Friday, April 18, 2014
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Bubbles without Markets

NEW HAVEN - A speculative bubble is a social epidemic whose contagion is mediated by price movements. News of price increase enriches the early investors, creating word-of-mouth stories about their successes, which stir envy and interest. The excitement then lures more and more people into the market, which causes prices to increase further, attracting yet more people and fueling “new era” stories, and so on, in successive feedback loops as the bubble grows. After the bubble bursts, the same contagion fuels a precipitous collapse, as falling prices cause more and more people to exit the market, and to magnify negative stories about the economy.

But, before we conclude that we should now, after the crisis, pursue policies to rein in the markets, we need to consider the alternative. In fact, speculative bubbles are just one example of social epidemics, which can be even worse in the absence of financial markets. In a speculative bubble, the contagion is amplified by people’s reaction to price movements, but social epidemics do not need markets or prices to get public attention and spread quickly.

Some examples of social epidemics unsupported by any speculative markets can be found in Charles MacKay’s 1841 best seller Memoirs of Extraordinary Popular Delusions and the Madness of Crowds.The book made some historical bubbles famous: the Mississippi bubble 1719-20, the South Sea Company Bubble 1711-20, and the tulip mania of the 1630’s. But the book contained other, non-market, examples as well.

MacKay gave examples, over the centuries, of social epidemics involving belief in alchemists, prophets of Judgment Day, fortune tellers, astrologers, physicians employing magnets, witch hunters, and crusaders. Some of these epidemics had profound economic consequences. The Crusades from the eleventh to the thirteenth century, for example, brought forth what MacKay described as “epidemic frenzy” among would-be crusaders in Europe, accompanied by delusions that God would send armies of saints to fight alongside them. Between one and three million people died in the Crusades.

There was no way, of course, for anyone either to invest in or to bet against the success of any of the activities promoted by the social epidemics – no professional opinion or outlet for analysts’ reports on these activities. So there was nothing to stop these social epidemics from attaining ridiculous proportions.

MacKay’s examples may seem a bit remote to us now. Some examples that we might relate to better can be found in the communist, centrally planned economies of much of the twentieth century, which also had no speculative markets. To be sure, events in these economies might seem attributable simply to their leaders’ commands. But social contagions took hold in these countries even more powerfully than they have in our “bubble” economies.

China’s Great Leap Forward in 1958-61 was a market-less investment bubble. The plan involved both agricultural collectivization and aggressive promotion of industry. There were no market prices, no published profit-and-loss statements, and no independent analyses. At first, there was a lot of uninformed enthusiasm for the new plan. Steel production was promoted by primitive backyard furnaces that industry analysts would consider laughable, but people who understood that had no influence in China then. Of course, there was no way to short the Great Leap Forward. The result was that agricultural labor and resources were rapidly diverted to industry, resulting in a famine that killed tens of millions.

The Great Leap Forward had aspects of a Ponzi scheme, an investment fraud which attempts to draw in successive rounds of investors through word-of-mouth tales of outsize returns. Ponzi schemes have managed to produce great profits for their promoters, at least for a while, by encouraging a social contagion of enthusiasm. Mao Zedong, on visiting and talking to experts at a modern steel plant in Manchuria, is reported to have lost confidence that the backyard furnaces were a good idea after all, but feared the effects of a loss of momentum. He appears to have been worried, like the manager of a Ponzi scheme, that any hint of doubt could cause the whole movement to crash. The Great Leap Forward, and the Cultural Revolution that followed it, was a calculated effort to create a social contagion of ideas.

Some might object that these events were not really social epidemics like speculative bubbles, because a totalitarian government ordered them, and the resulting deaths reflect government mismanagement more than investment error. Still, they do have aspects of bubbles: collectivization was indeed a plan for prosperity with a contagion of popular excitement, however misguided it looks in retrospect.

The recent and ongoing world financial crisis pales in comparison with these events. And it is important to appreciate why. Modern economies have free markets, along with business analysts with their recommendations, ratings agencies with their classifications of securities, and accountants with their balance sheets and income statements. And then, too, there are auditors, lawyers and regulators.

All of these groups have their respective professional associations, which hold regular meetings and establish certification standards that keep the information up-to-date and the practitioners ethical in their work. The full development of these institutions renders really serious economic catastrophes – the kind that dwarf the 2008 crisis – virtually impossible.

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  1. CommentedFred Nicol

    Human beings (on average) speculate. Several psychological experiments have shown this, perhaps economists need more experiments to be conducted before they finally accept this obvious truth. Speculation leads to bubbles and bubbles crash - that's part of nature.

    The universe is not set up to be stable, nor is this earth. Nature is constantly sorting and also constantly changing the rules that govern who survives and who fails.

    In the 19th century when the financial system was composed of more independent actors it was more robust. Crashes were more numerous, but the ability of the system to absorb the shocks was quite high.

    In pursuit of dynamic equilibrium and perpetual prosperity we have created a highly interconnected system that is anything but robust. Within the context of that system a gigantic speculative bubble has been created and now threatens to break.

    Just as honeybees cannot live outside a hive, none of the interconnected economies can survive without the whole. Knowledge of that fact is what is keeping the "system" on life support even though it has ceased to function. Capital formation, the generation of surpluses that can be loaned out, is breaking down as few real surpluses are being generated and neither borrowers nor lenders are willing to bear the obvious risks for the paltry rewards available.

    I suppose it is conceivable that some new system may be contrived, but I cannot conceive of an entity that will take the place of the US as enforcer (the UN is a naked emperor).

    As a New Yorker cartoon put it years ago, "War is nature's way." Interesting times are on the way.

  2. CommentedLiz Rosell

    "Ponzi scheme, an investment fraud which attempts to draw in successive rounds of investors through word-of-mouth tales of outsize returns. Ponzi schemes have managed to produce great profits for their promoters, at least for a while, by encouraging a social contagion of enthusiasm. Mao Zedong ... Worried, like the manager of a Ponzi scheme, that any hint of doubt could cause the whole movement to crash."

    Makes the 2008 financial crisis sound like a Ponzi scheme:

    The banks who had developed and agressively promoted mortgage securitization we're afraid that any hint of doubt would cause the whole movement to crash.... And so kept pushing the stories that inflated Tge bubble to worse heights..

    Interesting points...

  3. Commentedjames durante

    This is wonderful, truly hilarious and entertaining stuff. ALWAYS look for the plural pronouns in any analysis concerning politics/economics (economics being a subset of politics). See Dr. Shiller write about "early investors," "more people" and "more people" lured into the market. "More people" exiting the market. See Dr. Shiller write about a "social contagion" which actually is only a contagion among a very small segment of the society. Well Dr., I am a lowly wage slave, one of the vast majority who does not invest or own or speculate or manage. I am not in private equities or bonds or hedge funds or derivatives. I don't know anyone who is.

    Here, let's try this: "a bunch of wacked out investment bankers and hedge fund managers and other assorted pigs figured out a way to make insane profits by farming out ludicrously complex mortgage backed securities. It was all backed up by their friends in the fed and on the relevant congressional committees and in the treasury department. These pigs figured out that, when the music stopped, they'd be sitting in all the golden thrones, and the idiots in pension funds and overpriced houses and everybody that actually makes something or provides a real service would be left standing to clean up."

    What happens when the whole shit house goes up in flames?

  4. CommentedJohn Wiederspan

    "Bubbles" will occur because of an obvious flaw in Classical market economics. Most people, in fact no one, has perfect information upon which to base financial decisions. Also, both buyers and sellers can be, for the lack of a better term, stupid. They willingly ignore danger, using whatever justification necessary to validate their action. Governments can help alleviate some destructive actions; governments, for political gain, can increase risk (government insured anything). In a relatively free market, there will always be sheep and someone ready to shear them. In spite of, or because of, government actions.

  5. CommentedKapil Khetan

    Dr Shiller has drunk the kool-aid. thinking regulations will and has alleviated bubbles. the 2007 debacle was the doing of regulators who convened in Basel. They said there is no capital charge for sovereign debt and very very little for AAA. So no surprise. The markets generated tons of paper that met the criteria. the banks got leverage. great ROI. the public went along for the ride. until the music stopped. our regulators are filled with too many academicians and lawyers. we need traders, portfolio managers to regulate. people who have some understanding of profit and loss

  6. CommentedGraham Hodgson

    The overriding distinction between speculative bubbles and social epidemics is that social epidemics involve people getting up off their backsides and doing something themselves: committing their attention, their efforts and their enthusiasm into trying to bring about the social change envisaged. Speculative bubbles are the exact opposite: they are mass attempts to grab the achievements of others without making any immediate personal commitment, just a willingness to take on debt. And it's only that willingness plus the ability of the banking system to finance unlimited debt, given willing borrowers, that allows speculative bubbles to develop. Certainly there is an element of tacit approval by governments due to the misguided view that rising asset prices make people feel richer and therefore more inclined to consume and are therefore a Good Thing for the economy, but it's bank-issued debt that supplies the gas to blow them up.

  7. CommentedJules Pierre

    Dear Pr. Shiller,
    You are playing on words and setting up a deception. I totally agree that bubbles are caused in the first place by subjective individual behaviour, not markets. However, your main point is to show how good the markets are, and that they don't really need to be reined further. Well, I am sorry, your demonstration is critically flawed ; you are using some classic rhetoric tricks to distract your reader's attention.

    First, showing that the current system is better than terrible ones (like communism) does not implies that it is good. Incidentally, it is not, the current crisis is only once appearance of this.

    Second, nobody wants to discard the markets, though this is what you suggest in your title and points of comparison. You write yourself : «All of these groups have their respective professional associations, which hold regular meetings and establish certification standards that keep the information up-to-date and the practitioners ethical in their work. The full development of these institutions renders (...) catastrophes (...) impossible.» That's exactly it. Professional associations, standards, information, ethics. There are problems with all them, for which solutions can be found. The current system needs reform.

    Finally, focussing on «economic catastrophes of the kind that dwarf the 2008 crisis» is an explicit attempt to minimize the crisis. Same rhetoric trick as before ; that it is less serious does not mean it is not serious. You are pleeing for buisness as usual.

    The markets have to be questioned and reformed.


    1. CommentedMark Pitts

      Mr. Pierre totally ignores the fact that government regulation produces its own problems, and often makes things worse.

      For example, the biggest casualty to taxpayers in the recent financial crisis was by far Freddie Mac and Fannie Mae - despite the fact that these entities were directly regulated by Congress.

      What evidence then, does Mr. Pierre have for believing that government regulation will make things better rather than worse?

    2. CommentedSteven Cox

      Jules...unfortunately, the one market that needs intense scrutiny, banking, was the market most opened up under Clinton. People argue for market regulation as if it is one monolithic market. The 'market' is made up of 100s of markets. Some need regulation, some don't. In one California city they are encouraging development downtown, then throw on 100s of rules on what can be built here, and what must be built there, etc. Some retail blocks will allow shoe repairs, and others won't. That is an actual example! They don't seem to realize with each rule they put on there is a greater and greater chance of someone not going ahead and building something. This city requires 2.5 parking stalls per condo. There are lots of good sites that could be redeveloped easily, but because of their shape one can't fit 2.5 parking spots per on them for the amount of condos they are zoned for. Guess what? They won't get redeveloped. And, why not let the market decide on how many parking spots are needed. If I put too few parking spots on the site, they won't sell. A parking spot can cost $30,000+, so going in the cost of a condo is $75,000 just to cover the parking, add in land and construction. Any starter stuff? Nope. Any small stuff being built? Nope. Any rentals? Not a chance! About $400 per month of your rent goes to paying off the portion of the mortgage pertaining to the parking structure, plus add in another $60 per month to cover property taxes on the value of the parking structure. If you want to build a small suite, say a 700 sf small two bedroom, something that works for a single Mom, you haven't got a hope. Close to $500 pm of rent goes to parking. This is one example of a market crying out for something that regulation foils. There is too much regulation. But don't deregulate banks!!

  8. CommentedChee-Heong Quah

    Whilst I agree that financial market is not the main culprit behind all the bubbles, I find it hard to swallow to compare wars and totalitarian commands with real estate bubbles.

    They are very different things, so to speak.

    Yes, Ponzi scheme resembles a bubble and that does not necessarily involve the capital markets.

    But, entering wars such as Crusade and the worship of communist leaders are closer to a religious belief than to a bubble epidemic.

    Incidentally, I do believe that the root cause of the crisis lies with the Fed, the greatest money counterfeiter of all time. Without discretionary monetary powers by the Fed, the private economy would not have been thrown into waves of crises and instabilities.

    For more, please read papers from Milton Friedman, Cato, Mises Institute, Hoover Institution, and the like.

    Quah, Chee Heong

  9. CommentedMelanie holzman

    I think that the negative impact of "bubbles" such as the and housing bubble -- have escalated by the increasing amount of media the average individual experiences every day. The people I knew who were the ultimate victims of a frenzy, simply got to a point, too late, to resist the dream of easy payoffs. For, it was generally a long position; the loss was unleveraged. For housing, leveraged. The learning lesson, softened and pushed into the future by politicians. I agree with Dr. Robert Shilling, on policies. Perhaps we only need a warning label on the media: do not believe everything you read/hear/see. If it seems too good to be true, it's too good to be true.

    1. CommentedSteven Cox

      Ultimate victims?? Perhaps a bit overly dramatic. You invest; sometimes you win, sometimes you lose. No one is a victim here, unless one is talking about an out and out scam.

  10. CommentedZsolt Hermann

    I agree with the author that the bubbles have nothing to do with markets, financial institutions, politicians, and so on.
    They are all simply symptoms.
    They are all symptoms of our inherent human nature that is driven by the powerful human ego tricking the "humanoid animal" into disconnecting itself from its previous natural environment, to start chasing a dream, that exponential constant quantitative growth, excessive overproduction and over consumption is possible in a closed finite system, that we can satisfy our insatiable desire for fulfilment with larger, better, more complicated, many times more twisted or dangerous material, corporeal pleasures.
    It seemed to work for a while but now the magic has run out, the dream is over and we find ourselves in a dead end.
    In truth we are still the same "humanoid animal" living in a vast natural system governed by unbreakable laws, and we find today that we cannot cheat those laws any longer.
    It is not only the natural forces disasters we have no answer for, even the human institutions we ourselves built are slipping through our fingers and we have no idea how to make the work again.
    The only difference between an animal and a human is that while an animal lives within the conditions of the natural system instinctively, automatically, a human has to do the same with full awareness, overruling its inherent selfish, greedy nature to become a harmonious part of the system it belongs.

  11. CommentedMarc Laventurier

    Wouldn't want to pop anyone's cartoonish free-market thought bubble, but look carefully at the process by which professional and partisan interests have insinuated themselves into the pageant of high ideals that is the U.S. congress. Professional economists (yes, Virginia, even academics) are selected for their 'caste' of mind, resulting in much market optimism and jingoism sprayed across the lurid electronic pages of the funny paper known as CNBC. POW! BAM! Take that you dirty socialist rat! America is in a bullshit bubble, obese, ignorant and broke, having succumbed to the longest running Ponzi scheme, the promise of impossible social benefits, pulling consumption and therefore profits forward. Half the eight highest sovereign credit-rated nations are Scandinavian, but of course they are murderous, inhuman tyrannies.

  12. CommentedProcyon Mukherjee

    A brilliant article that raises the point that bubbles do exist where markets are not efficient as well, which brings us to the realization that there is only one way that one could eliminate possibility of a bubble to propagate into a catastrophic event, through building of institutions that are intertwined in a manner that their individual objectives and goals are designed and aligned to deliver a higher common good, stopping bubbles for example in this case. But is that actually possible to create when we have seen how very efficient market operators have behaved in concert with the regulatory bodies to create expectations that were just always higher than what they created value for and when conditions became worse, the expectations were downgraded to orchestrate a collapse equivalent to the contagion in the upswing. The back-stop to this problem is not so obvious in the incentives provided by the institutions designed for restitution and neither are they governed by rules and covenants that make them efficient and responsible or accountable. The free market principles, while providing conditions of efficiency, do not apply in the areas that govern and regulate these principles.

    Procyon Mukherjee

    1. CommentedSteven Cox

      Dan Star....without regulations there would never be anything approaching free markets. Cartels would form, instantly preventing them. Also, having participated in 'free markets', I can tell you, they aren't fun. For one very important reason. Most people are not self-motivated to be good. It is true, in the long run they lose. But, in the short run they do a lot of damage. Go to a country where there is economic anarchy, no orderly regulation. You constantly deal with thieves, and the bureaucracy usually requires a little greasing.

      Libertarianism is like socialism. It works great in theory. But, it is a disaster in practice.

      Order requires, order. Just the regulations should be a light touch, rather than the heavy handed stuff happening now. And, a lot of stuff requires very little regulation. Most planning departments in various cities can be cut by 3/4. Lay out the rules, and let people build according to the rules. Here is the building envelope, build within it. Why does someone have to spend 4 months getting a building permit for a project which fits within the guidelines? Why not just build it?

    2. CommentedJules Pierre

      @Dan Star
      This is short-sighted dogmatism. I'm still waiting for evidence that «All Bubbles have the encouragement of the government in some form» and I'm sure counter examples can be found easily. Likewise I would like to know how you arrive to the idea that once regulators have been eliminated, «competitors can always jump in with better price/quality». You don't have the first piece of evidence for what you're saying.

    3. CommentedDan Star

      All Bubbles have the encouragement of the government in some form. Absent government encouragement it is rare or impossible for true Bubbles to form. Free Market Theory does not allow monopolies to form since competitors can always jump in with better price/quality. If we view Bubbles as a form of monopoly on investing, then we can see Free Markets offer hope in this area too as individual investors express individual sovereignty.