The Myth of Bubbles
Rather than summarize Kirchner's well-researched Policy Monograph, I can best give you a feel for his conclusions by quoting it directly:"The idea of 'bubbles' in asset prices quickly breaks down as soon as one tries to give it analytical coherence or empirical substance. Most commonly, the idea of a 'bubble' is little more than a tautology or circular argument."
Kirchner looks at theories of both rational and irrational bubbles, and finds them all lacking. In the process, he subjects the works Robert Shiller to withering critique:"Shiller's earlier work Irrational Exuberance was largely built around the observation of statistical mean reversion in equity prices, with the behavioural finance component tacked on in an effort to disguise the fact that he otherwise had nothing to say about the determination of asset prices."
In the process, Kirchner effectively defends the efficient market hypothesis (EMH) from behavioral critiques:"violations of the EMH are often misinterpreted as an argument against the allocative role of markets. In this respect, the EMH is analogous to the idea of perfect competition in markets for goods and services. No one believes that any real-world market for goods and services is perfectly competitive, and violations of the assumptions of the perfectly competitive model do not lead us to reject the model's usefulness or the role of markets in setting prices."
Continuing to quote Kirchner:"The behavioural finance and experimental economics literature questions the rational choice assumptions underpinning standard models of economic and financial behaviour. This literature is notable for failing to advance a generally applicable alternative behavioural model, but even if such a model were found, it might struggle to explain the irregular occurrence of 'bubbles.' Much of this literature relies on static experimental results divorced from real-world institutional settings. The irony of the behaviouralist literature is that it has no general behavioural model. Instead, this literature now serves mainly as a laundry list of actual or potential exceptions to the efficient markets hypothesis--to be ritually recited to either dismiss the role of markets as allocators of capital or to explain away market outcomes that do not conform with the prior beliefs of the analyst."
Kirchner continues with an excellent survey of"'Bubbles' as historical myth," which he wraps up with an account of Greenspan's policies, absolving Greenspan of responsibility for both the dot.com boom and the housing boom. Withal, his monograph merits close reading. With the added benefit that Kirchner favorably quotes David Henderson's and my Cato Briefing on Greenspan's monetary policies. :-)
Coda: Another economist who has recently risen to the defense of the efficient markets hypothesis is Scott Sumner, on his blog, "The Money Illusion." He points out an internal inconsistency in some behavioral critiques:"if investors are foolish to ignore the risk of Black Swan events, why should we trust probability values in anomaly studies?" More important, he offers a fundamental explanation for the housing boom that I have not seen elsewhere:"The housing bubble in 2004-2006 was partly driven by rapid immigration from Latin America (as was the bubble in Spain itself!), and also by a perception (which turned out false) that coastal zoning constraints were spreading into interior markets. Many Hispanic immigrants were snapping up older ranch houses, allowing native born Americans to move on to bigger McMansions. The immigration crackdown in 2007 dramatically slowed this immigration (as did the worsening economy.) Population growth estimates going several years forward fell sharply, hurting housing speculators. Ground zero of the sub-prime bust is in working class areas of the Southwest and Florida. Any guess as to who bought homes in those areas?"
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mary lili jory - 8/16/2009
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Bill Woolsey - 3/31/2009
I think bubbles exist.
As far as I can tell, nothing in this paper shows that they don't.
I think this paper is mostly a set of arguments (sometimes inconsistent) that monetary authorities should not be tasked with identifying bubbles and then implementing a contractionary policy to pop them (or dampen them.) I agree with that policy position, because I think bubble popping would involve creating monetary disquilibrium. And also would oppose alternative regulatory approaches to dampening bubbles. (Say, higher capital requirements for lending into a bubble, as opposed to the extra low ones that really existed in what I see as the recent bubble in housing.)
I believe in bubbles because I personally know investors who look at past performance of asset prices and use that to forecast future asset prices. At least that is what they tell me. Something like, all my friends have been making money as stock prices (or housing prices) have been going up. I want in on it too! I am going to buy.
Further, in stock markets, there is a whole industry of technical analysis. What is rational about that?
And perhaps, I am influenced from being exposed to an advocate of technical analysis who explained it was all about guessing what everyone else will do. His approach had to do with some kind of golden ratio that is reflected in the ratio between the length and width of a standard window. When the market has gone up (looking at a chart) by the length of the window (with the previous drop being the width,) then people will sell because it "looks" like it is time for the market to go down. Profits of the firms that the shares are claims to? Discount rates? Irrelevant.
Now, perhaps all of these people have no impact on market prices. Fundamental sellers are able to sell short to keep them from bidding up prices. Or they can buy enough on margin to keep foolish selling from impacting the market.
Maybe sometimes. But maybe not.
To me, asset price bubbles are ugly in that foolish investors (who buy because the price went up in the past) are fleeced by greater fool traders. And, of course, some greater fool traders fleece other greater fool traders. The better ones fleece the worse ones.
Wealth is removed from the hands of those who don't know what they are doing.
So, I suppose there is a useful function here.
Still, if such things exist, the proper response is better education of investors. No, that the price went up in the past is actually a reason not to buy. You should have bought before the price rose. And, of course, maybe you should still buy, but that the price rose in the past is not why. It is because the price will be higher in the future.
Similarly, to the degree that technical trading is fundamentally about outguessing a greater fool, it should be subject to greater criticism. We can't all win by fooling each other.
Of course, economists already tell people to diversify and buy and hold. Unless you have good information about the fundemantals.
But instead of saying, markets are efficient, (there is no penny on the sidewalk, says the economist, someone would have already picked it up,) we need to teach people what they need to do if markets are to be efficient.
Millions of people invest. How many investors do we have in single family residences? Has market competition filtered all of them out so that we can assume they must know what they are doing?
As I see it, neoclassical equilibrium assumes that the entrepreneurs have already competed away all the profits. And then, rational expectations and the efficient market hypothese basically requires that everyone be a perfect entrepreneur.
I don't see it that way.
But that doesn't meant the political system can improve things by intervention.
Bogdan Enache - 3/31/2009
I have read the paper and I have found it very unconvincing, particularly in those sections where he makes such a big case out of the fact that basically "there are no bubbles because we don't have a model accepted by everyone which says when there's a bubble and when there's just normal market driven changes in asset prices".
It's a very poor argument, really. I don't find it any more convincing than saying that "depressions or recessions and so on basically didn't existed because of Say's law of markets". However, Keynes tehn showed that they actually can exist.
William Stepp - 3/30/2009
I just skimmed it and will read it more closely later, but he seems to focus on the housing market to the exclusion of all other asset markets.
But the housing market wasn't the only market featuring stretched (to say the least) valuations. The prices of stocks, bonds, private equity, LBO's, commodities, and art
were all too high, and they've all reverted to their means, indeed overshot them.
I also wouldn't use the word "irrational" (which I think should be banned from the social sciences) to describe a bubble, which is non conscientium, as my grandfather used to say in describing some of the stuff I got up to. Investors and entrepreneurs are rational even if they are wrong--and even if they are all bidding up the same class of assets to levels they wouldn't have dreamed of if they had read the Austrians and had had a grip on economic and financial history in their more sober moments.
And I hope he doesn't actually belive the EMT nonsense.
Btw, David Henderson wrote in the WSJ the other day that people were blaming the Fed for the housing boom in foreign countires. He didn't name anyone though, and I doubt he could. The ECB and the BoE were on the case in Europe in full central planning mode.
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