Larry Summers thinks its limited.
“In four years of reflection and rather intense involvement with this financial crisis, not a single aspect of dynamic stochastic general equilibrium has seemed worth even a passing thought,” Summers said, adding: “I think the profession is not entirely innocent.”
Still, Summers said, the complaint that economists should have seen the crisis coming represents “a confusion” on the part of critics. Identifying financial bubbles and knowing when they will burst, he claimed, “is to ask more of the profession than it can reasonably expect to discover.”
This is a common viewpoint but I am not sure that I share it.
The basic way reasoning here is that if it were possible to see bubbles then one of two things would happen.
1) Private participants will see them and act so as to deflate the bubble in real time.
2) Government agencies – the Fed ect – will see them and act to offset them, preventing a catastrophe.
The problem here is that we have had hundreds of years of market evolution under a capitalist system where bubbles can and did occur. No, solution has emerged. This is despite the fact that evolutionary systems can evolve solutions to problems that no one understands or indeed is even aware exist.
This tells me that there is at least a reasonable chance that bubbles are the result not of mistaken expectations but of some combination of market and government failure. Its not crazy to suggest that we will be able to see this.
Its an open question whether we could do anything about it.
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Friday ~ November 11th, 2011 at 11:56 am
Josh Doody
There’s a big difference between predicting/preventing bubbles & mitigating them. We should focus on mitigation, which we CAN affect. The evidence so far suggests that we (collectively) cannot accurately predict them, although it’s obvious a few individuals will accurately predict them (“The Big Short”).
But, as you say, bubbles have been happening for a long time, some worse than others. I think our reaction to them plays a significant role on their ultimate impact. We should focus on understanding how to detect and then mitigate bubbles so that their ultimate impact is minimal.
Obviously, this gets us to the point where multiple viewpoints contradict on HOW to mitigate them, and that’s why it’s so tricky to do so. That’s where economics comes in: economists can tell us what SHOULD happen if we take certain steps to mitigate the effects of a bubble. It seems that ideology may be our biggest barrier to using economics as an effective tool to mitigate the impact of theses bubbles.
Friday ~ November 11th, 2011 at 12:19 pm
Lord
When increasing levels of debt seem to make sense, it is a sure sign of apocalypse. This is the other variable the Fed should be monitoring to see if its policies are on track.
Friday ~ November 11th, 2011 at 12:35 pm
mn
Is seems there were plenty of economists that saw the crisis coming. Maybe there wasn’t a critical mass but even if there was would the policy makers and the Fed have acted? Doubtful judging from the post crash response where there seemed to be a pretty strong consensus to bail out Lehman and pass a much larger stimulus package. Even now the EU, Fed, and the Washington could do more but are afraid to take bold action.
I also think you are ignoring what the actual responses were to the warning signs and instead suggest what the responses should have been in your two “predictions” in the hypothetical reality.
1. Individuals did not act to deflate the bubble but instead took measures to shelter themselves against the eventual burst and everyone else be damned.
2. Government officials and the Fed essentially deluded themselves into believing the warnings were wrong and a response was unnecessary. After all if a response was necessary that meant the policies and ideologies that helped to create and inflate the bubble were also wrong. It was more important to maintain the image of how things are rather than change and adapt to a new image.
Friday ~ November 11th, 2011 at 3:25 pm
engineer27 (@engineer27)
“…evolutionary systems can evolve solutions to problems…”
This is true, but it seems that evolutionary systems can also create things akin to bubbles. Consider the “bigger is better” arms race that drove dinosaur evolution to the point where a drop in the available food supply spelled extinction. Or take a modern example: elk horns. At some point, those bubblicious antlers are going to become a liability, although at the moment it seems that the value of horns can only go up.
Friday ~ November 11th, 2011 at 3:47 pm
Sam
“No, solution has emerged. ”
Indeed it’s perfectly reasonable to assume that bubbles will keep happening. Most unsophisticated investors invest in something simply because it’s going up. I say unsophisticated liberally and the 2006 version of myself when I bought a bigger house thinking they’d be soon out of reach. I never took a step back and wondered how that could be possible given my household income is solidly in the top quintile and the house was about the median.
Speaking of bubbles, I’m seeing a lot of hand-waving in the “analysis” of the future of gold prices.
Friday ~ November 11th, 2011 at 4:26 pm
Matt
The problem is not recognizing the bubble, it’s exiting the bubble when there’s still a lot of money to be made by riding it.
Go tell the average homebuyer in 2003 that the value of their home will rise by double digits yearly, but will crash sometime in the next eight years with 100% probability. No matter how persuasive you are, a lot of them will buy the home anyway and take their chances they can flip it before the crash. Now do that in 2004, in 2005, in 2006…there will still be enough chance-takers to keep the bubble growing.
A lot of people made a LOT of money on the housing bubble. The problem was the millions more who were left without a chair when the music stopped. Even if everyone knows the growth is unsustainable, there are enough who think they are smart enough to get out before the bubble bursts, and that was probably a rational decision.
Friday ~ November 11th, 2011 at 4:48 pm
Johnnie Linn
Anticipating bubbles may be akin to ancitipating big solar flares. We may not be able to predict particular flares, but by building up a theory of the cycles of solar activity, we may be able to predict times when there will more flares and times when there are fewer flares. Similarly, for economics, what we need is to build up the theory of unerlying economic cycles.
Friday ~ November 11th, 2011 at 9:40 pm
Dave
This answer is on par with answers from Greenspan. Anyone who claims to speak for the entire field of economics with a definitive answer that nothing can be or could have been done is lost in their own nebula of arrogance.
Case-Shiller anyone? Get out much? Talk to somebody who was buying a home and they’ll tell you there was a bubble.
This is ‘a confusion’? Summers has a confusion all his own. Some people really need to learn how to say, “I don’t know.”
Friday ~ November 11th, 2011 at 11:11 pm
Curt Doolittle
I think we can see and measure booms. I just think we’re lying to ourselves when we say we want to stop them.
We WANT people to live beyond their equilibrial (‘natural’) value to the world market. Bubbles and credit help us do that.
If predicting bubbles meant that the class structure would become even more rigid (it would) then would you want to eliminate bubbles? Or would you simply try to allow them to pop earlier?
We can predict bubbles. Because they’re easy to predict. A bubble occurs whenever people seek to sieze opportunities in a domain in which they have no expertise. ie: when they are gambling on momentum – swarming.
You cannot necessarily deduce a bubble from the trading data as other than some vague heuristic driven by price volatility. But if you survey consumers you can deduce bubbles all the time. If members of the lower middle class, and upper proletariat are speculating then it’s a bubble. If people outside a field are rallying to create speculative gains rather than PRODUCTIVE gains, then it’s a bubble. (PRODUCTIVE meaning that they applied additional capital to the thing that they purchased, prior to reselling it.) There is always value created by speculators who identify asymmetry of information and profit from informing others of that asymmetry. There is no value created by speculators who are swarming information that they do not understand, and where capital is not applied to transform the asset they wish to resell — in effect, where speculators are distorting information in the pricing system. (Ethically, this means liquidity encourages fraud.)
If we are borrowing to create productive increases so that people can live a higher standard of living now than they could in the future if they had the ability to use current knowledge to create current production, then it’s good spending. If we are providing liquidity because of a shortage of ‘money’ (money in the broader sense) then we are helping people to create the highest level of productivity possible. If we are borrowing to to increase consumption without increasing relative production (exports) somewhere else in the economy, then we are not creating productivity and spreading it around, we are just going into debt by consuming now despite not increasing productivity — i.e. the ability to pay it back.
A bubble is a knowledge problem caused by the failure of the pricing system to convey accurate information to participants in the economy. Cheap GENERAL credit allows average consumers to swarm opportunities.
Productivity matters. The inter-temporality of consumption vs production matters. And disconnecting consumption from productivity causes booms and busts.
So, again, maybe we (you) actually want our booms and busts if it gives people the ability to consume during booms that would never be able to consume goods above their economic class otherwise?
But targeting inflation or nominal GDP is too loose a tool for accomplishing policy goals unless the country is small and relatively homogenous.
Saturday ~ November 12th, 2011 at 12:34 pm
Lord
I think you are right. We want bubbles because we have exhausted all other avenues for profit, so we produce them so the more astute can prosper at the expense of the gullible and presumably invest it more wisely though if there were wiser investments there would be no need for them. With no profit available, society becomes zero if not negative sum.
Saturday ~ November 12th, 2011 at 8:03 pm
Friedrich Brieger
very interesting and well written!
Saturday ~ November 12th, 2011 at 12:05 pm
Cahal Moran (@CahalMoran)
As far as I’m aware there were no significant bubbles under Keynesian interest rate management post-WW2 (?)
Saturday ~ November 12th, 2011 at 8:06 pm
Friedrich Brieger
There doesn’t exist such bubbles due to the gold standard. Since its abolishment, the money-printing machine is running so that poor investments could be done.
Sunday ~ November 13th, 2011 at 2:08 am
Lord
Except for Tulips, South Sea, Mississippi, real estate in the 1830s, railroads in the 1850s, etc., etc.
Sunday ~ November 13th, 2011 at 8:00 am
Friedrich Brieger
bubbles due to expectations, not due to an expansion of money supply. I assume that an expansion of money supply has increased the pobability of bubbles in the recent time.
Monday ~ November 14th, 2011 at 5:05 pm
Lord
No economy exists without credit and credit exists even under gold.
Sunday ~ November 13th, 2011 at 10:24 am
Becky Hargrove
Not so much the expansion of money as a problem but sticky markets that mean lower income needs to consume much of what gets consumed by higher income. Plus, consumption also gets pushed into the future for high service needs that are not as productive as they could be, hence the desire for more financial products than the marketplace can reasonably carry. A lot of bubbles are simply that attempt to provide for the ever escalating needs of our future consumption.