Why Bubbles Occur

In 1998, Paul Krugman explained why housing and stock bubbles occur. The answer? "Me want mammoth meat!":

The Ice Age Commeth, by Paul Krugman: The more I look at the amazing rise of the U.S. stock market, the more I become convinced that we are looking at a mammoth psychological problem. I don't mean mammoth as in "huge" (though maybe that too), but as in "elephant". Let me explain.

If you follow trends in psychology, you know that Freud is out and Darwin is in. The basic idea of "evolutionary psych" is that our brains are exquisitely designed to help us cope with our environment - but unfortunately, the environment they are designed for is the one we evolved and lived in for the past two million years, not the alleged civilization we created just a couple of centuries ago. We are, all of us, hunter-gatherers lost in the big city. And therein, say the theorists, lie the roots of many of our bad habits. Our craving for sweets evolved in a world without ice-cream; our interest in gossip evolved in a world without tabloids; our emotional response to music evolved in a world without Celine Dion. And we have investment instincts designed for hunting mammoths, not capital gains.

Imagine the situation back in what ev-psych types call the Ancestral Adaptive Environment. Suppose that two tribes - the Clan of the Cave Bear and its neighbor, the Clan of the Cave Bull - live in close proximity, but traditionally follow different hunting strategies. The Cave Bears tend to hunt rabbits - a safe strategy, since you can pretty sure of finding a rabbit every day, but one with a limited upside, since a rabbit is only a rabbit. The Cave Bulls, on the other hand, go after mammoths - risky, since you never know when or if you'll find one, but potentially very rewarding, since mammoths are, well, mammoth.

Now suppose that it turns out that for the past year or two the Cave Bulls have been doing very well - making a killing practically every week. After this has gone on for a while, the natural instinct of the Cave Bears is to feel jealous, and to try to share in the good fortune by starting to act like Cave Bulls themselves. The reason this is a natural instinct, of course, is that in the ancestral environment it was entirely appropriate. The kinds of events that would produce a good run of mammoths - favorable weather producing a good crop of grass, migration patterns bringing large numbers of beasts into the district - tended to be persistent, so it was a good idea to emulate whatever strategy had worked in the recent past.

But now transplant our tribes into the world of modern finance, and - at least according to finance theory - those instincts aren't appropriate at all. Efficient markets theory tells us that all the available information about a company is supposed to be already built into its current price, so that any future movement is inherently unpredictable - a random walk. In particular, the fact that people have made big capital gains in the past gives you absolutely no reason to think they will in the future. Rational investors, according to the theory, should treat bygones as bygones: if last year your neighbor made a lot of money in stocks while you unfortunately stayed in cash, that's no reason to get into stocks now. But suppose that, for whatever reason, the market goes up month after month; your MBA-honed intellect may say "Gosh, those P/Es look pretty unreasonable", but your prehistoric programming is shrieking "Me want mammoth meat!" - and those instincts are hard to deny.

And those instincts can be self-reinforcing, at least for a while. After all, whereas an increase in the number of people acting like Cave Bulls tended to mean fewer mammoths per hunter, an increase in the number of modern bulls tends to produce even bigger capital gains - as long as the run lasts. Any broker can tell you that in the last few months the market has been rising, despite mediocre earnings news, because of fresh purchases by ever more people distraught about having missed out on previous gains and desperate to get in on the action. Sooner or later the supply of such people will run out; then what?

OK, OK, I know that this isn't supposed to happen. Sophisticated investors are supposed to take the long view, and arbitrage away these boom-bust cycles. And maybe, just maybe, the market is where it is because wise and far-seeing people have understood that the New Economy can produce growing profits forever, and that the rise of mutual funds has eliminated the need for old-fashioned risk premia. But my sense is that people who try to take a long view have been driven to the edge of extinction by the sheer scale of recent gains, and that the supposed explanations you now hear of why current prices make sense are rationalizations rather than serious theories.

The whole situation gives me the chills. It could be that I just don't get it, that I'm a Neanderthal too thick-skulled to understand the new era. But if you ask me, I'd say that there's an Ice Age just over the horizon.

Comments

[Spectator]

Yes, your sense is pointing you in the right direction. This is what the Austrians would call financialization of the economy. A combination of fiat money, fractional reserve lending, cheap credit, unrestrained leverage, and moral hazard caused it. Maybe it gives you a hint that some pain has to be inflicted on the bad actors to reduce the magnitude of these bubbles.

Unfortunately, you wish to encourage this once again with a bailout of the financial industry. Cheap money, TAF, and all the other actions of the Fed have been just that. It's not doing anything good for the economy. Sad to see so many liberal economists just not get it.

[Paltry 2%]

Once upon a time investors demanded a dividend yield higher than interest rates, to compensate them for the extra risk of stocks. Now, the S&P dividend yield is a paltry 2%. Its potentially a long way down if former risk premiums reassert themselves. Of course, as many have learned, the market can stay irrational longer than individual investors can remain solvent.

The Japanese market was about 40,000 around 1980. Now it is under 14,000. 28 years of losses for anyone who bought at the top. Risk is very real, and there is no safe haven for the timid. Inflation erodes 401k or IRAs invested conservatively. There are no more rabbits to hunt. That may be the real story behind the multi decade rise in valuations. Take the risk of hunting mammoths or starve. Some will get eaten by the mammoth instead.

[Icarus]

Bubbles occur because of greed and fear; nothing more, nothing less. They are traits inherent to human civilization.

[esb]

Nonsense.

Better to interact with the monolith, learn to use tools, use them to kill your competetion, and then hunt and/or take whatever the hell you want.

The Richard Bruce Cheney solution to (the illusion of) scarcity.

Further, what is just over the horizon is not an ice age but the new Chinese century, into which the geostrategic, fiscal and monetary stupidity of the Bush Administration has (most likely) delivered us.

Perhaps the AEI gang can start a new think tank, The Project For The New Chinese Century.

Hey Bill Kristol ... would you be happy working there?

Scooter?

None of your sorry lot?

Sorry for the rave, but after 60+ years I had no idea that I would witness such an apex of governmental stupidity.

I know that many, perhaps most of you feel similarly.

But what can we do, 'cept trade around it.

If we can.

[hari]

Bubbles occur because of greed! That's simple, ain't it? I lost my whole portfolio in Oct'87!

Paul is trying to deal with Wall Street psychology...and I've been reading a lot recently on Bloomberg blog about the negative trends in the capital markets. Boolmberg is also dealing with something new - comparative market analysis.

These are surely speculative market cycles which seem to come (also) during downturns. However, if globalization has reduced Street leverage in managing the market, we're soon to find out exactly who controls the tiller now.

[Carolyn Kay]

There's also the flocking factor:

Sheep In Human Clothing: Scientists Reveal Our Flock Mentality

Carolyn Kay
MakeThemAccountable.com

[ndd]

Well, no.

Krugman isn't taking into account Keynes' famous line about investments being like a beauty pageant in which you don't win by best determining beauty, but by correctly anticipating what your fellow judges will determine is beauty. And you can make fantastic gains by correctly anticipating when a particular type of judging is at its highest or lowest point. By definition, that means when the fewest/most judges ($ weighted) are using that particular yardstick of beauty.

Yes, all bubbles are about animal spirits, and are fads just like pet rocks or Hannah Montana. Investment manias occur because even the most blockheaded think they have figured out how all the judges will determine beauty. Which means the yardstick of beauty is at its highest point.

Greed and fear are obviously central. Beyond that, there is tremendous social pressure to conform. A flipper falling in love with condos is no different from your teenybopper falling in love with the Jonas Brothers.

And that brings us to the psychological concept of attribution. How well is any particular person able to see the likely impact of various people's actions on other people. At one end of the scale are the autistic and the high functioning Asperger's people. They barely have any social sense about human interaction at all. And there are social blockheads, and people who couldn't tell a lie to save their lives. At the other end of the scale are smooth operators, politicians, and con artists, who are able to tell not only how their own actions will directly impact the person they are interacting with, but how that person will interact with the next person, and what the next person will do to the person after that. So powerful a tool is being are these levels of attribution, that there is likely a strong evolutionary preference for them, and there may even be an evolutionary "arms race" in the human species to select for this ability.
The most successful investors probably fall at either ends of the spectrum: people who are aware how all the social dominoes will fall, i.e., how all the social interactions among the judges will determine their finding of beauty. Ironically, some of the most successful investors of all seem to be at the other spectrum: high functioning Asperger's or social clods (Warren Buffett seems to fit the mold). Social pressure to conform has almost no effect on them. Also, they probably have learned how to interact with other humans by brute intellectual effort, and their intellectual focus may have lead them in a detached way to see how other humans will interact, i.e., how the judges will determine beauty.

So, imho, bubbles occur at the intersection of greed, social pressure to conform to the latest fad, limited intellect, and (by definition) average levels of social attribution.

[ndd]

Shorter version of my above bloviation:
So long as mammoths are reasonably plentiful, when you hunt mammoths, you are competing against the mammoths.
When you invest, you are by definition competing against your fellow hunters. The mammoths are just the maguffin (sorry for mixing metaphors).

[paine]

krug does ally oop
as well as the coyote bit

cartooning has its lights in the darkness

i guess

but is there danger here

to feel
you've arrived at comprehension
when you only have ....a toon's kit
of brainthinkdrives

[Cyrille]

Well, in the compulsory obituaries for William Buckley (compulsory because few people were ever less deserving of them), there was this:

"I am, I fully grant, a phenomenon, but not because of any speed in composition," he wrote in The New York Times Book Review in 1986. "I asked myself the other day, `Who else, on so many issues, has been so right so much of the time?' I couldn't think of anyone."

Somehow, I can think of another columnist who has been right so much more often, this column being one example. Somehow, he would also be among the last to write that about himself.

May we long enjoy Krugman's writings.

[groucho]

"So, imho, bubbles occur at the intersection of greed, social pressure to conform to the latest fad, limited intellect, and (by definition) average levels of social attribution."

ndd, excellent, thanx for the insights!

[bp]

there were also cave parasites in addition to cave bulls and bears ... cave parasites didn't care whether rabbits or mammoths are aquired as long as they got a cut of the action

cave parasites established a level hunting and trading field for mammoths and rabbits ... seems like 400 rabbits fetched a mammoth around 100,000 BC, at least before they learned how to run 'em off a cliff

the parasites began forecasting rabbit and mammoth production and consumption (all the same back then) for large fees of ... well, rabbits and mammoths

cave parasites began to hold seminars on subjects like "which hunter should get the largest rabbit, how many hunters does it take to tackle a mammoth at 10 mph before a hunter gets killed, and how much of a mammoth should be consumed per tribe member to convert a perishable consumption item into a durable saving good for several days before it rots" ... this was before calculus of course

the mammoth bubbles came about as a result of "best practice" seminars, between the "the total quality managment of fruits and berries" and classes in "strategic planning of killing or cooperating with neighbors"

the parasites convinced the bears to switch from rabbits to mammoths on a best practices basis that "everyone was doing it"

so the forecasters took their cue from the parasites and forecasted all mammoths and no rabbits, and the clan elders for bears followed suit with an "all mammoth" policy and the rest was a self fulfilling prophecy which created a mammoth bubble, in terms of rabbits of course

and back then, there were no austrians around that said this couldn't happen in the absence of fiat money

that's how random hunting died a naturally selected death through evolutionary forces and why random walking is dead today ... it was a mutant gene that didn't make it, but if it had, it could have saved us from inflation and business cycles

[Callahan]

Tiny bubbles, make me warm all over.

How about 8 more years with the likes of Bush-ism? Bet that would bust yer bubble.

[anne]

http://delong.typepad.com/sdj/2008/02/still-stocks-ra.html

February 28, 2008

The U.S. Equity Premium: Past, Present, and Future *
By J. Bradford DeLong and Konstanin Magin

ABSTRACT

For more than a century, diversified long-horizon investors in America's stock market have invariably received much higher returns than investors in bonds: a return gap averaging some six percent per year that Rajnish Mehra and Edward Prescott (1985) labeled the "equity premium puzzle." The existence of this equity return premium has been known for generations: more than eighty years ago financial analyst Edgar L. Smith (1924) publicized the fact that long-horizon investors in diversified equities got a very good deal relative to investors in debt: consistently higher long-run average returns with less risk. As of this writing the annual earnings yield on the value-weighted S&P composite index is 5.53%. This is a wedge of 3.22% per year when compared to the annual yield on 10-year Treasury inflation-protected bonds of 2.31%. The existence of the equity return premium in the past offered long-horizon investors a chance to make very large returns in return for bearing little risk. It appears likely that the current configuration of market prices offers a similar opportunity to long-horizon investors today.

* http://www.j-bradford-delong.net/2008_pdf/20080228_jep_submit.pdf

[João Carlos]

Sorry, but I cannot resist it.

http://www.youtube.com/watch?v=TkGxGPmAKC8&feature=related

Krugman was right about the Dot bubble. And right about the house bubble.

[Alex Tolley]

PK:

Now suppose that it turns out that for the past year or two the Cave Bulls have been doing very well - making a killing practically every week. After this has gone on for a while, the natural instinct of the Cave Bears is to feel jealous, and to try to share in the good fortune by starting to act like Cave Bulls themselves. The reason this is a natural instinct, of course, is that in the ancestral environment it was entirely appropriate. The kinds of events that would produce a good run of mammoths - favorable weather producing a good crop of grass, migration patterns bringing large numbers of beasts into the district - tended to be persistent, so it was a good idea to emulate whatever strategy had worked in the recent past.

Assume this, assume that. Just speculation. This is just window dressing to tell a story for a particular mathematical model. Unfortunately, with an infinite number of models, there arises an infinite number of stories. Behavioral experiments have shown how bubbles arise. We really don't need speculative evolutionary psychology as a explanation.

[bullbust]

----------------------------------------------------
The state of received wisdom (as elucidated by various actors) 2004-2007.
----------------------------------------------------
Fed:
There is no bubble (various Fed Research papers)

Fed Chairman:
There is no bubble, we have any number of studies which say so. [ we can always claim we never heard about the NINA loans blasted 24x7 on the radio, news and internet] And we don't know what a bubble is, we only know about the busts.

Economists (99.9% of them)
What bubble? Rational Homo economicus cannot be an economic actor in a bubble.

Economist Jim Hamilton:
I redefine the term bubble, and according to the new definition, this is not a bubble.

Economist Brad Delong;
I think there is no bubble, even though all the data says there is no bubble. I like my feet in both camps, so that when the no bubble crowd is proved wrong, I wont be.

NAR/brokers/Homebuilders;
Buy, or you'll be priced out. The Fed, the govt, and all the economists state there is no bubble

Stock Market:
If there is a bubble, the Green-bum put will bail us out.

Wall Street pigmen:
We better take the loot in this bubble and run before it all comes down. The govt will do the cleanup. Greenspan has stated that this is the official policy of the Fed, and Bernanke has no balls to change it.

Economists Roubini, Volcker, Dean Baker:
This house of financial chicanery is going to come down and it will end in tears.

Jim Rogers, Buffet:
Invest in anticipation of a collapse in housing and the dollar, and the middle class getting screwed by inflation.

Middle-class pre-bubble owners:
Stratospheric housing prices are great, because we get free money. It is a great thing that given todays prices, we cannot buy the house we live in, with our current income. ( just read the comments on this very blog by the boomer middle-class on housing topics). Roubini et. al. are chicken littles.

Gold nuts and Austrians
Beware, there is going to be inflation, as all this debt cannot be paid. Buy gold.

----------------------------------------------------
State of received wisdom today, by the same actors
----------------------------------------------------

Fed:
Banks are bust. Did'nt we tell you we only know busts? We need to bail them out. Bail out the banks, and we wont have to change anything. We can repeat this bubble. And we will never ever mention that we created this bubble with our mop-up-bubble policy, or that there was anything wrong with what we did. If we admit it the bubble con game will be over. How will we serve the pigmen then?

Fed Chairman:
There is no inflation, we have any number of studies which says core inflation is what matters and even that is overstated. [ we can always claim we never heard bread and milk prices, or metals]

Economists (99.9% of them)
How does rational Homo economicus become an economic actor in a bubble? We have never seen this before, it cannot be explained.

Economist Jim Hamilton:
There would have been no bubble in a free market. It is all because of the GSEs.

Economist Brad Delong;
Inflate, inflate. It may be unjust and arbitrary, but its better than having the system break down. If the system breaks, it is our economic theory, on which the system is based, that will get discredited. And I want a Fed post one day.

NAR/brokers/Homebuilders;
Buy,prices are at the bottom. Buy now or you'll be priced out. The Fed, the govt, and all the economists state ther is no bubble

Stock Market:
buy, buy, buy. The Green-bun put is here. Buy, so that we can dump it on you.

Wall Street pigmen:
You better bail us out. If you don't, we'll bring the whole house down. That's an empty threat, but you don't have the balls to call us on it, and, Bernanke is our bitch anyway.

Economists Roubini, Volcker, Dean Baker:
Told you so.

Jim Rogers, Buffet:
Told you so, and if you listened, you would have minted money.

Middle-class pre-bubble owners:
Inflate, inflate, inflate. We are so stupid that we think its good for us.

Gold nuts and Austrians;
Even we can't believe you would be that stupid, that it makes us seem smart in comparison.

[dd]

Then there are the truly insightful Cave Gatherers whose knowledge of vegetation, storage, drying and food processing combined with wise eating habits allow them to feed themselves and their offspring with enough left over to trade for meat enough to eat, but also to dry and store for later consumption. Cave Gatherers are of course not important enough to be considered (not even part of the GDP!) despite the fact that their skills have continually bailed out Cave Bulls and Bears in the lean times.

[wimpie]

"Wall Street pigmen:
You better bail us out. If you don't, we'll bring the whole house down. That's an empty threat, but you don't have the balls to call us on it, and, Bernanke is our bitch anyway."

bull, SWEET!

but, unfortunately true.

[Holly W.]

PK:

The Cave Bulls, on the other hand, go after mammoths - risky, since you never know when or if you'll find one, but potentially very rewarding, since mammoths are, well, mammoth.

I would argue that bubbles occur when people stop perceiving that there is any risk in a particular hunt. The tech bubble came about when it seemed that almost no matter what stock a person bought, it went up -- the entire S&P 500 soared right along with the dot-coms. To an extent, it didn't matter if you were hunting rabbits or mammoths, because the rabbits were pretty big and meaty then, too.

Likewise, the housing market looked pretty risk-free, as well, when house prices were doubling every three years. "Housing prices never go down, only up!" we were all told by the Realtors and the feds. So as long as you could get hold of a house, you would be set -- the market would pay off your loan for you, and you were a fool not to take advantage of that. So in this case, a house was a mammoth, period -- there weren't even any rabbits involved.

In both the stock and housing bubbles, it appeared to people that money in the market was guaranteed to make jaw-dropping gains, while keeping your money out of the market was clearly the riskier, losing game.

In short, bubbles make it look as if we can make huge returns while barely putting any effort into the hunt, because everything has become a mammoth.

[calmo]

Following dd's note,

Cave Gatherers are of course not important enough to be considered (not even part of the GDP!) despite the fact that their skills have continually bailed out Cave Bulls and Bears in the lean times.

and adding the note that the labor of repeating a task however mundane is only appreciated by the engineers driven by economists to gauge it's efficiency. How mindless can picking blueberries all day be? [Well, assuming you are not hungry...and not sharing the bush with a bear.] How can we free up this labor intensive activity with a machine? How can we reduce the costs of the berries so that more people can enjoy them? Ok, that wasn't it: how can we increase our profits whether it be reducing labor costs or increasing output? How can we drive these berry pickers to do something...value-added, important-like, profit-generating...so they can be like us, privileged and powerful members of society...real leaders like Arnold...and other action heroes too pitiful to mention.
So that "consideration" amounts to, as Arnold tells us, exploiting those muscles and making the adoptive country pay for this entertainment...this concentration of wealth...this suffocating self-interest.

[Keith]

Me short Nasdaq, me eat good.

[anne]

Remember; what is important, really imporant is to use disgusting sexist language to show just who we are. The more disgusting the sexist language the better ,because that is just who we are.

[anne]

What is interesting about hateful prejudice is how infectious it is, how we take delight in another person's prejudice and make it our own but then it must have been there to begin with. Remember; the more sexist the metaphor, the more demeaning the better.

[JRossi]

Ok bullbust, you're my new financial guru. Sorry it doesn't pay much. What do you think about the DeLong paper referenced above by Anne?

[WangoTango]

"Remember; what is important, really imporant is to use disgusting sexist language to show just who we are. The more disgusting the sexist language the better ,because that is just who we are."

Hey anne! It's time for your meds, babe.

[art byrne]

I picked a zip code in nyc [11419] and looked at the first 27 listing for mortgages in distress at realty trac .com. The median mortgage was $490,000 and the average was $512,000.Then I went to melissa .com and looked up the adjusted gross income reported to the IRS in 2005 in that zip code. It was $28,926. Asuming two earners you have a family income of $57,852[2 returns?] So their mortgage payments after the teaser would be north of 80%. Who did the due diligence for the CDOs?

[Blissex]

«which created a mammoth bubble, in terms of rabbits of course» That "in terms of rabbits" is one of the wisest points I have seen in a long while (outside my own comments of course :->).

[Blissex]

bullbust I think that your summary of pre/post bubble positions is not only rather very realistic (down to BDL's Fed ambitions) but also quite well expressed. Thanks for such an excellent summary.

To add something of my own: your summary makes it clear that many of the people described are biased in favour of bubbles, because their compensation is tied to beta, and in particular to positive deltas only.