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Monday, July 23, 2012

Shiller: Bubbles without Markets

Robert Shiller argues that reining in markets is not the answer to bubbles:

Bubbles without Markets, by Robert Shiller, Commentary, Project Syndicate: 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... The excitement then lures more and more people into the market ... 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... 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. ...
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.

Setting aside the extent to which these are really bubbles as commonly understood, nobody is talking about eliminating markets entirely. The push from those of us who want to "rein in the markets" is to regulate them so they function better than they did prior to the crisis. I don't see how these examples of so called non-market bubbles argue against regulating markets to make them work better. Modern economies may have something like the "free markets" Shiller talks about, but unregulated markets do not always function in the public's best interest and regulations that rein them in and make them more competitive, less subject to catastrophic failure, etc. can improve their social value. The question isn't about markets versus non-markets, the question is how to make our existing insitutions perform better and none of the above helps much with that question. How, for example, can we make business analysts, ratings agencies, accountants, lawyers, and regulators that Shiller lauds -- all of whom fell down on the job to some extent prior to the crisis -- do a better job next time?

Finally, I can't help asking: What is his definition of "really serious catastrophe"? How many millions of unemployed does it take? I'd hate to see a crisis that "dwarfs" this one, but this was no walk in the park. Perhaps the crowd Shiller hangs around in didn't think it was all that serious, but for many, many people it was quite catastrophic.

Update: I should have also added that the fact that this recession, while severe, didn't reach the depths of the Great Depression has more to do with improved social insurance, better automatic stabilizers, better policy (though far from perfect), and a higher initial level of wealth than it does the presence of free markets, business analysts, ratings agencies, accountants, auditors, lawyers, and regulators.

    Posted by on Monday, July 23, 2012 at 03:33 PM in Economics, Financial System, Market Failure, Regulation | Permalink  Comments (37)


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