Bubble trouble: about asset booms and busts

By Lorenzo

Assets are items that produce income or retain value across time periods. Gold is a pure store-of-value asset, as it produces no income. Bonds are pure income assets, as they have no value apart from the income they produce–they are best thought of as a congealed money stream, their value being set by that money stream. Other assets–such as houses–can operate as both sources of income and stores of value. Particularly if they (or at least the land they are on) are positional goods (houses themselves being large decaying physical objects).

Asset prices can go up and can go down

Colloquially, asset bubbles are high levels of volatility in asset prices so that there are dramatic price surges and collapses. More precisely, they are major upward spikes well in excess of the long-term trends in the price of the asset which, after a time, collapse back to the long-term trend.

Because assets can generate capital gains, the expectation of rising prices can itself drive up demand. If supply is constrained, then you get demand feedbacks based on the expectations of rising prices. So prices rise because prices are expected to rise. The price becomes dependent on expectations about future prices anchored, to a significant degree, in nothing but expectations. As long as those expectations are positive, prices rise. When those expectations become negative, prices fall. The effect is dependent on not being able to reliably predict turning points, since people would not buy at a price which would lose value if turning points were predictable.

bubbleburst

So, if you can predict turning points, you cannot have bubbles. If you get rising prices significantly anchored in nothing but expectations of rising prices and are unable to predict turning points (as the relevant information does not yet exist), then you get asset booms that can become bubbles. And you cannot have bubbles in bonds, because they are pure congealed income. (“Busted bonds” are a different matter, but they are no longer congealed income, merely possible income.)

Note that the point that one cannot predict turning points has to be taken seriously. Even if prices are significantly based on expectations of rising prices, that in itself tells us nothing about when those expectations will collapse, or even if they will. The only vindication of characterising a asset price surge as a bubble is the price collapse actually occurring. As long as it has not, then the possibility of the expectations about rising prices turning out to match long term price trends remains open. Hence the asset price surge in the first place–because you cannot reliably predict turning points.

Moreover, the price of the asset will reflect current information, the current level of supply and demand. It is the “real” price. Whether or not it turns out to be above or below the long-term trend as it actually manifests is a matter for discovery.

What do you mean by ‘bubble’?

So, I do not agree that there are no such thing as asset booms and busts that can be reasonably described as bubbles; as an empirical matter of fact, they happen. But I also do not agree that they are somehow “false” prices. They are merely prices that turn out not to be sustained, which is not the same thing.

But it does rather turn on what one means by ‘bubble’.  I was prompted to write this post by this post by Scott Sumner. In the comments, Prof. Sumner makes the point that:

 No one denies that there are sharp rises and falls in asset prices. The debate is over what that means.

preview_Preview

Quite. Typically, it is really a debate over the efficient market hypothesis or, more generally, the “rationality” of markets. It is true that people and institutions can get into serious financial trouble by betting against (either their own bets or funding other people’s) any downward volatility in asset prices. A famous case in Oz history was the collapse of the 1880s land boom in Melbourne that led to the 1893 banking crisis and did a great deal to make the 1890s depression so severe in Victoria. But that prices are not sustained does not make them “unreal”, it just makes them volatile. And there is no reason to expect assets prices not to be volatile, particularly if there are restrictions on supply or inherent uncertainties (such as the effects of new technology [pdf]).

If people think that current prices are “obviously” unsustainable, there are various instruments whereby they can put their money where their mouth is.  But that is just another way of presuming foreknowledge of future asset prices; indeed, a level of foreknowledge that, if it was in any way reliable, would preclude the asset price volatility we observe.

The really unknown future

So, there are asset price bubbles but they are only reliably discernible after the fact. Claiming that something is “obviously” a bubble before the fact is another way of not taking the lack of foreknowledge, and thus asset price volatility, seriously. Which is the real problem with asset price booms and busts. And if all you are really saying is that asset prices can be volatile–well, yes, obviously.

Identifying possible scenarios is perhaps a more productive exercise than unspecified predictions of a putative price collapse at some unknown point in the future.

Perhaps the last word should go to the wise trader quoted in the acknowledgements of Carmen Reinhart & Kenneth Rogoff’s splendid This Time Is Different: Eight Centuries of Financial Folly:

A trader with an uncharacteristically long memory explained, “More money has been lost because of just four words than at the point of a gun. Those words are ‘This time is different’.” (p.xxxvii)

Asset prices go up and down because markets register the information, including expectations, people act on. The folly is in assuming that the future can be known, that this time is different. And yes, markets are the worst way of generating and collating information about the value of assets: except for all the others that have been tried from time to time. (Which does not preclude there being very live issues about the structure of particular markets.)

11 Comments

  1. Posted April 19, 2013 at 11:34 am | Permalink

    There is no reason to expect assets prices not to be volatile

    I’ve never really understood the obsession with the ‘market price’. The notion that the price the latest numpties decided to buy or sell at should be considered some sort of authority on what the ‘true’ value should be seems a little arbitrary. The fact that money exchanged hands does suggest the price is somewhat more legitimate than if those same people had merely speculated what they might buy or sell at. However to accept that price, devoid of any information about the expertise of the parties or their motivations for trading, as indicative of future prices seems more than a little foolish.

    And yes, markets are the worst way of generating and collating information about the value of assets: except for all the others that have been tried from time to time.

    Not necessarily disagreeing, but I do think this applies more to markets that are founded on rich interactions between participants rather than abstract, anonymous, price-only transactions.

  2. Mel
    Posted April 19, 2013 at 12:14 pm | Permalink

    Lorenzo:

    “And yes, markets are the worst way of generating and collating information about the value of assets: except for all the others that have been tried from time to time.”

    If that is true then what we need is massive deregulation. Why ban Ponzi schemes etc if the market is best placed to value them?

    How about that GFC thing? Have you forgotten it already?

    Neither regulation or the market are perfect but both are needed.

  3. kvd
    Posted April 19, 2013 at 1:15 pm | Permalink

    Interesting (probably off-topic) article by Paul Krugman which makes me think that anyone professing expertise in economics should probably be kept well away from the levers of the world 🙂 Sumner’s interesting post and comments refer frequently to the acronym EMH which I’m assuming stands for the ‘efficient market hypothesis’ that you mention just following. I’m happy to be corrected, but if it does, I’d ask two things:

    1) that last word, ‘hypothesis’: I take it that you would use it in the ordinary sense of a tentative explanation of some observed phenomenon or other? (I ask this because it seems to me to have achieved some sort of cult status as iron-clad ‘fact’)

    2) what is the closest IRL example you can think of which, with minimal reproduced variance over a fair timescale, supports EMH? (I ask this because I can’t myself, think of one)

  4. Posted April 19, 2013 at 4:50 pm | Permalink

    [email protected] You seem to have missed the significance of the sentence:

    (Which does not preclude there being very live issues about the structure of particular markets.)

    Markets have rules, and different rules have different consequences. I am certainly not going to rule out, for example, prudential regulation from having a useful role.

  5. Mel
    Posted April 21, 2013 at 1:09 pm | Permalink

    Lorenzo:

    “Perhaps the last word should go to the wise trader quoted in the acknowledgements of Carmen Reinhart & Kenneth Rogoff’s splendid This Time Is Different: Eight Centuries of Financial Folly”

    Turns out Reinhart and Rogoff are at best incompetent or at worst, fraudsters who tried to hide the decline, their work on debt and growth having being demolished by a bespectacled and pimpled graduate named Thomas Herndon.

    As is so often the case, Krugman smelt a rat long before the rat was trapped.

    In other economic news, the IMF does an about turn on expansionary austerity, advising Tory chancellor George Osborne to rethink his strategy.

    It’s time to heat up the popcorn and wait to see just how much damage the Tories will do to the UK economy before reality sinks in.

  6. Posted April 21, 2013 at 4:32 pm | Permalink

    [email protected] That was a different study, and it was error not fraud–otherwise they would not have simply sent the data set.

    Was never sold on expansionary austerity myself. Did smack of free lunches. That fiscal restriction could be more than compensated for by monetary expansion seems clear enough, and is a different claim.

  7. Posted April 21, 2013 at 4:42 pm | Permalink

    [email protected] On the effect of debt on growth, I suspect the answer is, as so often, “it depends”. I raised the possibility that debt levels could help growth–given certain conditions.

  8. Mel
    Posted April 21, 2013 at 5:44 pm | Permalink

    L @6:

    [email protected] That was a different study, and it was error not fraud–otherwise they would not have simply sent the data set.”

    I agree. But this raises two points- why are economists so secretive? Why did Herndon have to wait weeks and send countless requests before getting the data?

    In this day and age all research data science and otherwise should be put the the Web. This is cheap easy and effortless. I would like to see a bipartisan push for this kind of transparency.

    Secondly, this shows yet again how powerful ideology is. Note how the mistakes we make almost always favour our pet theories? Funny that.

  9. John H.
    Posted April 21, 2013 at 8:48 pm | Permalink

    In this day and age all research data science and otherwise should be put the the Web. This is cheap easy and effortless. I would like to see a bipartisan push for this kind of transparency.

    Biomedicine has been heading in that direction for years Mel. There is even a push now for pre-registering of planned trials so that the bods, and especially Big Pharma, cannot hide the data and cherry pick it. Things are improving in science generally, with many open access portals and archives.

    Was never sold on expansionary austerity myself. Did smack of free lunches. That fiscal restriction could be more than compensated for by monetary expansion seems clear enough, and is a different claim.

    Yeah but you’re sensible, you look at evidence and give it precedence of nice little charts and neat little ideas. The world is messy and you know it but sometimes I think economists are so preoccupied pushing their barrow they cannot see what is in front of them. I think economists try too hard to be scientists, not realising that science is not that good in the big wide world. In the big wide world we grope along, we make our educated guesses and then pray. It is the best we can do and we’re not that bad at it. Forget the falsification mantra, if that were strictly followed many modern medical treatments would be deemed irrational. Try something and hopefully learn something, try nothing and we learn nothing.

  10. Posted April 21, 2013 at 9:14 pm | Permalink

    [email protected] I think it was more a status thing–mere graduate student and all. And they weren’t being secretive, merely dilatory.

    I read quite a lot of economic papers, the data is pretty upfront and offers to provide full data on request are quite common.

    But as JH points out, things are getting better, partly due to the expanded possibilities of science.

    [email protected] There are swings and roundabouts with the scientific aspiration. Clarity and rigour are admirable, and useful counterweights against congenial cherry-picking.

  11. Posted April 23, 2013 at 6:09 pm | Permalink

    [email protected] The efficient market hypothesis comes in various forms. And it is easy to disprove–find some way of continually, systematically, beating the markets that is not just luck-selection. Conversely, volatility does not disprove EMH.

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  1. […] I have discussed before, we can indeed identify such a period–the various railway manias and other asset booms and […]

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