Business Cycles and Psychology

Business Cycles and Psychology

There has been great popular interest in the psychological basis for business cycles from very early times. Daniel Defoe spoke of the over-optimism of business men when business was good causing them to expand their capital equipment beyond the point of safety. The first modern statement of this conception came from John Stuart Mill in his On credit Cycles and the Origin of Commercial Panics. He said that economic practices were less responsible for crises than emotional factors which in­fluenced business policy. The cycle might be expressed in psy­chological terms in this way: Fair trade leads to optimism, opti­mism leads to recklessness, recklessness to disaster, disaster brings pessimism, and pessimism inhibits action and fosters stagnation. It is perhaps unnecessary to point out that the psychological ex­planations of the business cycle do not eliminate the economic ex­planations.

As a matter of fact the psychological theory might easily be associated with any one of the economic analyses, be­cause the former merely shifts to the mind of the business man the real cause of the economic action. This situation is well illustrated in the way that Professor Pigou links the psychological together with the economic influences in order to present a complete analysis of the causes of the business cycle. From the psychologi­cal point of view, there is an overly optimistic attitude toward business conditions and the prospect for future profits. Professor Pigou calls this the "error of optimism." When the investor or the business man awakens to the fact that his expectations will not be justified, he reacts as strongly in the reverse, producing an "error of pessimism." The pessimistic reaction is about equal to the extent of the original optimism; it may be increased by the number of bankruptcies and other obvious evidences of the depressed state of business conditions.