| May 23, 2009 More About Bubbles There are two reasons to buy an asset. One is to gain a stream of income that arises from the economic activity that the asset supports. The other is to profit by selling the asset when its price changes. The former is “investing,” the latter “speculating.” The two motives are distinguishable, but often both are involved in the purchase of an asset. That is, in buying an asset you typically seek a stream of income in the form of dividends or interest, but you’re also trying to buy low and sell high. This duality of motive is in some degree unavoidable. Financial markets require liquidity, the ability to quickly sell assets considered overvalued and buy ones considered undervalued. So profiting by anticipating price changes is integral to financial markets. And many would argue that that’s as it should be. You can sell an asset you think is overvalued. But the fact that you can sell it means there’s a market of individuals out there of varying perspectives who think it’s worth that price. And generally there should, according to theory, be constant pressures from supply-and-demand forces pushing prices toward “intrinsic” values. As an embodiment of the collective wisdom of multitudes of investors, markets, most economists believe, are good at setting prices. But how good are they, really? It depends on a key assumption: that investors are, on average, “rational.” Behind the supply and demand for an asset could lie rational valuations based on “fundamentals.” Or not. Price movements could be based on anything—whim, line patterns on charts, unfounded beliefs, astrology. We can’t know from the prices themselves why people believe those prices are justified. And surely, from time to time, groups of investors will get wrong ideas about assets’ proper values and bid prices in the direction in which they think they will go. Their belief is then “justified,” triggering a perverse feedback that could drive the price still further off course. What could now happen is that savvier investors, recognizing the bubble for what it is, exploit an arbitrage opportunity and bring prices back to rational levels. Or they might try to ride the bubble as it expands, inflating it still more, and calculating when to get out (leaving the innocent holding the bag). If enough parties believe there’s now something new in the nature of things—e.g., that prices in this asset category can only rise, or that risk has been controlled though financial innovation—then leverage (debt financing of asset purchases) should come into play. After all, if it’s a sure thing, why not multiply your returns through leverage? This seems, to me at least, a plausible scenario of how asset bubbles might form. I’ve tied the possibility of bubbles to the dual motives for purchasing assets—investing and speculating—with the speculative component enabling prices to stray far from “intrinsic” values. But more fundamentally what enables bubbles to form is simply the fact that people price assets. “Laboratory” experiments have found that even in the absence of speculation (i.e., in laboratory asset pricing games where participants can purchase but not resell assets) bubbles almost invariably form. Nevertheless I strongly suspect that in the real world, for bubbles to reach the pathological proportions of the most famous (and destructive) bubbles, a speculative component is necessary. So bubbles are a regular feature of capitalism. Famous ones include the “Tulipmania” in Holland, 1634-37; the South Sea Company bubble in England, 1720; the Mississippi Company bubble of 1720; the “Railway Mania” in the U.S. in the 1840s; the U.S. stock market bubble of 1928-29, the “Nifty Fifty” bubble in U.S. stocks in the late 1960s and early 1970s; the Japanese stock market and real estate bubble of the 1980s; the U.S. tech bubble of 1995-2001; the U.S. housing bubble of 1998-2006; and property bubbles in recent years in such places as the U.K., Ireland, Spain, and Romania. The common feature of all bubbles is that people buy an asset because they expect its price to keep rising. Which brings us back to the question: why did economists miss the housing bubble? (And why, especially, did the Fed miss it?) As I noted in this space last week, one factor was the scientific pretensions of the discipline, which led economists to favor a single, seemingly more accurate, formula (the user cost formula) over conventional indicators of bubbles. Here are three more: 1. An Ideological Predilection to Believe Markets are Efficient This is the underlying reason economists failed to see a bubble, all other reasons being subsidiary. If markets are efficient, there can be no bubbles. People will value assets rationally, using all available information to make buying and selling decisions. Asset prices will then be anchored to fundamentals. Of course, efficiency is a matter of degree, and no economist believes markets are always perfectly efficient. But most economists simply doubt that irrational price movements will go very far before the disciplining hand of the market intervenes to bring prices back to justified levels. This view was expressed by then Federal Reserve Board Governor Ben Bernanke in a 2002 speech in which he argued against the idea of a “bubble-popping” Fed: [P]rices of equities and other assets are set in competitive financial markets, which for all their undeniable foibles are generally highly sophisticated and efficient. Thus, to declare that a bubble exists, the Fed must not only be able to accurately estimate the unobservable fundamentals underlying equity valuations, it must have confidence that it can do so better than the financial professionals whose collective information is reflected in asset-market prices. Bernanke’s argument is that markets have greater insight into the “unobservable fundamentals” than the Fed has; therefore the Fed shouldn’t diagnose bubbles that market participants don’t themselves see. But there’s a problem. We know from history (and from the tech bubble not a couple years before Bernanke’s speech) that bubbles occur. And we know that most participants in bubbles don’t view themselves as being in a bubble. Can a methodological assumption (that economic agents are rational) that rules out a certain phenomenon entail that the phenomenon doesn’t occur? No. But it can blind one to it. A bubble means people buy an asset because they expect its price to keep rising. To determine whether a housing bubble exists—to observe the “unobservable fundamentals”—therefore, we need to get into the heads of homebuyers. One way is through “external” indicators like price-to-rent and price-to-income ratios, which should suggest whether prices are off course. Another would be through “internal” indicators like a survey of homebuyer sentiment. That way, however, was blocked during the bubble years by the prevalent methodological assumption of rational expectations. Which isn’t to say surveys of homebuyer sentiment weren’t performed, only they were performed by economists somewhat out of the mainstream. The only serious survey of homebuyer opinion during this period appears to have been Karl Case’s and Robert Shiller’s survey for their 2003 Brookings paper. Their findings were not encouraging for the efficient market hypothesis: Many of the answers [about interest rates, a dominant theme in people’s responses] to these questions are disappointing. Typically the answers read like random draws from the business section of the newspaper, or else the respondents refer to casual observations that one might make just driving around town. Respondents presented no quantitative evidence and made no reference to professional forecasts. One should not be surprised at this, however. After all, the single-family home market is a market of amateurs, generally with no economic training. Once more we see evidence that in neither period [including in 1988 when the authors conducted a similar survey] did many homebuyers perceive themselves to be in a housing bubble. References to market psychology were quite rare. The most shocking finding from the survey was that the average expected annual rate of home price increase over the next ten years (survey conducted in 2003) among recent homebuyers was 13 to 15 percent. That is, respondents on average expected house prices to rise by between 13 and 15 percent each year over the next ten years. Increases like this were common in the bubble years, but the average annual rate of home price increase from 1987 to 2008 (which includes the bubble years) was about 4.7 percent. And in non-bubble years the rate has pretty closely tracked inflation, which since 1914 has averaged 3.41 percent per year. If the survey respondents understood the question they were being asked, then their perceptions of reality are seriously out of whack. If they didn’t understand the question, then their knowledge of basic economic concepts is seriously out of whack. Either way, it’s hard to reconcile the portrait of the homebuyer that emerges from this survey with that of the rational economic agent most macroeconomic models assume. The latter assumption, of course, is the lynchpin of the view that markets are efficient. Overall, Case and Shiller found from their survey “that elements of a speculative bubble in single-family home prices—the strong investment motive, the high expectations of future price increases, and the strong influence of word-of-mouth discussion—exist in some cities.” Additionally they found, from an econometric analysis of factors that may have caused the run-up in house prices, that while “income alone explains patterns of home price changes since 1985 in all but eight states,…we cannot reject the hypothesis that a bubble exists [in the other eight states].” Though Case and Shiller state their results cautiously, their conclusion, from two sorts of evidence (their homebuyer survey and their econometric analysis), is clear: there may well be a housing bubble. 2. Obliviousness of Popular Culture Another source of information about homebuyer sentiment, albeit not scientific, is the popular media. Case and Shiller found, from a Lexis-Nexis search of newspaper and wire service articles, that use of the term “housing bubble” increased dramatically beginning in 2002. Another indicator: from 2002 to 2005 The Economist magazine ran a series of articles with titles like “Castles in Hot Air,” “House of Cards,” “Bubble Trouble,” “Betting the House,” “Going Through the Roof,” “Still Want to Buy?”, “Will the Walls Come Falling Down?”, “In Come the Waves,” “After the Fall,” and “Hear that Hissing Sound?” By 2005 there were many on-the-ground media accounts of people clearly engaged in what could be called “bubble behavior.” A March 2005 New York Times article began: Real estate-crazed Americans have started behaving in ways that eerily recall the stock market obsession of the late 1990's. In Naples, Fla., some houses have been bought twice in a single day, an early-21st-century version of day trading. Buying stocks on margin has morphed into buying homes with no money down. The over-the-top parties of Internet start-ups have been replaced by flashy gatherings where developers pitch condos to eager buyers. Five years ago, the cable channel CNBC sometimes seemed like a backdrop to daily American life. Its cheery analysis of the stock market played in offices, in barbershops, even in some bars. Today, ‘Dude Room,’ ‘Toolbelt Diva’ and other home-improvement shows are the addictive fare that CNBC's exuberant stock shows once were. ’It just seems like everyone is doing it,’ Laurie Romano, a 26-year-old self-described real estate investor, said with a giggle as she explained why she was attending an open house this month for the Nexus, a 56-unit building going up in Brooklyn's chic Dumbo neighborhood. She and her fiancé, a dentist, had already put down a deposit on a Manhattan condo earlier in the week and had come to look at another at the Nexus. (“Trading Places: Real Estate Instead of Dot-Coms,” Motoko Rich and David Leonhardt, New York Times, 3/25/05) A Los Angeles Times story of the same week tells of Chris Boome, an insurance agent in Burlingame, California who, at 58, “knows he hasn’t saved enough to retire,” and so “a few weeks ago…sold most of the mutual fund shares and used the cash to buy an $83,500 chunk of land in the Nevada hills, a stretch of ground he had seen only in a photograph…. ‘This is more exciting than a mutual fund,’ Boome said. ‘It feels safer too. You buy a piece of dirt, you feel you’ll always have a piece of dirt’.” The article continues: The astounding rise in home values is enticing many middle-class Californians to bet on dirt, gambling their retirements that they can do better with property than with any other investment. In the same way that the stock market’s apparently limitless ascent in the late 1990s seduced investors into buying shares in untested dot-coms, relentlessly rising house and land prices are spurring people to do things that used to be considered unusual – if not irresponsible…. They’re cashing in retirement funds, selling stock and taking out second mortgages. They’re pouring the money into real estate, often in distant states, often without seeing the property.” (“Putting Stock in Property,” David Streitfeld, Los Angeles Times 3/27/05) (And there is a lot more of this. See also “What Happens if it Bursts?” Marek Fuchs, New York Times, 3/27/05. And note this sampling is all from one week in March of 2005.) This is not to say that journalism is science, but it can capture cultural trends that economists and others who should care about the potentially destructive effects of price distortions might heed. Further along these lines, the role of cable television in pushing prices off course—of CNBC and programs like “Flip This House”—should be examined. One can reasonably ask: If such programs exist, isn’t there a bubble? For they are megaphones that blare to the entire country messages like “House prices can only rise; invest now,” or “Tech stocks can only rise; invest now.” Obviously some portion of the American public will take these messages seriously. The development of such media enable these virulent memes to be transmitted nationally, making the intrinsically local phenomenon of a housing bubble a national one. 3. Obliviousness of the Subprime Phenomenon In literature of the bubble years that considered the possibility of a housing bubble—even that that found a bubble likely—the word “subprime” almost never appeared. Within the Fed, one Federal Reserve governor, Edward Gramlich, repeatedly raised concerns about subprime lending practices, but was consistently rebuffed by Fed chair Alan Greenspan. But otherwise few voices anywhere noted the problem—wherein lies the general failure of economists to predict the crisis. For even if one knew about the housing bubble, unless one also knew about the absurd products being pedaled by the subprime lending industry (option ARMs, stated-income loans, piggy-back loans, for example), and the role of securitization in financing them, one would not have been able to connect the housing bubble to the credit crisis, let alone the near collapse of the economy.* On the other hand, had economists known about subprime lending practices and about the nature of the financing of subprime loans, then predicting the credit crisis would have been like putting two and two together. So why were most economists oblivious of the subprime problems? One must suspect their credo: the view that markets are efficient—which fostered an overconfidence in markets and in market participants and a predisposition to regard all capitalistic competition (including that that engendered option ARMs, alt-A loans, mortgage-backed securities, and credit default swaps) as healthy. Of course, this trusting attitude blinded economists not just to problems in the subprime market, but to the housing bubble generally, awareness of which was a prerequisite for predicting the general crisis. In short, signs of a bubble were everywhere. The failure of most economists to see them surely ranks as one of the worst-ever performances by a body of experts. It suggests that a reconsideration of the foundations of economics is in order. *For the record, I knew about the housing bubble, thanks to Dean Baker and Paul Krugman, but not about the impending brush with Great Depression 2. |
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