood.I think you need to study Austrian Economics more, because booms and busts are not "mania" types of phenomena. They are the result of economic incentives created ultimately by an artificial interest rate.
Ultimately, the reference to emotions is a distraction and impediment to economic reasoning. It's easy, as highly complex economic activity can be "explained" by reference to "animal spirits", manias, and emotional states. But it presumes irrationality on the part of the market participants, it suggests the free market is inherently flawed, and it obscures the role of the government interventions that caused all of it. It also adds nothing useful to the explanation.