Bubble, bubble, toil and trouble

As a professional in Finance, i fully agree with this Scott Summer's analysis.

The Psychology of Investment Bubbles

From The Atlantic by Virginia Postrel 12/2008

A rise in price above a reasonable value (a price bubble), followed by a fall back to that value (a crash), seems to be a part of psychology rather than bad insight or poor mathematics.

Bubbles occur even in constructed trading situations where the expected value of a trade is easily calculated. Still, people trade on the fluctuations to create price bubbles most of the time.

Of course, the real world also has market manipulators. The Government was an eager promoter of the housing bubble, setting low lending standards, buying up the risky mortgages, and pressuring the credit rating agencies to put AAA on the bundled mortgages.

Interesting, but not that useful. Neither Fama nor anyone else ever claimed that all markets are efficient always and forever. The claim is that markets tend towards efficiency. I did not gather from the experiment that the same group of students would replicate bubbles over and over again - only that there is a marked tendency for groups of students to initially bid prices up above their calculable value, and that these "bubbles" tend to collapse around the 15th round. If my interpretation is correct, the practical value of the experiment is limited to new markets with small stakes that involve inexperienced traders. It is an amusing experiment in psychology, but it is not any sort of meaningful attack on EMH.

I also find the rest of the criticsms of EMH pretty weak. Market go up and down, sometimes by a lot. EMH never said they didn't. When markets move, especially by a lot, some people make a lot of money and some other people lose a lot of money. Well, this is obvious and not contrary to EMH. The people who make a lot of money tell stories about how they "knew" the price was going to change in the direction they predicted. So what? People who win money at roulette have explanations for how they did it, but that is pretty weak evidence for their predictive abilities. Only the ability to perform the same trick over and over and over again provides real evidence of market inefficiency.

Fama is right. His detractors finally do not seem to understand EMH.

Perhaps we err in calling them bubbles. Perhaps what we've been witnessing is a collapse in the relative value of money.

Yes, perhaps. I made a similar conjecture in my question above about non-unifrom inflation. If the money supply increases in one market more than others and in turn the value of money in that market falls relative to the others, prices in that market might rise faster than in the others. There would need to be some mechanism that would keep the money/inflation concentrated in the bubble market and hinder it from dispersing into the rest of of the economy... preferred credit rates could do it... or tax advantages...

That's why the was an excess supply of money in the housing market, low interest rates.

This is why there should be a free market in credit. The optimal rate would be sought for each market.


"The government fails to succeed because it is not permitted to fail."

Yeah, it does seem like buyers could not have bid up home prices without access to such an amply quantity of money. But is this really the same thing as devaluation? Possibly -- home buyers had access to vast amounts of money at virtually no cost, and so they treated it like Monopoly money; sellers knew that access to money was cheap, so they kept adjusting prices upward to more accurately express the value of their homes in terms of cheap (devalued) money. Interestingly, the rise in home prices might have triggered alarms of inflation had home prices not been removed from the CPI in '83... If there was inflation, but the inflation was concentrated in a market not represent in CPI, then people focused on CPI would not have noticed the change. CPI includes rental prices, but the cheap loans, to my knowledge, were not available for purchasing rental properties, and moreover, housing policy encouraged people to exit the rental market in favor of cheap mortgages, so rents did not rise as quickly as home prices. Maybe that's an example of the mechanism at work: the "play money" could only be used to play one game -- purchasing homes -- which inhibited the spread of inflation into other markets, including the rental market, even as it amplified inflation in the housing market.

Other markets are affected as home buyers were able to budget less for mortgage payments than otherwise and thus were able to, say, afford a longer commute...til gas prices went up.

Thus cheap money in the housing market affects other markets via consumer budgeting decisions.

That's true, I only meant that the price inflation effect does not spill over into other markets; i.e. the conjecture is that if growth in the money supply does not flow freely between markets, then wherever growth in the money supply is concentrated, prices will rise more sharply. Incidentally, I was reminded last night by the new Munger econtalk podcast that this idea is similar to the Austrian notion of asset price inflation. Perhaps, "bubbles" could be viewed as peculiar instances of Austrian asset inflation where particularly loose credit is available for the purchase of a certain class of asset such as houses.

From my trench hewn experience...

Bubbles - never ending that is - are the desire for all investors and governments. It is a never-ending growth and appreciation of assets. The origin of bubbles is very simple, too much money chasing to few opportunities in a given opportunity class. Debt or leverage is not needed for a bubble. Leverage adds to the height of the bubble and the speed of deflation of the bubble, it is not the cause of the bubble. I have seen commodity bubbles, professional talent bubbles, event bubbles, and yes - even real-estate bubbles.

We all like riding on and working in bubbles. Mistakes are slathered in the save of the continued appreciation of assets. Bubbles are easy to spot, as long as you are not inside the bubble. People who have no business in that commodity or business begin discussing it and choosing to deal in it. The dumb money is being sucked in is a benchmark of the last gasp of a bubble's inflation. For example clerks at convenience stores, 2 plus years ago, talking to me about how many homes they have bought in the last 6 months - is an example of the last gasp of a bubble in real-estate. Now the clerks are discussing how much of their savings they have put into gold!

This discussion of the origin and terminations of bubbles reminds me a bit of that silly stock broker marketing phrase somehow attributed to Einstein about the miracles of compound interest. At 10% interest you investment doubles every 7 years! WOW! (Actually its 7 and a fraction - but remember these are marketing guys - its not an error, its just puffing). Uninterrupted you could have more money than the GDP of some small countries in a generation starting with a paltry 1,000,000.

The miracle of compound interest and never-ending bubbles - ignore reality. Reality comes back in the form of no money left to keep inflating the bubble, the business cycles, governments desire to tax success wherever it can be found, obsolescence of the item, litigation and other wealth redistribution exercises such as children, paramours, plumbers and death taxes.

As for the origin of the term, I am certain that the term "bubble" came from recent popular culture. When the "bubbled headed" newscasters are championing how great X - industry is - it is the top of the bubble. Seems so simple.

Seems to be a good example of people arguing past each other.

As Professor Jeremy Siegel recently said, EMH states that securities prices reflect all known information which impacts their value, but does not claim that the market price is always right. [Efficient Market Theory and the Crisis, WSJ, 10/27/09]

For a more complete explanation, it's mandatory to dig deeper into financial market nuts and bolts.

Equities markets are real time, very accurate from a repricing frequency perspective. They're usually much faster at reflecting changes in information than comparable assets.

Fixed income instruments do not have an equivalent centralized marketplace, so their price behavior is much more fragmented, though they do react quickly to fundamental changes.

The more deep and liquid a market, the more accurate (and timely) the price information. As we saw with so-called toxic assets recently, there was no market, hence no information, and no way of knowing how truly risky they were. When a market stops quoting, pricing becomes a valuation problem (See FASB Rule 157). That is precisely the problem the banks carrying toxic inventory ran into.

When it became apparent that many of these assets carried on bank books would have to be liquidated, this further depressed any market buyer interest ("spooking the market"). While the bubble-like pricing of these securities during the runup was inaccurate, this fire-sale valuation is inaccurate as well.

Further, higher yields on riskier assets is a financial markets tautology: investors demand greater return in exchange for shouldering increased risk. Leading up to the meltdown, AAA (least-risky) mortgage- and asset-backed securities were yielding 200-300 basis points more (sometimes even higher) than their US Treasury equivalents. That discrepancy was a clue that they were riskier than denoted by their rating.

The fundamental issue is that different people and investment institutions have differing interpretations and information, and market price movements are a reflection of the perpetual struggle between these competing views, not the convergence to one single static price. It is this erratic and sometimes violent price movement which people perceive as "bubbles."

Good comment. I have noted before that one of the primary roles of Fan and Fred (per their charters, I believe) was to maintain secondary markets in mortgage-related derivative instruments. When they failed, the only buyers in the market and by far the largest providers of two-way liquidity disappeared. At that point there were potentially trillions of dollars worth of securities on the sell-side of the market with no one left on the buy-side. (And, unlike in energy markets, for example, no one is naturally short mortgage credit risk and so would be buying to hedge.) The requirement that the banks mark their positions to market (apparently with no adjustment for market liquidity) forced them to sell to maintain regulatory capital levels, and pushed the market price of those securities to zero. Note that these securities were and are still generating positive cash flows, but since, by law, the banks didn't have the option of holding them and Fan and Fred were dead, the markets in which to sell huge quantities of them no longer existed.

I believe some hedge funds, Warren Buffet and others jumped in and bought securities at a deep discount, but the overhang was just too huge to clear quickly with all the traditional players forced out of the market.

This has been my hypothesis for at least a portion of the crash, but I have never seen anyone (besides Mesaeconguy) address it. Am I missing something in this narrative?

In a way it's like the power price spikes that were observed in California during the "crisis" from the other direction. In that case the Independent System Operator was required by law to purchase all the power demanded by consumers at fixed retail prices regardless of the wholesale price of power. This created a race to be the last resource dispatched because at that point a single supplier faced a perfectly inelastic demand and could pretty much charge anything.

Question: It seems to me that the idea of bubbles is very similar to the idea of inflation. Inflation occurs when the nominal prices of goods rise faster than the real values of goods. A bubble occurs when a nominal price rises above the "fundamental price." An important difference is that inflation is related to the purchasing power of a currency and when it occurs, it happens everywhere goods are priced in the given currency, i.e. across all regions and markets using the currency, whereas a bubble is generally thought to be contained in a particular region or a particular market for a particular good. However, it seems to me that inflation is not so uniform. For example, the purchasing power of the dollar is not uniform across all regions of the US; e.g. a dollar buys more in Tennessee than in Boston. One could imagine that the money supply may not change uniformly across all regions, which could contribute to sharper inflation in regions where the money supply grows more quickly. Suppose that, similarly, the supply of money available to a particular market for a particular good were to increase more quickly than in other markets; e.g. the government floods a particular market with newly printed money via preferred credit to actors in that market. Might such a scenario result in a bubble-like rise in prices? Could the same mechanisms that cause currency devaluation across all markets in the long run, cause price inflation in isolated markets in the short run? Are price bubbles in particular markets simply examples of non-uniform inflation? Perhaps, as the money supply percolates, inflation bubbles up...

The debate about the EMH seems circular. Sumner's challenge - that doubts about the EMH are only contentful if they can outpredict the market - is a fool's gambit in that it still lets the market play referee. One can only win that bet by accurately predicting market prices, thus demonstrating that the market is predictable and in some sense efficient. But the opponents of the EMH don't seem to be playing fair either insofar as they won't tell us what these "fundamentals" are that they know about and the market, apparently, doesn't. Both sides seem to be stacking the deck in their favor, and I just don't see this going anywhere but in circles.

Very interesting read.

If it's still breathing some one needs to put a wooden stake through its heart.

Seriously... how can one call The Great Depression and todays Great Recession "effecient". The wisdom of markets ends in these places but unfortunatly the belief in them like all good religions carries on.

Muirgeo,

You might want to read the Scott Sumner post before commenting. You don't understand the context.

I did read it. I also read and researched Eugene Fama and Efficient Market Theory. I read no fewer than 10 articles related to this post. I do my research because I am ignorant and inquisitive together. I think I understand Scott Sumner's claim perfectly. I thus I understand how misleading and irrelevant it is. Thus I would ask Mr Sumner of the pre-crash memo's floating about Wall Street among insiders and Hedge Fund manager noting that they'd be long gone when the house of cards collapsed. I believe somewhere there was even a code for it. Wall Street speak of a sort, mentioned in David Wessel's book, In Fed We Trust. They are long gone, they beat the market...they beat it silly taking billions and using nothing of pricing mechanisms. Just ponzi schemes and complex financial products that made the pricing mechanism irrelevant to them. They beat the market Russ and they destroyed it too. That's why guys like Posner, Rajan and Shiller call it , "the most remarkable error in the history of economic theory." and why what Sumner presented was nothing but a logical fallacy propped up as something pertinent.

They beat the market Russ... they have billions and the world is broken.

I think I understand Scott Sumner's claim perfectly. I thus I understand how misleading and irrelevant it is.

I'm thrilled muir. Can't wait for the slew of papers you will publishing your perfect economic understanding. Thrilled to have you and our team


Love you, mmmwwwwwaaaaahhhh

I don't mean this in an offensive or condescending way, but you should really open some economics textbook (some real, honest, scholarly economics textbook) and read up on expectations, equilibrium, efficiency, etc. I'm not saying that what you wrote is irrelevant, and the problem here is not whether you're right or wrong, it's that this isn't the essence of what's being discussed in Sumner's post...

It is interesting to note that Muir's response to Prof. Roberts had nothing to do with Scott Sumner's post or specific hypothesis in it. He didn't criticize any particular concept from the article. Given his perfect understanding, you would expect a little better, wouldn't you? But that's muir's track record.

The FUNDAMENTAL issue with EMH as well as with ALL theories is that they rely on concepts that to say the least are vague--they do not refer clearly and directly to anything that can be easily identified and agreed upon by most people.
EMH implies that the pricing of assets is based on "fundamentals" but we don't know the fundamentals and more important we cannot know the fundamentals, even ex post. Or take the case of the quantitative theory of money that implies that an increase in the supply of money, with no change in the demand for money, will bring about an increase in the general price level. Well, we don't have a good definition of money--actually it's impossible to have one (ask anyone that has done research on the demand for money; ask in particular to Eugene Fama who wrote the most paper on "monetary" theory in which he distinguished between "monetary" systems of payments and accounting systems of payments). In addition, we don't have a good measure of the general price level (read the reports of the several commissions responsible for assessing the CPI and other price indexes).
The problem with many economists that have made their life to expand and apply theories is that they don't want to accept the limits of their knowledge. It's stupid to claim that you can predict anything on the basis of these theories. At best, economic theories are useful to understand what happened. Sorry Milton, I don't agree with you about the purpose of economics.

Very well said.

When will Fama be on Econtalk?

I second the motion

Best Quote:

"There is no 'fundamental value.' There are only amounts people think it is worth."

Government backed debt is the cause of most financial bubbles. The S&L crisis the current housing crisis were because of government backed debt.

People are taught that the status quo is the free market. When the "free market" fails they call for more government regulation and intervention which often leads to more market failures. But the status quo is government intervention and not "efficient markets"

Very well said.

Isn't a bubble just when something is valued based on the presumption that other people will think its value is going to increase (and so on in an infinite loop), rather than for its practical use in consumption?

In that sense, I suppose all forms of money are bubbles, since they are only considered valuable because everyone thinks everyone else values them. Yet money serves a very important social function, and it can only serve that role because we are all doomed by our very nature to participate in this 'irrational' social phenomenon. Yet, considering the role it plays, perhaps it's not so irrational after all.

lol.