Sunday, March 3, 2013

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.


  1. "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."

    I prefer your way of approaching things than Scott's.

    That being said, I'd add that there are stable bubbles... assets which trade at a steady premium to fundamental value for very long periods of time. I'd argue that most goods and assets have some "bubble" component. It is abnormal when this premium suddenly explodes upwards or collapses downwards. But we want to understand both stable and unstable bubbles.

  2. "Bill, I do not insist that economists try to predict asset prices. Indeed I suggest they don't, because they cannot. And they can't because markets are efficient. If markets were not efficient then asset prices would be predictable.
    For an economist to say "asset prices don't reflect fundamentals, but you can't predict them anyway," is about like saying "blue skies are pretty." It's an opinion with no practical value.

    Scott Sumner

    1. Does this imply that an NGDP futures market would be inefficient under an NGDP targeting regime? Participants would supposedly be able to accurately forecast future prices.

      Separately, I think asset prices don't always reflect fundamentals and you can predict them. A troubling question is why in many cases it may be harmful to do so (i.e. investment managers, analysts, politicians).

  3. I agree with JP's comments but have an additional thought...

    "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."

    Do you support a central bank using monetary policy to create bubbles? Bernanke and other FOMC members have repeatedly said things to the effect of "equity prices are higher than they otherwise would be." Furthermore the Fed's actions have often corresponded with declining stock prices (not necessarily NGDP). If the Fed plans to target higher stock prices to create a wealth effect, than it seems they should also have a responsibility to dampen seemingly exuberant rises in those same measures.

  4. Joshua:

    I don't think that a central bank should be trying to create bubbles. However, an increase in the supply of saving combined with an increase in the demand to hold money should result in an increase in the quantity of money, a matching increase in the supply of credit, and a decrease in the market interest rate. One impact of a decrease in the market (and natural) interest rate is an increase in the fundamental value of assets. For assets that generate a stream of revenues, the present value of that stream will be higher. There is nothing wrong with asset prices rising in this circumstance. It is part of the process that coordinates the increase in saving supply.

    But you can see that I wouldn't see that increase in asset prices as a bubble.

  5. I don't believe that just because bubbles can exist in asset markets, that index futures convertibility will lead to bubbles.

    At least, I what I count as bubbles don't seem possible when an asset price is fixed.

    On the other hand, I am pretty sure that the market in index futures would be less that perfectly efficient.