Is It Possible to Detect Bubbles?

On the one hand, it seems obvious; didn’t we all know there was a housing bubble back in 2006? On the other hand, if it’s that easy, why aren’t we all as rich as John Paulson?

A while back I suggested that the Fed could spot a housing bubble by treating housing prices the same way if treats the prices that make up the CPI. If there is high inflation in the core CPI, you don’t stop and ask if there is a fundamental reason for higher inflation; you tighten monetary policy (raise interest rates). The Fed could do the same thing for housing prices, since housing is an asset that people need to consume. But that’s probably a simplistic view.

Leigh Caldwell thinks that behavioral approaches may be able to separate out irrational overvaluation from changes in fundamental values. I believe his argument is that you can measure the degree of irrational overvaluation for certain types of assets, and you can extrapolate from there to see if there is a bubble:

Outside of the laboratory, precise knowledge of the returns of some assets does become available at times, and it would be possible to measure investors’ behaviour with regard to those assets. If investors, in aggregate, become overconfident about returns it will be possible to spot this from certain types of price change.

This makes logical sense to me, but it’s pretty vague. Caldwell’s VoxEU post goes a bit further:

I propose that regulators develop a small set of measures of irrationality that can be calculated and published at least monthly. These might include measures related to expected personal income, job security and asset values; measures of expectations about the performance of the economy as a whole; and measures of hyperbolic discount rates and other specific observable cognitive biases.

In essence, I think, the idea is that instead of trying to figure out whether a given financial asset is overvalued, we create an index of consumer expectations and cognitive biases and use that to tell us if we are in a bubble. If people are wildly optimistic, as reflected both in what they say and in how they act, then asset prices are probably also irrationally high.

There may be something here, but I worry that you still have to have something to compare your expectations index to. We already have indexes of consumer confidence – which, granted, are not quite what Caldwell is talking about – and I don’t think they have been much good as bubble-spotting devices. Maybe if you graphed consumer confidence against average economic forecasters you might see something – but most likely those forecasters are just as prone to irrational exuberance as the ordinary person. Really what we want is a reliable indicator of irrational exuberance that will be the same in every bubble; but how you would find such a thing, and how you would be sure that it would work in the next bubble, is beyond me.

By James Kwak

54 responses to “Is It Possible to Detect Bubbles?

  1. it pays to remember that lots of people lost lots of money betting against the housing bubble in 2003, 2004, 2005, and 2006.

  2. Here is a link on nakedcapitalism that leads to a number of articles that argue that while many perma-bears were (finally) right about the bubble, there were reasoned voices with good methods for detecting bubbles which could form the basis for a better economic theory.

    http://www.nakedcapitalism.com/2009/07/guest-post-anticipating-financial.html#links

    An interesting paper linked off this argues that economists using accounting (flow-of-funds) models of the global/macro-economic system had better tools to see the bubbles developing in the financial system. They contrast this with the mainstream thinking represented by equilibrium models of the global system which are blind to such systemic instability.

    This was the first readings I’ve seen in a while that give me hope we’ll find better methods to deal with our madness. Enjoy.
    http://mpra.ub.uni-muenchen.de/15892/1/MPRA_paper_15892.pdf

  3. The housing bubble was clearly visible in a large discrepancy between housing prices and rental rates in the same markets, as well as some other simple measures.

    The Internet Bubble and related stock market bubble was clearly visible in absurdly high price to earnings ratios of stocks.

    Many people did see the bubbles and make fortunes from them. In the housing bubble, home builders and others mass produced homes and otherwise cashed in on the bubble. In the Internet Bubble, venture capital firms and other financial firms mass produced dubious dot coms, telecom companies, and other “investments”.

    Because of the long duration of the bubbles and because there seems to be no way to predict exactly when the bubble will pop, many “ordinary” people who see the bubble have a limited ability to “cash in” on the bubble. For example, regularly traded put options on stocks last no more than a year, much shorter than the duration of the bubble. Hence an “ordinary” investor cannot safely sell put options to cash in on an “obvious” stock bubble. They would need put options with a duration of at least 10 years to have a reasonable level of safety.

    Sincerely,

    John

  4. One problem is that the irrationality is not spread uniformly among market participants, making the ultimate consequences less obvious to some. I remember some of Rosenberg’s very early commentary when he was trying to make a case that there was a housing bubble. He would cite statistics from different cities where things had gotten way out-of-hand in housing. The obvious criticism is, “well, that is LA,” etc.

  5. Scot Griffin

    Before anybody can develop a proper set of metrics to identify bubbles, we need to dispense with a lot of false dichotomies that permeate the way economists think about things.

    First, there is the false dichotomy of rational v. irrational. The behavioral economists are on the road to something, but they are too busy trying to dispel the myths of the rational market and the rational investor to see the real value of what they’re learning, which is how people decide. Instead, behavioral economists change how a particular problem is posed, discover that the a negative frame produces an opposite result to a positive frame, then conclude that people are irrational because they respond to different problems differently. Behavioral economists seem to argue that since the frame does not affect the expected value of the choices, the choice to accept risk on the one hand while not on the other defines irrationality, but if you don’t change the expected value, the decision to embrace risk or not is irrelevant. From a utilitarian (aka economic) perspective, this is rational behavior. What is irrational is the behavioral economists’ insistence on believing that they did not change the problem by changing the frame.

    Second, there is the false dichotomoy of stable v. unstable. The fact is that markets are stable until they are not. They are metastable, which should be expected when human decision making is heavily influenced by positive feedback (i.e., the dopamine system, confirmation bias and reflexivity).

    I’m sure that there are other false dichotomies, but these are the two that dominate so much of the debate. What economists really need to do is to leave behind the political part of political economics and focus on just the economics.

    Once economists clear their minds of the conventional wisdom, I still don’t think they can create an “index” for identifying bubbles. The problem is that destructive bubbles, which ultimately result in Ponzi financing, are created by asymmetric access to information. The most you can hope to do is develop something that will tell regulators when to start asking hard questions, particularly of foundational assumptions. Black Swans are much more likely to arise from mistakenly believing you know something that you actually don’t. These “unknown knowns” are leveraged every day by people in making financial decisions, and when they suddenly evaporate, and markets often crash.

  6. The housing bubble was clearly visible as early as 2003 in Northern California (the San Francisco Bay Area). The local economy was still very depressed from the Internet Bubble bursting. Apartment rental rates were either static or dropping sharply. Many apartment buildings had heavy vacancies and sported large banners advertising the vacancies and special move in deals.

    And yet…housing prices were soaring! This astonishing discrepancy between housing prices and apartment rental rates/vacancies lasted for years.

    Yes, first it was claimed that there was no housing bubble. Then the bubble was only in some markets. Finally, there seem to have been claims that the bubble applied only to certain homes in a market. For example, “cheap” homes were bubbling but your home was not. Special case excuses for the blatant anomalies proliferated.

    It is almost always possible to come up with special case explanations for otherwise obviously contradictory evidence (or in some cases the absence of evidence that one would naively expect). In this case however, the housing bubble appears to have been clearly visible in most markets with zoning regulations that limited construction of new homes that would probably have choked off the bubble at some point.

    The fact that the bubble was worse in some areas like Northern California does not indicate it was not clearly visible at a national and indeed international level. It was.

    The bottom line is that bubbles appear to usually be clearly visible in large deviations in ratios of related prices as well as large deviations from historical trend lines. The argument that a bubble exists based on a historical trend line appears less convincing to me, since something might have changed (e.g. new technology). But a large discrepancy between housing prices and rental rates in the same market was and is a red flag.

    Sincerely,

    John

  7. I think that it is unreasonable to ask regulators to be market gurus. After all, markets are largely unpredictable. I believe that markets are not all that efficient and that market gurus exist. But they are few and far between and we cannot count on their becoming regulators.

    All you need is for regulators to be able to smell bubbles. If it smells like a bubble or like it will become a bubble, let them take some braking action. As Soros says, the market will respond to their actions and tell them if they are right or not. There will be many false alarms, but that is a small price to pay. The uptick rule may not mean much now, when prices are denominated in pennies, but in its day it helped to retard bear raids and in general to reduce volatility. Most markets are too volatile. Smoothing small waves may be unnecessary, but does little harm, if any.

    Also, fail-safe mechanisms, that work automatically, can work as well. Like segregating different types of financial institutions, a la Glass-Steagal, like reasonable curbs on leverage, like down payment requirements and interest rate caps. Some of these may in theory entail costs, but think of those costs as insurance. :)

    Financial regulators should be like attorneys general, not like supermen. Our laws and regulations should not require any more of them.

  8. Scot Griffin

    @John,

    I saw the housing bubble, and I benefitted from recognizing it. (Actually, calling it the “housing bubble” is kind of like saying that the housing bubble was all about sub-prime. Just wait for the “commercial real estate bubble” to hit. The real bubble was the “credit expansion bubble.”)

    What I did not foresee was how the housing bust would unfold. We have had many bubbles burst since the Great Depression, but this is the first to rival the Great Depression in the threat it posed to the economy.

    The bursting of the internet bubble was vastly different than that of the “housing bubble.” I think we can deal with things like the internet bubble. What we can’t deal with are bubbles that threaten the very integrity of the system that people need to trust in order to spend and borrow money.

    So, seeing the bubble is the easy part. Understanding the nature of the bubble and what bursting it will cause is the hard part. Having come through the internet bubble without any harm to the broader economy, it was easy for people to assume that even if there were a housing bubble, if it bursts, it won’t harm the broader economy. Not all bubbles are created equal . . .

  9. Scot Griffin

    I’d prefer that regulators ask questions before taking some kind of braking action. Not all bubbles create systemic risk, and some things that look lke bubbles are actually just the type of creative destruction that capitalism requires to renew itself.

    The fact is that market participants are constantly looking for ways to avoid the current regulatory system, so regulators should be focusing on identifying new innovations that are nominally outside of the scope of their regulation and then extending their authority to regulate those innovations.

  10. History has shown that one concomitant of bubbles is fraud. Fraud was rampant in the late housing bubble. Bubbles attract fraud — easy money. We may not be able to use fraud as a predictor of bubbles, but publicly rooting out fraud may help people come to their senses and behave more cautiously than before.

    And if we are going to go after fraud we need more regulators. Understaffing contributed to our last crisis.

  11. Scot Griffin: “Second, there is the false dichotomoy of stable v. unstable. The fact is that markets are stable until they are not. They are metastable, which should be expected when human decision making is heavily influenced by positive feedback (i.e., the dopamine system, confirmation bias and reflexivity).”

    Like nearly all human systems, markets are, I think, chaotic. I agree that stable vs. unstable is a false dichotomy.

    As for “irrational exuberance”, research indicates that people can learn through experience to avoid bubbles. Doing so may depend upon private information, that would not be obvious to regulators, but which might be revealed through interviews and questionnaires.

  12. Scot Griffin

    Not all of the behavior that was fraud is legally recognizable as such. If the behavior was not specifically prohibited and arguably within the bounds of fair play as understood at the time, nobody will even think to question whether it was fraud and investigate. This is a problem. It’s kind of like Balco(steroids) and ectasy (narcotic): there are these designer drugs that do exactly what the laws say banned substances do, but because they have a slightly different molecule, they are not covered by the law.

    Maybe the answer is that the law regarding financial innovation should say that anything that is not specifically allowed is criminal and subjects the perpetrators to the same type of forfeiture penalties that drug traffickers see. Even if you understaff the regulators, you will see a drastic reduction in this kind of risky re-invention of banned practices under different guises because the perps will not be able to keep their ill-gotten gains and will rot in jail.

  13. GreenEngineer

    You ask “if it’s that easy (to spot bubbles), why aren’t we all as rich as John Paulson?”

    But that’s the wrong question. To spot a bubble as egregious as the housing bubble (and for that matter as the internet bubble before it) one need merely observe, and not be misled by wishful thinking. To become rich from this insight (without already having a huge pile of dough to play with) you have to know, not only that there is a bubble, but when it will burst. That’s a much harder, nay, impossible question.

    But just spotting the bubble really isn’t that hard. Forgive the bluntness but: I’m an engineer, not an economist or financial person, and it was bloody obvious to me. The only thing that surprised me was how long it inflated before it exploded.

    The problem with bubbles is that they are fueled by exuberance, and exuberance is both inherently irrational and highly contagious. And it’s quite hard to hold on to a rational, well-considered pessimism when everyone around you is jumping for joy (and apparently correct, at that moment in time). It sucks to be Cassandra.

    While I agree that developing better metrics for market misbehavior might be a very good idea, I think the bigger problem is getting regulators to use them and believe the results, even (especially) when the models raise a red flag in the middle of a huge party.

  14. Scot Griffin

    @Min,

    Returning to your prior invocation of Soros, the fact is that you can use public information to detect boom-bust cycles, just as Soros showed in his “Alchemy of Finance.” I recently started digging into the math behind what he calls reflexivity, and there is no there there (just like Oakland across the bay). This is because he has confused a symptom of reflexivity with reflexivity itself. Still, Soros’ central thesis is correct, that bubbles manifest themselves as an accelerating delta between the prevailing valuations and the underlying fundamentals.

    The problem is who gets to decide what the fundamentals are and how far the regulators can go to determine the cause of the delta. Again, not all bubbles are, in fact, bubbles, and not all real bubbles pose systemic risks. Thus not everything that is a bubble should necessarily be discouraged, particularly when discouraging a contained bubble could harm the broader economy.

    As an aside, you seem to assume that public companies will reveal to regulators what they won’t to their investors. The fact is they will reveal exactly to regulators what they reveal to investors, which is as little as possible for fear of tipping off competitors.

  15. “Really what we want is a reliable indicator of irrational exuberance that will be the same in every bubble; but how you would find such a thing, and how you would be sure that it would work in the next bubble, is beyond me.”

    How about are people borrowing at current interest rates because they expect the asset or asset class return to be higher?

    Here is an example. Should someone borrow at a 2% to 4% teaser rate if that person expects the asset (house) to go up by 7% to 12% a year? The problem is interest rates are too low.

    Another problem with most bubbles is that the margin requirement (down payment for housing) is too low.

    The labor market also needs to be tightened up so that new “bubble” indutries are NOT depended on for full employment. When the new “bubble” industries come along, they should have to compete for workers possibly thru higher wages, which will lower the financial asset return.

    geekspeak (greenspan) will hate this, which probably means it is a good thing for the lower and middle class.

  16. You can identify bubbles, but first, you need to have a solid definition of just what a bubble is.

    Do note the chart showing the value of the S&P 500 with respect to its trailing year dividends per share. The bubble is unmistakable.

    Ref: http://politicalcalculations.blogspot.com/2008/07/defining-bubbles-order-disorder-and.html

  17. “If there is high inflation in the core CPI, you don’t stop and ask if there is a fundamental reason for higher inflation; you tighten monetary policy (raise interest rates). The Fed could do the same thing for housing prices, since housing is an asset that people need to consume. But that’s probably a simplistic view.”

    Aren’t you assuming debt levels are the problem? What if something else is the problem?

  18. Whether prices for assets are reasonable or not is a matter of opinion. And it’s hard to say whose opinion is best.

    But when people are borrowing more and more money to pay higher and higher prices for some assets. Then the danger of such debt build up is pretty obvious in an objective way. There is a limit to how much money people can borrow before they become incapable of repaying their debts. And in such a situation, it’s irrelevant whether the asset prices are too high or not. Because it’s the debt that’s important and not the prices.

    The people’s average debt to income ratio is the important measure of any bubble. And when that ratio gets too high in the economy. Then financial regulators should step in and prevent any more build up of debt leverage.

  19. Scot Griffin

    One false meme that is just as destructive as false dichotomies is the “easy money” meme.

    Just because the demand for credit was increased by “too low” interest rates did not mean that the supply of credit could or should have increased beyond reason, as it did in this bubble. The Fed and Greenspan did not make these financial institutions engage in Ponzi (i.e., fraudulent) schemes, the financial institutions did that on their own.

    I am not sure that I can agree with your conclusion that “another problem with most bubbles is that the margin requirement . . . is too low.” Which bubbles are yout talking about, and how did the margin requirement play into each of them? Is this set of bubbles really represantive? I ask this because I don’t see how the margin requirement played into the internet bubble.

    Finally, I have no idea what you are talking about in terms of tightening up the labor market. Could you please explain further? Thanks in advance.

  20. Scot Griffin

    Fed Up,

    Good questions. Did you ask them of yourself when you argued that bubbles are caused by interest rates and margin requirements being too low, both of which lead to too much debt?

    What do you think the real problem(s) might be?

  21. Scot Griffin

    The real problem is that it is irrational to assume that everybody will behave the same regardless of varying access to information and abilities to process that information. The fact that economists continue to insist that macroeconomics is really just a summation of all microeconomic decisions, all of which are made by the identical “rational” investor, is what is really irrational.

    Blaming reality for not fitting the model is a sure sign that economics ain’t a science, dismal or otherwise.

  22. Oh its really quite simple. You just find a rational person and you ask him what he thinks of everyone else.

  23. Thanks for the link James, and thanks everyone for your interesting comments.

    I agree with your comment that my proposal is, as yet, too vague to be implemented in practice. I am developing a more concrete model for this, in particular to work out how to calculate a numeric measure for investors’ implied valuations that can be compared to objective predictions of returns. In practice, a range of such measures would probably have to be used to minimise the chance of a single metric being either gamed or arbitraged away.

    Scot Griffin’s comments were especially insightful – removing the dichotomy between ‘rational’ and ‘irrational’ is absolutely a critical part of moving the discourse on behavioural economics forward. Sometimes it is convenient to use the word ‘irrational’ as a shortcut for ‘not behaving according to neoclassical rational preference axioms’ but I try not to overuse the term.

    Some interesting thoughts from Min too. Greater transparency – of the right kind – will also be a contributor to revealing and minimising the dangerous extremes of asset bubbles.

  24. What’s the problem?

    If you get unprecedented price inflation substantially above trend for some asset or class of comparable assets, you very likely have a bubble.

    Lots of people spotted the housing bubble, and the tech stock bubble. If you have been blinded by the light — like Bernanke was — then you can always ask a smart person with no vested interest as Patrick suggests above.

    The underlying problem is that neoclassical economics can’t explain how bubbles arise because these theories rest on a rudimentary & wrong theory of Human Nature.

  25. You might want to check out Dean Baker’s “Plunder and Blunder.” He has a few heuristics for spotting bubbles. There’s a two-page box on spotting stock bubbles (including some rules of thumb about P/E ratios), and one for housing bubbles (centered on the premise that home prices, on average nationwide, had not risen in real terms in a century; if we get much beyond zero appreciation, Baker says it’s a bubble).

  26. Weren’t there economists and analysts who predicted the crisis? Were they just Taleb like in predicting a crisis is going to happen every day, or did they have an inkling of evidence? They could probably shed some light on the situation.

    Also, from a survey I would argue you could predict a bubble in the case of housing by asking people do they consider themselves investors in the housing market. If they say yes you then ask them, what percentage profit do you intend to make? Then ask them what they think growth will be in their area and surrounding areas. If their profit far exceeds the expected growth they see and the data shows there is probably a bubble.

  27. I am providing a link (I hope) to a chart published in the NYTimes in 2006 showing the vertical climb in house prices over the previous 10 years. (http://graphics8.nytimes.com/images/2006/08/26/weekinreview/27leon_graph2.large.gif) If that’s not a bubble, I’d like to know what is. This has been perfectly obvious for years. There were shows on TV showing people how to buy and flip houses—slap some paint on and double your money. It took real effort even for qualified borrowers to get a conventional mortgage because the the lenders’ agents got such high commissions for generating subprime loans.

  28. In my opinion this is not the right question.
    In the last years the problem with monetary policy is that it has been too expansionary since policy-makers have not been able to make a good diagnosis of the evolution of inflation.
    In the last years there has been a supply shock thanks to the Chinese increase in production and exports, this shock made that the price of the goods produced in China or which compited with them dropped enormously taking the inflation index severy down.
    In the meantime the prices most of the domestically produced goods and specially services have been rocketing.
    What did the monetary authories? reduce interest rates, thus adding more wood to the fire of the price increases of domestically produced goods and services (all of us are aware on how have increased the prices of medical services, restaurants, repairs, hairdressers,… while many goods have become cheaper: computers, imported forniture, washing machines, cars…). Only inmigration has been able to push down a little bit the price of some of this domestically produced services.
    At the same time this policy increased the demand of imported goods, creating a shortage of the commodities necessary to produce them.
    When the Fed (and the ECB and any other single central bank) was fearing inflation in 2002 and 2003 and reducing its base rate, what was doing was inflating a bubble of domestically produced goods and services including housing. For that reason, despite the general acknowledgement that economics were fantastic at the begining of the 2000s, most workers felt that their purchasing power was going down.
    This is not a bubble of housing or financial prices, it is a bubble of most prices: especially services, commodities and domestically produced goods as houses.
    Now that bubble has to deflate and it is really a huge bubble, much bigger than the housing and credit bubble.

  29. The answer, to your headline question, is it possible to detect bubbles, is absolutely YES. Anyone with any sense knew that there was an internet bubble in the late 1990s. Greenspan made his famous “irrational exuberance” comment in 1996. And yes, everyone knew there was a housing bubble in 2006. No need to invent new metrics; all you had to do is look at home prices vs. rents or home prices vs. buyers’ incomes. Or reverse engineer Amazon’s stock price and see that it in 1999 it implied astronomical rates of growth and market share.

    However, what no one ever does know is when the bubble will burst. You didn’t know whether to short Amazon in 1998 or wait until 2004 to do it. On a personal note, I kept postponing a home purchase until after the bubble burst. But I would have made out even better if I waited longer. Again, I did not know how much housing prices would fall or how long the trend could continue.

  30. “On the one hand, it seems obvious; didn’t we all know there was a housing bubble back in 2006? On the other hand, if it’s that easy, why aren’t we all as rich as John Paulson?”

    I for one was certain there was a housing bubble in 2006 and tried to find a way to profit from it (other than delaying a home purchase, which I did). Unfortunately, I was unable to bet against housing prices because people like you have limited that investment option to people with more money than me, for my own good per your other op-ed. So, thanks for protecting from myself, I really appreciate it.

  31. “The Fed could do the same thing for housing prices, since housing is an asset that people need to consume. But that’s probably a simplistic view.”

    Not at all. Housing is a pretty simple concept, a pretty simple basic need. A perfect example of where the KISS principle should be applied. It only seems complicated when defining housing as a financial “asset”. Housing is shelter, a roof over ones head. Simple.

  32. Scot Griffin: “The problem is who gets to decide what the fundamentals are and how far the regulators can go to determine the cause of the delta. Again, not all bubbles are, in fact, bubbles, and not all real bubbles pose systemic risks. Thus not everything that is a bubble should necessarily be discouraged, particularly when discouraging a contained bubble could harm the broader economy.”

    We do not need to ask of regulators that they assess the reality of bubbles or their degree of systemic risk, at least, not to a high degree of certainty. Most markets are too volatile, and would not be harmed by negative feedback by regulatory action. Furthermore, the cost to the broader economy should be minimal, and considered as insurance.

    (One problem is that, if you look at the history of bubbles and crashes in modern economies, you see a lot of regulatory effort in last ditch attempts to forestall or minimize crashes, but not much, if anything, in attempts to forestall or minimize bubbles. So we do not have much experience to draw upon. Mistakes will be made if we attempt to do so, which we should.)

    “As an aside, you seem to assume that public companies will reveal to regulators what they won’t to their investors. The fact is they will reveal exactly to regulators what they reveal to investors, which is as little as possible for fear of tipping off competitors.”

    I was passing on a remark by Soros, who did not go into detail. As I gathered, however, the feedback he was talking about was not via communications from regulated companies, but from market action.

  33. @ Scot Griffin

    Oh, I see, you were referring to information from interviews and questionnaires. The subjects of those are investors, not companies.

  34. Dave — the link I posted above was to a paper which looks to see what the reasonable economist who predicted the crisis have in common.

    The commonality of those who got it “right” is a macroecomonic view that can track unsustainable flows of money in the economy. i.e. is debt growing larger than the ability of the real economy to support it.

    http://mpra.ub.uni-muenchen.de/15892/1/MPRA_paper_15892.pdf

  35. @ Scot Griffin

    Let’s take a garden variety fraud, which occurred thousands if not millions of times during the housing bubble:

    “For the first two years your payments are less than the rent you are paying now. Then the payments go up, but you can refinance then.” (Big smile)

    Nothing in writing, of course, and probably not enough to go to trial, even if you can prove it. We really need undercover regulatory agents.

    Scot: “It’s kind of like Balco(steroids) and ectasy (narcotic): there are these designer drugs that do exactly what the laws say banned substances do, but because they have a slightly different molecule, they are not covered by the law.

    “Maybe the answer is that the law regarding financial innovation should say that anything that is not specifically allowed is criminal and subjects the perpetrators to the same type of forfeiture penalties that drug traffickers see. Even if you understaff the regulators, you will see a drastic reduction in this kind of risky re-invention of banned practices under different guises because the perps will not be able to keep their ill-gotten gains and will rot in jail.”

    Actually, the law now does cover designer drugs. As I have suggested before, new financial instruments should be treated like designer drugs, for essentially the same reasons. ;)

  36. Green Engineer: “While I agree that developing better metrics for market misbehavior might be a very good idea, I think the bigger problem is getting regulators to use them and believe the results, even (especially) when the models raise a red flag in the middle of a huge party.”

    Yes. Greenspan admits that he was afraid of bursting the bubble. He and the Fed would be blamed for any ensuing crash. (He probably understood how he would be blamed for causing the bubble in the first place.) Few people have the fortitude of Andrew Jackson, who said that it was better to ruin 10,000 families now than 50,000 families later. It is better to nip bubbles in the bud, if possible, even if it means responding to false alarms, and even if occasionally it hinders economic growth.

  37. It’s not about detecting the bubble. They are obvious. The problem is that the greater the number of people who are making money from the bubble, the less interest there is in calling it out and/or bursting it. THAT is why the housing bubble (or, as noted above, the entire credit expansion bubble) was so destructive – so many people were profiting from it in so many ways there was no interest in changing anything. Stock and other investment bubbles, on the other hand, tend to have a larger contingent of disenfranchised, “sour grapes” folks pointing at the thing and screaming the whole time.

  38. The problem with bubbles is once a market gets a little attention paid to it, it gets more irrational, not less. Take baseball cards. When the hobby started expanding, along came the idea of the “rookie card.” The rookie card of a star player was supposed to be very valuable, because, so the theory went, collectors collected all cards of star players and the rookie card, being the oldest, would be the rarest and thus the most valuable.

    This notion is almost entirely fraudulent. It isn’n necessarily true that every 30 year old collectible is rarer than every 28 year old collectible. If you look at antique/collectible markets with less attention paid to them, the difference between 28 and 30 years is nominal at best. Yet the difference in baseball cards, a market with more attention paid to it and a massed produced collectible at that, has a huge value difference. This value difference is almost entirely due to the derived desire of purchasers of rookie cards to own rookie cards than the obstensible original reason to own the cards in the first place.

    Housing suffers from a lot of the same irrationality in different forms. The public en masse just lost sight of the fact that housing was a product and if it came into demand more could be built by suppliers. Even in desirable areas like Manhattan and San Francisco there seem to be no end of warehouses and such that can be converted into high rise condos, so any idea of scarcity of housing was irrational.

  39. Phil Sullivan

    Bubbles and irrationality. Are we assuming that a bubble forms only when irrationality abounds?

    I suppose I have to ask what does the field of economics interpret ‘irrational’ to mean?

  40. Is this method compatible with the existence of oil price shocks as predicted by Shai Agassi?

  41. This economist Dirk Bezemer rounded up the analysis of the people who DID see this coming and found the common factors in their methodology. Here’s an excerpt:

    The credit crisis and ensuing recession may be viewed as a ‘natural experiment’ in the validity of economic models. Those models that failed to foresee something this momentous may need changing in one way or another. And the change is likely to come from those models (if they exist) which did lead their users to anticipate instability. The plan of this paper, therefore, is to document such anticipations, to identify the underlying models, to compare them to models in use by official forecasters and policy makers, and to draw out the implications.

    There is an immediate link to accounting, organizations and society. Previewing the results, it will be found that ‘accounting’ (or flow-of-funds) models of the economy are the shared mindset of those analysts who worried about a credit-cum-debt crisis followed by recession, before the policy and academic establishment did. They are ‘accounting’ models in the sense that they represent households’, firms’ and governments’ balance sheets and their interrelations. If society’s wealth and debt levels reflected in balance sheets are among the determinants of its growth sustainability and its financial stability, such models are likely to timely signal threats of instability.

    Here’s the link:
    http://mpra.ub.uni-muenchen.de/15892/

  42. Spotting bubbles is a second line of defense/ regulation..
    The first or front line needs to be the Financial Products regulator. FDA exists for the purpose of preventing adverse health repercussions of a product on an individual/ society, likewise a Financial product can have adverse repercussions for a person’s financial health and if the product is not inspected properly, it can result in a social calamity like the sub-prime.. If the FPs are properly regulated, then bubbles can be nipped in the bud.. Surely, the industry will not like any regulation of FPs and even if it is created, it will not have adequate powers..
    Then the next best regulatory action can be the imposition of equity on any asset securitization.. It is agreed that the Securitization is a sort of shadow banking system, so a money multiplier principle comes to the picture.. Regulate the percentage of any financial asset that can be securitized, due to the firm’s residual equity in the loan quality will be automatically controlled.. The current regulation is specifying 5% requirement which is a good begining but this is a parameter that the regulators can use to control the flow of securitizations/ liquidity.. FDIC regulates depository banking instituions.. Is there a need for another separate regulator for shadow banking institutions?

    Forming regulation is one thing, but enforcement requires strong-willed individuals like Paul Volcker..

  43. You might be interested in the book, “Why Stock Markets Crash: Critical Events in Complex Financial Systems” by Didier Sornette, a geologist/astrophysicist at UCLA and the Sorbonne. He basically posits that markets are driven by trend followers and fundamentalists. Then argues that a combination of sinusoidal and super exponential functions would should fit the price action. His work predicted the 2000 stock crash (and several others) well, but failed to “fit” after late 2001. The most interesting part of the book talks about other crashes along the lines of “Collapse” and notes that human society has been growing super exponentially and should thus crash at some point. His model predicts a 50% chance by 2042 as I recall.

    He also touches on a wonderful of array of history, mathematics, and physics along the way. Thus it’s a fun read even if you are very skeptical of curve fitting.

  44. bayardwaterbury

    Niall Ferguson, in his four part series, The Assent of Money, really gets us to the understanding of how “bubble” economies are formed, how they work, and why they crash. Most are really a kind of cross between con and ponzi scheme, and are virtually all caused by cooperation between financial elitists and governments, just like our present depression.

    How do we know when “bubbles” are happening? For me, it is like always asking the question: “If what is happening is too good to be true in the normal world, is it real?” In the run up to the current disaster, without the continuous cheerleadership of guys like Alan Greenspan, could we have gotten there? I doubt it sincerely. But, he had had so much adulation from the media and business (and Congress and economists), that it was very unlikely to ever break the momentum that his view of unfettered capitalism sponsored.

    I think that the actual lesson to learn is that we, as human beings, need to understand that wealth for the sake of itself is always a bad idea. Only wealth which engenders other non-financial increses in human value is to be admired, desired, and respected.

  45. A fundamental challenge for econometric approaches to predictive modeling is to model the links in the causal chain between our so-called “animal spirits” and their economic outcomes. To build such a structure would require, first, finding accurate measures of the former and the latter and linking them mathematically. Then, a feedback loop would have to be incorporated into the model that captures changes to our expectations and emotions that result from economic outcomes caused by the former, pre-feedback behavior (which was driven by the original emotional state, intellectual considerations and their consequent behavior).

    This is incredibly difficult, if not impossible. Is anyone even close to this type of model? My limited acquaintance with econometric models is that they look no deeper than the national income and product accounts and the financial flows in order to “postdict” previous cycles, then, cross their fingers and hope that events repeat themselves in almost the same sequence and magnitude as before. They model events without “reaching through” those events to their underlying causes. This activity is essentially trial and error using huge arrays of variables in huge systems of equations without looking carefully at the underlying logic of the theory within which such models are constructed. Trial and error and data-fitting without a narrative that predicts connections and removes surprise in predictable ways is a necessary stage in the evolution of a scientific discipline. But, it’s symptomatic of an immature science. Will it ever be as “easy” to predict economic events as it is to predict the location of the moon at a given time relative to the location and rotation of the earth accurately enough to land a space ship on it?

    The guys who predicted this collapse reasonably accurately (or better) were lucky or “perma-bears” (LOL, I love it!). As James so aptly puts it, “what we really want is a reliable indicator of irrational exuberance that will be the same in every bubble.” Economists know how to build models, no doubt, but, they don’t have a good understanding of how to build the type of model that would achieve reliable, replicable predictive accuracy. They just don’t understand people well enough. Who does?

  46. Yes. I would go one step further and include the “rational/irrational” dichotomy among those false dichotomies to which you refer elsewhere in this blog. I nominate, as well, the “rigged/free markets” dichotomy for expulsion from our thinking.

    All people are influenced profoundly by their emotions in their decisions and acts, and all markets are rigged by their participants, by regulators or by legislators (usually by all three).

  47. Kondratieff, anyone?

  48. P.T. Barnum is ofter erroneously quoted as saying, “There is a sucker born every minute.” But the phrase works for markts. Bubbles are suckers being caught. Anytime one has to spend more then they can afford for the “new Must have” you are at the top of a bubble, or it is the new must do. To regulate them is folley unless you are going to regulate everything from Beany Babies, six sigma type Blackbelts to housing. Until people learn to buy things they want; within their means and not look at them as a make money quick venture there will always be bubbles. Regulating them would be like trying to stop the wind and is not part of a free economy.

  49. Scot Griffin

    @Brenda,

    Your post is a perfect example of why the discussion of spotting bubbles is of little value. One of the prevailing memes– and your post states it pretty much perfectly– is that the REAL problem was the American consumer living beyond his means.

    As long as we focus on bubbles, we ignore the man behind the curtain: a rotten financial sector. Just because the profligate, irrational American consumer demanded more credit did not mean that the financial sector had to supply it. Since the financial sector have the money (actually, it is mostly our money and not theirs), what right do they have to lend money that they cannot reasonably expect will be paid back?

    Perhaps the corrolary to “there is a sucker born every minute” is “there is a con man born every minute.” We can’t regulate stupidity, but we sure can regulate reckless behavior and criminalize criminal behavior, provided that we focus our attention on the real problem, which I guarantee you is not the consumer.

    It’s like blaming a child for burning down the house when it was his parent who handed him a box of matches and told him to go into another room and have fun.

  50. Yes. Even though we don’t understand how to model that, we still have to try to manage it. Remember the Wall Street adage, “Stocks are not bought. They’re sold.” This bubble isn’t about fools being taken where they were destined to go, anyway – the cleaners. This bubble is about people buying on emotion (as every sales pro knows) and supporting it with logic, as have been most financial and real estate bubbles. This applies to the professionals as well as to the “odd lotters”. The game needs rules, not because there’s some intrinsic value to having them or some moral principle that they embody, but because we’re all better off in the aggregate with them, if they’re equitable, reasonable and set limits on behavior. That’s why we have laws. Why is theft at gun point worse than theft by promises and lies?

  51. One more word. No “free economy” exits. Besides, why is a free economy a goal in itself? My response to the argument that policy leads away from a free economy is, “So what?”

  52. We are too caught up in regulating. What we need to teach is ethics.

  53. Your right no totally free economy exits. But government involvement/regulation, due to the nature of the engine, is too slow and is fighting the last war on economic problems. We would be better with less government and more education.

    To that end, everyone should have a solid concept of Supply and Demand, and limited resources; think in those terms on most decisions. If you add stealing is the only crime, then you will have an ethics class that will solve most of our problems that “need to be regulated”. As for the consumer, buyer beware has always been the rule. We also allow litigation if a product does not meet customer expectations. I am still surprised no one has not taken a bank to court over their sup prime loan, but then they would have to be determined to be incompetent to understand a contract.

  54. What’s up, is there anybody else here?
    If there’s anyone else here, let me know.
    Oh, and yes I’m a real person LOL.

    Later,