Bubbles

Scott Sumner agrees with Eugene Fama's dismissal of bubbles.

What I found must troubling was Sumner's statement:

But unless I am mistaken, that is exactly Fama’s point. Unless your Nostradamus-like ability to spot fundamental values does give useful predictions of where asset prices are going, with at least more than a 50/50 chance of success, then the theory of bubbles you have developed is essentially worthless. It would have no utility, for investors and more importantly for regulators.

I am an economist. My role is to understand social phenomenon. I am especially interested in spontaneous orders--patterns that are the unintended consequence of individual action. The market economic system, including markets for financial assets, is an excellent example of spontaneous order. Are bubbles possible in financial markets? What might cause bubbles? What consequences might bubbles have? Does a theory of bubbles help explain historical events?

I am not a financial advisor, nor is my focus training financial advisors or investors. I am not interested in whether or not a theory of bubbles can be used to help investors make money.

Nor am I interested in developing tools for command and control regulation of markets. I don't favor command and control regulation. In particular, I don't support a policy of manipulating the quantity of money in order to keep the prices of financial assets at levels that regulators find appropriate. Nor would I favor varying taxes, margin requirements, or anything else based upon whether or not a regulator determines there is a bubble in some market.

According to Sumner, there is no point to thinking about bubbles if the result isn't a scheme for making profits for financial market speculators or else a system of command and control regulation.

What?

While I do believe a sound understanding of social phenomenon, particularly market phenomenon, allows for an informed choice between alternative institutional arrangements, I value economic understanding as an end in itself.

I believe bubbles exist. Vernon Smith's experiments provide enough evidence for me. The basic problem is "momentum" traders. They buy into a rising market and sell into a falling market. They have naive expectations, projecting past price changes into the future.

Do such people exist outside of the lab? Yes, I have met some of them personally--friends and relatives. I listened to their "advice" for years! "You need to buy a house, Bill." "It is the best investment." "Home prices never go down."

But won't "the market" offset any foolish speculative purchases by offsetting sales? While that is an important factor, there is an entire industry of financial advice based upon the "greater fool" strategy. Forget the fundamentals. Ride the trend and sell to a greater fool. It is called "technical analysis."

Of course, this process does tend to separate fools from their money. And so, in some kind of "long run," maybe it improves the operation of financial markets. But the process of separating the fools from their money could be a bubble.

Again, this is all worth knowing even if there is nothing to be done about it. However, I think there are two things that should be done about it.

First, economists should explain that momentum trading is unwise. Second, they should do more to explain how "technical analysis" is about the exploitation of "greater fools." I suppose this is more like explaining the concept of sunk costs than the consequences of price controls.

More importantly, monetary institutions should be reformed so that they can survive the bubble process without monetary disequilibrium. In my view, adjusting the federal funds rate in order to generate an expected 2 percent increase in the core CPI from where ever it happens to be now, taking into account the output gap, has failed that test.