Sunday, November 23, 2014

Bubbles Forever

NEW HAVEN – You might think that we have been living in a post-bubble world since the collapse in 2006 of the biggest-ever worldwide real-estate bubble and the end of a major worldwide stock-market bubble the following year. But talk of bubbles keeps reappearing – new or continuing housing bubbles in many countries, a new global stock-market bubble, a long-term bond-market bubble in the United States and other countries, an oil-price bubble, a gold bubble, and so on.

Nevertheless, I was not expecting a bubble story when I visited Colombia last month. But, once again, people there told me about an ongoing real-estate bubble, and my driver showed me around the seaside resort town of Cartagena, pointing out, with a tone of amazement, several homes that had recently sold for millions of dollars.

The Banco de la República, Colombia’s central bank, maintains a home price index for three main cities – Bogotá, Medellín, and Cali. The index has risen 69% in real (inflation-adjusted) terms since 2004, with most of the increase coming after 2007. That rate of price growth recalls the US experience, with the S&P/Case-Shiller Ten-City Home Price Index for the US rising 131% in real terms from its bottom in 1997 to its peak in 2006.

This raises the question: just what is a speculative bubble? The Oxford English Dictionary defines a bubble as “anything fragile, unsubstantial, empty, or worthless; a deceptive show. From 17th c. onwards often applied to delusive commercial or financial schemes.” The problem is that words like “show” and “scheme” suggest a deliberate creation, rather than a widespread social phenomenon that is not directed by any impresario.

Maybe the word bubble is used too carelessly.

Eugene Fama certainly thinks so. Fama, the most important proponent of the “efficient markets hypothesis,” denies that bubbles exist. As he put it in a 2010 interview with John Cassidy for The New Yorker, “I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.”

In the second edition of my book Irrational Exuberance, I tried to give a better definition of a bubble. A “speculative bubble,” I wrote then, is “a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increase.” This attracts “a larger and larger class of investors, who, despite doubts about the real value of the investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.”

That seems to be the core of the meaning of the word as it is most consistently used. Implicit in this definition is a suggestion about why it is so difficult for “smart money” to profit by betting against bubbles: the psychological contagion promotes a mindset that justifies the price increases, so that participation in the bubble might be called almost rational. But it is not rational.

The story in every country is different, reflecting its own news, which does not always jibe with news in other countries. For example, the current story in Colombia appears to be that the country’s government, now under the well-regarded management of President Juan Manuel Santos, has brought down inflation and interest rates to developed-country levels, while all but eliminating the threat posed by the FARC rebels, thereby injecting new vitality into the Colombian economy. That is a good enough story to drive a housing bubble.

Because bubbles are essentially social-psychological phenomena, they are, by their very nature, difficult to control. Regulatory action since the financial crisis might diminish bubbles in the future. But public fear of bubbles may also enhance psychological contagion, fueling even more self-fulfilling prophecies.

One problem with the word bubble is that it creates a mental picture of an expanding soap bubble, which is destined to pop suddenly and irrevocably. But speculative bubbles are not so easily ended; indeed, they may deflate somewhat, as the story changes, and then reflate.

It would seem more accurate to refer to these episodes as speculative epidemics. We know from influenza that a new epidemic can suddenly appear just as an older one is fading, if a new form of the virus appears, or if some environmental factor increases the contagion rate. Similarly, a new speculative bubble can appear anywhere if a new story about the economy appears, and if it has enough narrative strength to spark a new contagion of investor thinking.

This is what happened in the bull market of the 1920’s in the US, with the peak in 1929. We have distorted that history by thinking of bubbles as a period of dramatic price growth, followed by a sudden turning point and a major and definitive crash. In fact, a major boom in real stock prices in the US after “Black Tuesday” brought them halfway back to 1929 levels by 1930. This was followed by a second crash, another boom from 1932 to 1937, and a third crash.

Speculative bubbles do not end like a short story, novel, or play. There is no final denouement that brings all the strands of a narrative into an impressive final conclusion. In the real world, we never know when the story is over.

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    1. CommentedParrain Boursorama

      It is instructive that Professor Rogoff cites Harmston. The value of gold is more discussed than the value of bread but there is no doubt which one is the more important and it is not the value of the mineral. Malthusian limits will devalue gold in the long run.

    2. CommentedWayne Davidson

      Real estate bubbles are inherently cyclical and manifestly driven by the contagion of greed. Regulatory intervention will not contain the avaricious pursuits of humanity.

    3. CommentedSalil Mehta

      Great read. Irrational exuberance appears here.

    4. CommentedPaul Labonne

      For having a bubble you must have an underlying-value disconnected from the investors' expectations, which is not always the case.

    5. CommentedPaul Labonne

      For having a bubble you must have an underlying-value disconected from the investor's expectations, wich is not always the case.

    6. CommentedJose araujo

      GOLD is the mother of all bubbles. Gold is a shiny rare metal, with very little intrinsic value, a part that its shinny and rare. Yet nobody complains about the gold bubble because although irrational everyone understands the origin of the value.

    7. CommentedMartin Jenkins

      if you can predict bubbles - i.e. the ability to spot over priced assets - why have you not profited from this and become incredibly rich?

    8. Portrait of Pingfan Hong

      CommentedPingfan Hong

      "Rational" behavior can also generate overshooting in asset prices, as shown by Dornbusch a few decades ago.

      The concept of "efficient market hypothesis" can have different interpretations. It does not necessarily mean the market prices are always in line with the underlying value, but it means given the information at the moment, the prices are the best estimate the participants in the market could get. Of course, those malodorous practices and chicanery in the financial sector in the run up to the subprime mortgage crisis, as revealed afterward, can hardly be defined as part of an efficient market.

        CommentedJose araujo

        The market is still efficient but there is a change in the underlying asset. There is a moment where the title stops to represent the assets they were issued for and start to be the underlying assets themselves, having their own demand.

        Collectibles have this behavior, and the mother of all bubbles, the tulip bubble can be explained at the light of the efficient market theory if you consider a change in the asset itself.

    9. CommentedDennis Campbell

      You neglected to mention that the bubbles of the 1920s, 1990s, and 2000s were aided and abetted by ultra-easy monetary policy. Isn't this always the case?

    10. CommentedGeorge Stockus

      I think of bubbles as characterized by rising supply AND rising prices, reflecting speculation and challenging the simple economic laws of supply and demand. Think ipo's 1999, or over 50% of home buyers in 2006 being 2nd home buyers, propelling starts to all time highs.

      I worry that exploding government debts globally are manipulatively priced via central bank printing...again rising supply and rising prices. Debt bubble.

    11. CommentedThomas Aubrey

      When defining bubbles it is also useful to differentiate between bubbles that are driven by rising but unsustainable credit growth such as the 1920s and the 2000s as opposed to bubbles that are not linked to rising profits (hence credit growth) such as the dot com boom in the 1990s. The latter type of bubble is generally short lived whereas the former can continue as long as the supply and demand demand for credit growth continues, which can be a significant period of time.

        CommentedJose araujo

        There is a strong inverse correlation between housing prices and interest rates, because interest rates are a factor on housing development and also because real-estate is a very sophisticated industry capturing consumer surplus.

        This correlation is being confused with causation but is negated by the fact default rates on mortgages are historically low. There was no housing bubble in the 20's nor the 2000's, its just the natural real-estate market dynamics.

        There was on both cases fraud on the financial markets, and a huge demand shock caused by the inequality of income distribution which translates to excess leverage.

        My point is that the cause of the problem is the inequality of distribution associated with high productivity growth periods, not the interest rate levels or easy money.

    12. Commentedyancey simon

      Take off the blinders---speculative bubbles have been occurring since the 1980's as a result of the liberalization of national economies. The currency bubbles in SE Asia, the securities bubbles in the 1990's, the various commodity bubbles, and the 21st centuries R/E bubble. These are not the result of market forces---these are the result of market deregulation that lacks oversight, national political corruption co-opted by investor parties, and precisely planned market manipulations that inflate local economic sectors and then divest precisely while the value of the targeted asset is irrationally inflated.

      How does this stuff get overlooked---there is a string of bubbles concentrated in various investment sectors that was produced by the liberalization of economies in Japan, Korea, SE Asia, South America, Europe, and the US. Aided, naturally, by local political surrogates.

    13. Commentedjim bridgeman

      Jarrow, Protter and Shimbo claim to have a precise technical definition of a bubble: a price process that behaves as a strict local martingale. This can be analyzed with theoretical precision in terms of the price volatility process. Alas, it can be problematic to detect the characteristic volatility signature statistically in real time with any high confidence. The statistical signature at least is noticeable, however, in many historical processes that are commonly agreed to have been bubbles.

    14. CommentedJose araujo

      Real estate is speculative by nature, its part of the business/value model. Land scarcity isn't real, land is made scarce by legislation and regulation, so the prices of real estate can remain high.

      But it is not only land that makes real estate speculative, this is an industry that specializes in taking advantage of price discrimination supplier surlus. This leads to the high volatility of real estate prices and the perception of bubbles when in fact real estate prices follow a very close inverted correlation to interest rates.

      Real estate prices went down because mortgage interest rates went up, and in growing economies, when interest rates go down, prices go up.

      Fact that negates the spread of real estate bubble is that low historic default rate on mortgages. If we have experienced a generalized bubble wouldn't people default on their houses?

      The last financial crises there were scams and fraud, sub-prime and all, but that was a US reality, that didn't happen in the world.

    15. CommentedPaul Mathew Mathew


      The government share of the United States economy has been growing for many decades now, fundamentally transforming the country as a result. And by 2007, the United States economy had reached the extraordinary point (outside of a major war) where the government was consuming a full 35% of the economy. That is, government spending amounted to 35% of the economy, and 65% was the private sector.
      Then something remarkable happened. At the height of the Financial Crisis of 2008, the private economy imploded by $1.3 trillion per year when it came to the real private production of goods and services. This was a catastrophic decline that if left untouched, would have pushed the United States straight into an overt Depression.
      But this implosion, while confirmed in the government's own statistics and very real, is not what the government's surface level reporting of GDP shows at all. Instead, what the official statistics indicate on that top level is that there was "only" a $300 billion contraction in the economy, with the recession officially having ended in June 2009.
      Wait, what? How could it be that if the private sector within the economy plummeted by $1.3 trillion, that the total economy only fell by $300 billion?
      Well, when it comes to desperate governments in a time of economic collapse, there turns out to be a bit of a loophole. And that is that when GDP is reported by the media, what is reported is almost always total GDP - which is the sum of economic activity by the private sector and the public sector. So in looking only at total GDP then, any catastrophic declines in private economic activity can be effectively masked by equally extraordinary increases in public spending - at least temporarily.
      That obscure little loophole is the hidden-but-real story behind 2009, and every year since. In practice, the difference between the actual government-reported $1.3 trillion collapse in the private sector, and the officially reported $300 billion decline in the total economy, came from federal, state and local governments increasing their spending by a staggering $1 trillion between 2008 and 2009.
      This resulted in a massive and unprecedented shift in spending as the government soared in size, even as simultaneously the private sector was collapsing in size. So the economy nearly instantly shifted from being 35% government and 65% private, to being 43% government and 57% private – a level which remains in approximate terms true today.
      So when we look at these fantastic levels of deficits that have been consistently coming in at well over $1 trillion per year, what we have in fact been seeing is the increase in the size of the government from 35% to 43% of the overall economy, in order to maintain the facade of an intact economy.
      In other words, since the fall of 2008, a substantial chunk of the US economy has been "artificial". The private-sector imploded. It has not recovered to this day. And the great majority of damage containment has been dependent on the United States government running unsustainable deficits, of which it lacks the ability to pay back under ordinary circumstances.

    16. CommentedProcyon Mukherjee

      Robert Shiller has only covered the Part-1, but what makes the bubble inflate is the question. I would expect that he makes a sequel by explaining how bubbles in history got carefully nurtured by the polity and the Central Banks acting as the Impresario, with the main beneficiaries being the financial markets in particular.

      This concert, or should I call it the virtuoso performance, has a last movement, which is not the Schiller's 'Ode to Joy' as in Beethoven's 9th, but more the Third Symphony opening movement where Fate comes knocking at the door.

    17. CommentedMarc Laventurier

      The plain-spoken admission by the current Fed that they are attempting to inflate the value of 'risk assets' to induce 'wealth effects' and thereby amplify economic activity points to the larger political and ideological context for bubbles and other collective behavior, including warmongering.

      Capitalism, American-style, involves the methods of husbandry, manipulating the 'animal spirits' of a dim-witted and predictable majority to reinforce a particular scheme of political economy designed to serve the interests of the carnivorous.