Bubbles and Traditional Economics

Greg Ip reports from the Federal Reserve conference at Jackson Hole on the tension between those who believe in bubbles and those who believe in more traditional explanations of rapid price escalation:

The Tension Between Traditional Economics and Bubbles, by Greg Ip, WSJ Economics blog:  Economists, in particular those at the Federal Reserve, are loathe to believe asset markets have become bubbles because bubbles seem inconsistent with rational investor and consumer behavior, the bedrock of economic analysis. “The notion of a speculative bubble is inherently sociological or social-psychological, and does not lend itself to study with the essential toolbag of economists,” says Yale University’s Robert Shiller in a paper presented Friday at the Federal Reserve Bank of Kansas City’s research symposium in Jackson Hole.

Mr. Shiller has made a career out of trying to incorporate irrationality, psychology and bubbles into economic thinking. His book Irrational Exuberance was a timely warning on the stock bubble. For some years he has made similar warnings about the housing market. In his new paper he cites several historic episodes in which surges in real-estate values coincided with an intensifying public belief in ever-rising prices: in U.S. houses in the 1950s, in U.S. farmland in the 1970s.

For the latest decade, he argues that because home prices have so rapidly outstripped the growth in rent and construction costs, they must be “driven largely by extravagant expectations for future price increases.”

Yet Mr. Shiller’s paper may not convince skeptics. He does marshal interesting examples of how popular obsession with real-estate prices coincides with bubbles. ... He cites surveys he and a colleague conducted in both 1988 and 2006 that found attitudes in Los Angeles about future price gains in that city were highly correlated with recent history at the time.

But it isn’t surprising that expectations of prices — whether for real estate, stocks or goods and services — are heavily influenced by the recent past. The real question is, is that expectation itself an overwhelming factor in continuing to drive prices yet higher, the essence of a bubble? Perhaps, but he presents no empirical evidence of that. To be sure, designing an economic experiment that proves how a state of mind affects economic outcomes is hard. Perhaps that simply proves Mr. Shiller’s point: proving or disproving bubbles is still, for now, beyond the ability of mainstream economics.

Jim Hamilton has more on the conference, and he can be counted as among the skeptical:

...Yale Professor Robert Shiller ... struck fiercely iconoclastic tones...:

...a significant factor in this boom was a widespread perception that houses are a great investment, and the boom psychology that helped spread such thinking. In arguing this, I will make some reliance on the emerging field of behavioral economics. This field has appeared in the last two decades as a reaction against the strong prejudice in the academic profession against those who interpret price behavior as having a psychological component....

These principles of psychology include psychological framing, representativeness heuristic, social learning, collective consciousness, attention anomalies, gambling anomalies such as myopic loss aversion, emotional contagion, and sensation seeking.

One thing I have never understood is the source of Shiller's confidence that he is able to rise above these cognitive pitfalls in a way that market participants can not. Nor does his quantitative evidence help me to understand his position any more clearly. He notes for example a 1988 survey which found that the median new homebuyer in Los Angeles expected 11% price appreciation over the next 12 months, whereas the median buyer in Milwaukee expected only 5%. Since the OFHEO house price index shows a 13.9% appreciation for Los Angeles and a 6.2% appreciation for Milwaukee during 1989, it's hard for me to see how these survey results are supposed to convince us of people's lack of rationality. I also am unsure how Shiller's concept of real estate price bubbles in "superstar" cities is to be reconciled with the fact that the problems with mortgage defaults initially proved to be most serious in rustbelt areas where there had been very little real estate price inflation. ...

Comments

[david]

I simply cannot believe that people don't think these housing prices in San Diego were blown up in a bubble. Nobody could love a textbook that much.

[david]

Oh, sorry, and Pets.com.

[Lord]

Rents don't have to go up much; 5-6% when mortgages are 5-6% will do nicely. Rates won't and didn't stay that low for long, but if you were early to the party or locked in low rates, you did quite well.

[David]

I think a key component to these bubbles is short term (momentum) vs. long term (fundamental) perspectives. When people buy an asset and expect it to appreciate because it has recently been appreciating (same for houses or stocks), this can result in a positive feedback that entices even more people to pay attention and invest. Focusing on the fundamental, long term value of an asset as Shiller (and others) do it is easy to see that this type of appreciation is not sustainable. But it takes some external event to break the positive feedback cycle (a credit crunch, for instance).

[David]

I think one could create a pretty simple model of boom/bust dynamics by taking a population where most use recent history to predict the future and a smaller set use "common sense" (fundamentals) to make predictions. Any good like houses or stocks would work, but using houses as an example the dynamics would evolve something like this:

1) house prices are growing based on fundamentals (rising wages, population vs. supply, etc). Short term and long term thinkers predict equivalent growth rates.

2) Some external stimulus causes a rapid increase in prices (say, easy credit and innovative loans that permit many more people to borrow). On the fundamentals, prices should go up (a cap on demand has been lifted) so long term thinkers are willing to pay more.

3) Prices rise for a while.

4) Prices start to rise beyond fundamentals, but short-term "momentum" investors extrapolate to continued gains. Anticipation of high returns leads to more investment. Long-termers drop out of the market.

5) At some point prices are so out of line with fundamentals that the growth is not sustainable.

6) Prices crash as the momentum heads the other way.

This would not only explain the busts, but also the tendency for prices to overshoot on the way back down.

[billy]

Is Mark Thoma aware that JDH's definition of a bubble is quite different? To quote him in his various comments on his blog,

http://www.econbrowser.com/archives/2007/03/bubble_bubble_t.html#more

I realize that this is slightly treacherous ground here, since the word "bubble" has been appropriated by the popular public as a term they all feel free to use. But the problem is that no two people are using the term "bubble" in exactly the same way. Indeed, many of the commenters above seem to be describing what they call a "bubble" in terms of a framework that I would instead describe as an "economic fundamentals" way of thinking about things

"I would include adaptive expectations models (in which the expected price appreciation is a function of past price appreciation) as an economic fundamentals model, since, when you solve it out, the price is a function of the current and past fundamentals."

According to this theory, if people buy expecting prices to go up, it is based on fundamentals. Any model capable of solution based on fundamentals is not a bubble, even if that model uses expectations in it.

So even the NASDAQ bubble did not exist, as per his definition of a bubble.

Economist.ivory.tower.

[dd]

"...bubbles seem inconsistent with rational investor and consumer behavior."
Bubbles are very consistent with rational investor and consumer behavior as the bubble is driving rational behavior within the bubble context. Bubbles alter reality and humans rationalize accordingly; as in being on the moving train alters perception.

[David]

Bubbles can be rational in that there is a reason to believe that prices will increase in the near future (price momentum) but I think that it is commonly understood to mean prices that are not sustainable long term. The phenomenon is seen all the time in biological systems. Think of bacteria in a petry dish: they will grow exponentially for several generations but will eventually run out of space & food.

[Mark Thoma]

Quoting myself from yesterday:

"Before going any further, I should also point out that I am using the term bubble according to its current popular usage rather than according to its technical definition. Technically, a bubble is an increase in price that is disconnected from underlying fundamentals, but I am allowing the term to cover any run-up in prices. In the case of, say, housing markets while some of the recent increase in prices may have been due to a bubble in the technical sense, a lot of the price movement was also driven by fundamentals such as low interest rates and robust demand."

[david]

Rational is a red herring here. The efforts to worry things rational are mainly professional defense mechanisms. We're really wondering about whether price and value are aligned -- in housing they aren't, they weren't in tech 8 years ago, and so on. It confuses a certain group when price and value don't match up, what with so much depending on their link.

It's all in chapter 12 of the general theory anyway. I know, I know, not enough math.

[skeptonomist]

Is it rational to think that human behavior is always rational in some particular setting (i.e. economic matters)? If this is fundamental to economics it is no wonder that most economic "explanations" fail.

[Stephen Spear]

Last I heard, there was a large literature within economics that goes by the rubric of "sunspot equilibria" which clearly demonstrates that self-fulfilling prophecies are entirely consistent with rational expectations.

[Peter Schaeffer]

"In the case of, say, housing markets while some of the recent increase in prices may have been due to a bubble in the technical sense, a lot of the price movement was also driven by fundamentals such as low interest rates and robust demand."

The Case-Shiller indexes have more than doubled since 2000. Of course, some cities (LA, Miami) have risen much more. Atributing this to low interest rates and demand seems quite a stretch. Needless to say incomes haven't kept pace even allowing for cheaper loans.

says...

I can remember the rule was that house prices were 2.5 times earnings. That was in era of higher marginal tax rates and variable nominal interest rates, but notice no mention of interest rates in the rule. In fact I have seen other arguments about whether we should consider interest rates at all in determining the fundamental value of houses (i.e. is a house like a car or like an equity)? Could it not be that low real interest rates, meaning a low return on investment, imply low real wage growth in the future? I'm agnostic about this, but I would like to see a theoretical discussing of this.

[reason]

... theoretical discussion of this.

That was me!