Asset Bubbles – Causes, Consequences and Policy Options

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….



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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  1. The largest bubble (and the last one) is capitalism itself, based on two totally faulty assumptions 1) that energy resources are endless and cheap. 2) That in case this is not true, surely science and technology will “immediately” find the way to obtain endless and cheap resources again. This because most actors are infact stupid apes without a scientific background. Scientists and technologists on the contrary perfectly know that a breaktrough happens once in a century or so and not once every 10 years, expecially in energy related topics. But scientists are such a minority that what they think is not taken in account. But there is something good: when the last bubble will burst we will not have to worry for the next one.

  2. Great thoughts, Cullen. Would love to see some analytical rigor applied around these concepts, and probably some statistics / charts as well…

  3. Capitalism doesn’t assume resources are endless. Capitalism is just a system that is designed around keeping what resources we have, in private hands and not in the hands of the government.

  4. I think you can use just highly qualitative measures, maybe some psychological research. Bubbles were there since the invention of money, so it is not just Wall Street or capitalism. But without any doubts, capitalism generates friendly environment for the bubbles. I think that the worst part of the current capitalism is that it is regulation in favor of the big banking companies, which makes the whole market unstable (for example How credit unions escape new mortgage rules). They don´t need the information because they know they will be bailed out if they do a mistake and they are run by people who have no responsibility.

  5. I heard Sheila Baer talking about her book on the GFC: “Taking the Bull by the Horns”.

    She clearly would have done more for households (particularly those in the ‘subprime’ category) and to hold the big financial institutions accountable.

    She also obviously had her differences with Geithner and company. (Interestingly she mentions the ‘Midwesterner’ vs ‘Ivy League’ dynamic as perhaps at much in play as the gender one.)

    A self-described ‘market Republican’, she favors regulation and avoiding
    ‘moral hazard’, as well as greater capital requirements, for the big banks (and illustrates the inadequacy of conventional usages of ‘liberal’ and ‘conservative’).

    However, in agreement with views on human (and market) fallibility, I would go further to limit the capacity of the banking system to generate leverage. I suspect a fundamental connection to profligate tendencies in the consumption of resources, and also wonder how this plays out, if and as, resource limits are approached.

  6. Cullen,

    Great post! As for the “consequences” of bubbles, would you consider one to be that 1/2 of Spanish young people are unemployed now, with some eating out of garbage cans (apparently):

    This is really bad in my book… And now the Spanish government is instituting more austerity? I know people like Jim Rogers will tell you this is all the fault of having too many regulations and labor friendly governments that make the labor market illiquid… and they may have a point (to some extent), but how on Earth is this Spanish government going to survive by pushing more austerity? In your opinion, would Spain be better off just defaulting or dropping the Euro, or both? What about Iceland? They took the default route… are they suffering more than Spain because of it?

    These circumstances in Europe don’t look good at all… it seems something has to give.

  7. Speaking of bubbles:
    GDP revised downward, earnings reports keep coming in lower, no change in employment …. and the market is up another 100 points today.

  8. “Although I was a little early declaring housing a bubble in 2006 ”
    I have no idea why you thought you were early at all.Indeed if anything you were late.Property has an investment is notoriously illiquid when it counts so the earlier you are the better if you don’t wish to become a forced seller.

  9. “The amount of information and knowledge necessary to make a truly informed decision is incredibly difficult to acquire”

    I don’t agree with that either although it serves a purpose in setting incomes at a level that presupposes it is true. Rather it isn’t information that is the problem.It’s the manner in which people CHOOSE to interpret it to make their emotionally based desires executable on what they then laughably consider to be a rational basis.

  10. Good Philosophical Post Cullen, I would like to opine:

    ” 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.”

    Philosophically speaking we must understands man’s nature. Man realizes that he is finite, tho we create situations with leaders of us whom by our mere acknowledgement of their status create the feelings of infinite or God Complex.
    For example the Pharaohs of Egypt, The Emperors of Japan, even Obama’s election has show that people can exhibit irrational behavior when placing their hopes/bets on other human beings for their own prosperity.

    I think that this is a design trait of human nature and it simply plays it self out in markets. We look at our modern world of the “Stock Market” and claim “Follow the Heard” “Don’t Fight The FED”
    Well I would offer up a more simple explanation of this nature and that it is really about survival.

    Our heard mentality is natural because of our finite nature. look at the people in central Africa affected by the Lord’s Resistance Army (LRA). They would huddle together for safety sake in hopes the machetes would miss them.
    So I think when we understand that the heard mentality is simply a part of natures way of protecting us through odds, animals do it by nature and humans do it by choice. In my opinion, we humans who have a consciousnesses of the situation be it market’s or machetes need to be able to distinguish between “heard mentality” for the sake of saving one’s life in the micro frame and contributing to asset bubbles in the macro.

    I hope all that made sense..

  11. Can someone explain what’s going on with this market? GDP gets revised down, durable goods orders miss by a mile, KC Fed misses and the market rallies 1%. Is this all just the Bernanke Put levitating prices higher?

  12. And then there’s commodity bubbles. Looks like the corn bubble just popped (no pun intended!)

    It was crazy this week around here seeing farmers who didn’t lock in prices earlier, running their pickers 24/7 to get it in and sold before it goes lower.

  13. The big hedge funds have run this market up with Uncle Ben’s support and have created another equity bubble by pumping up the very, very high priced stocks like AAPL, AMZN, PCLN, MA, CMG…..

    It will probably continue for a while, but will end badly like all bubbles do.

  14. I think Alberto is right that capitalism is prone to bubbles (capital- a virtual resource chases a natural resource opportunity to expand itself). And JG is right in that rate of expansion has been amplified due to leveraging(creating virtual resources) and financial instruments(blurring the identity of these virtual resources). When virtual or natural resource expansion is not sustainable for some reason, the bubble crashes but capital can keep moving to a different natural resource. I think the limits he alludes to are there but for the human species as a whole they keep getting pushed out. The danger is that in a non-linear system when a stimulus hits, you are really gambling that limits can be pushed out in time .

  15. I laughed out loud last night while reading this paper. It’s like economists from, intellectually speaking, Chicago don’t even try to understand how the economy operates.

  16. Corn bubble has not popped, we are making harvest lows. Lets talk in a few months. Many farmers have sold theri crop at very nice prices. They are not all idiots as you would suggest.

  17. “Scientists and technologists on the contrary perfectly know that a breaktrough happens once in a century or so and not once every 10 years, expecially in energy related topics.”

    Total nonsense. There are constant breakthroughs in energy – nuclear power, horizontal drilling, fraccing. coal seam gas etc.

    The amount of recoverable oil is FAR higher now than it was 100 years ago.

  18. Bubbles are just people getting carried away really and becoming irrational about a specific thing. In investing its stocks or property. And then the “fad” dies as people return to being rational or a new fad comes along. With investing, it’s just that some make a lot and some lose a lot.

    So you could consider Justin Bieber a bubble? Like Lady Gaga. They are sort of bubbles for their managers….make the money while they are in bubble territory (popular) and then dump them for the next big thing.

  19. You are clearly NOT a scientist or an engineer but an avid reader of propaganda. Oil is not finishing, cheap oil is finishing and our overleveraged economy assumes cheap resources forever. It’s better that you study a little bit my friend before hitting some keystrokes on your notebook. It’s the future of your life not mine, I know what to do. There are some excellent infos on the net, for free. Try these just to start:

  20. Capitalism is exactly to cope with the “problem” of scares resources. Quite the opposite of what you claim! Doesn’t matter if this resource is energy, wheat, tin, capital, work force or what else.
    The biggest problem capitalism is facing is the fact that the most important resource (money) is not scarce anymore!

  21. That’s what I am talking about. Not with the “herd”,not against the herd,just willing to analyse and stand patiently aside. That doesn’t take pipelines of infirmation ,it just takes the willingness not to be sucked in when objective quantitative data tell you otherwise.

  22. Sorry, I won’t be talking to you until you improve your reading comprehension skills.

  23. 1) A day after you posted the corn market blew up, 2) Corn is not picked it is harvested. Please stick to markets you know something about.