Sumner on Bubbles

Scott Sumner argues that the claim that there is a bubble in some asset must be a prediction that the price of the asset will fall, and that this sudden price decline should have a particular date.

I disagree.

I agree that the theory of bubbles must involve some notion that there is a "fundamental value" that assets should have.   And it also involves the the notion that the price of some asset is greater than some "fundamental value."   

But what makes it a bubble is not the claim that the bubble will pop, but rather a theory as to why the price is greater than that fundamental value.   The theory is that people bought the asset because they observed past price increases and foolishly projected them into the future.    A closely related theory is that there exist "greater fool" speculators who seek to take advantage of the bubble, and implicitly, the foolish investors, by buying into the bubble intending to sell to a "greater fool."

As an economist, I very much believe that assets have fundamental values.   I also believe that asset prices can reflect those fundamental values, but only because there are investors who pay attention to the time path of returns the asset will generate.

I am very skeptical of economists who claim that they have some kind of special insight into the proper prices of assets, and especially have doubts about approaches that use past asset price performance.    Thankfully, few economists are involved in "technical analysis."   The last economist I knew who told investors about how his Ph.D. in economics gave him mathematical and statistical tools allowing him to forecast asset prices (especially collectibles,) is currently in prison.

Sumner's demand that economists forecast future prices of assets sounds to me like insisting that they behave like that fraud.   An economist who insists that his great economic insight suggests that gold is a bargain, is a fraud.   The doom and gloomer who insists that it is time to sell stock now is much the same.

So, I would never get involved in doing what every one of my friends want me to do and think that my training as an economist should allow me to do.  That is, predict future turning points in the price of some asset.  

Why then, do I believe that bubbles exist?   It is because I find the market process that generates bubbles plausible.   I personally know people who believe that if the price of an asset has gone up in the past, it will be more likely to go up in the future.  

There is an entire industry of "technical analysis," which is based upon "greater fool" speculation.   As they explain, the fundamental price of an asset is what someone is willing to pay, and that all depends on psychology.

The experimental evidence, where the fundamental values are known, suggest that bubbles exist.

I think the proper role of economists regarding bubbles isn't to study them like market participants are ants or bacteria under the microscope.   It is rather to seek to educate the foolish investors and speak out against the "greater fool" exploiters.   Use fundamental analysis if you can, buy and hold a diversified portfolio if you can't.  Don't try to time the market.   Don't be a sucker.  And it is wrong to try to take advantage of suckers.

I don't support having a central bank use monetary policy to "pop" bubbles sooner rather than later.   The monetary authority should keep nominal GDP growing at a slow, steady rate.   If there is a bubble in antique furniture, the central bank should do nothing except to the degree that it impacts expected spending on currently produced goods and services.   If the prices of antique furniture collapse, the monetary authority should just keep spending on output growing at a slow, steady rate.

But I am never going to insist that there is could never be a bubble in antique furniture.   But I am not going to get involved in trying to pick the turning points in that or any other market.  That is a fool's errand.