Very interesting paper out from the Chicago Fed this month on asset bubbles and their causes, consequences and policy options. I’ve had my fair share of fun with bubbles over the last decade. Although I was a little early declaring housing a bubble in 2006 I ultimately got it right. The same for silver last year when I declared it was a bubble. I got the Shanghai bubble dead right and traded it totally dead wrong. I’ve even done a little anti-bubble calling when I said the many “bond bubble” calls were wrong in 2010 (though I could still be early there as well I guess!). My experience in dealing with bubbles comes not from theorizing about them in ivory towers, but mostly in living them through some very real market experiences in which I had skin in the game and was forced to understand the underlying dynamics driving market action. So I take a bit of a different approach than some when it comes to analyzing these phenomena.
Of the three points the The Chicago Fed paper touches on, only one is all that interesting in my opinion. It doesn’t offer any earth shattering on the policy front. And we all know the consequences are usually devastating. But I find their section on causes particularly interesting. They write:
“What causes asset bubbles to form? In a seminal piece (originally published in 2003), José Scheinkman and Wei Xiong observe that asset bubbles are characterized by high trading volume and high price volatility. They develop a behavioral model of asset bubbles, assuming shortsale constraints. An asset buyer is willing to pay a price above fundamentals because, in addition to the asset, the buyer obtains an option to sell the asset to other traders who have more optimistic
beliefs about its future value. Werner De Bondt reviews Scheinkman and Xiong’s paper and offers a detailed overview of asset bubbles from the perspective of a behavioral financial economist—one who studies the effects of social, cognitive, and emotional factors on financial decisions. He challenges the idea that pure fundamentals and rationality drive financial decision-making and pricing. He argues the need to more fully incorporate behavioral aspects (like investor overconfidence) into investor decision making models.
To evaluate the role of monetary policy on the development of asset bubbles, Lawrence Christiano, Cosmin Ilut, Roberto Motto, and Massimo Rostagno construct models to simulate 18 U.S. stock market booms. They show that if inflation is low during stock market bubbles, a central bank interest rate rule that narrowly targets inflation actually destabilizes asset markets and the macroeconomy. The authors note that every stock market bubble of the past 200 years, excepting bubbles in war years, occurred during years of low inflation. Early in an economic boom, the natural rate of interest is often quite high. Most interest rate rules, however, do not include a time-varying natural rate of interest. Accordingly, if the natural rate is high and inflation is low, the central bank may set its target interest rate too low, and the bubble is further fueled. Thus, the authors argue that a central bank that follows a “hands-off” approach to asset bubbles may actually encourage a bubble in its growing phase. To reduce this problem, the authors propose including credit growth (as a proxy for the natural rate of interest) in the interest rate targeting rule to reduce volatility in asset prices and the real economy.
Viral Acharya and Hassan Naqvi examine how the banking sector may contribute to the formation of asset bubbles when there is access to abundant liquidity. Excess liquidity encourages lenders to be overaggressive and to underprice risk in hopes that proceeds from loan growth will more than offset any later losses stemming from the aggressive behavior. Thus, asset bubbles are more likely to be formed as a result of the excess liquidity. They conclude that policy should be implemented to “lean against” liquidity growth.
John Geanakoplos identifies leverage as a major cause of asset bubbles. He cites four reasons why the most recent leverage cycle in the U.S. was worse than preceding cycles. First, mortgage leverage reached levels never seen before. Second, there was an additional leverage effect because of the securitization of mortgages. These two factors reinforced one another. Third, credit default swaps (CDSs), which did not exist in previous cycles, played a major role in the recent crisis. CDSs helped those optimistic about the housing market to increase their leverage at the end of the boom. But perhaps more importantly, they provided an easier means for housing-market pessimists to leverage, and made the crash come much earlier than it would have otherwise. Finally, because leverage became so high and prices dropped so far, a much larger number of households and businesses ended up underwater than in earlier cycles.”
All good, but not enough focus on the root cause in my opinion. I work under the premise that any market is really just the summation of the decisions of its participants. To assume that the market is efficient or properly priced at all times is to assume that the people making these decisions are making efficient and well informed decisions. If you come from a heterodox economics background combined with a pretty savvy investment background then both of these ideas appear laughable. First, the majority of economists work under flawed econometric models. This is not even a debatable point in my opinion since so many economists don’t include a banking system in their models or just completely fail to understand how banking actually works. Since bank money (what Monetary Realism calls “inside money”) is by far the most important form of money we use in the economy then it is absolutely crucial that one understand how this tool of exchange is created and utilized. To misunderstand the banking system is like a baseball player misunderstanding how to use a baseball bat and swinging it upside down as a result.
Further, my experience on Wall Street leads me to believe that the people involved in these markets are highly irrational. The amount of information and knowledge necessary to make a truly informed decision is incredibly difficult to acquire. Especially in our increasingly macro world. It is no longer enough just to understand one company really well. You have to understand how the entire monetary system and its millions of moving parts work as well before you can fully understand how various things will impact asset prices. I’ve previously described markets as ” the summation of the guesses of a bunch of evolved apes sitting in front of computers who think they can predict the future.” That’s probably a bit extreme, but not far off. We humans have a tendency to give ourselves too much credit on many things. The markets are no exception. We are susceptible to irrational behavior because we are extremely biased creatures who are remarkably ill prepared to deal with the extremely fast evolution we have, in many ways, thrown ourselves into. Our brains are simply not designed to deal with the complexities involved in global markets. And the result is often times a highly irrational set of decisions.
So why do bubbles form? Because we tend towards herding behavior and other faulty irrational forms of thinking that result in a permanent and sometimes highly distorted market place. Why does this irrational thinking occur? Because we are inordinately ill-equipped to deal with the millions of variables that go into making rational market decisions. But I’ve droned on. I’ll have to detail this thinking more fully at a later date….
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.