Alex Soojung-Kim Pang, Ph.D.

I study people, technology, and the worlds they make

The Atlantic on financial bubbles

The latest Atlantic is devoted to The Crash. The most outstanding piece, in my view, is a Virginia Postrel essay on experimental economics and the nature of financial bubbles.

[L]ab results should give pause not only to people who believe in efficient markets, but also to those who think we can banish bubbles simply by curbing corruption and imposing more regulation. Asset markets, it seems, suffer from irrepressible effervescence. Bubbles happen, even in the most controlled conditions.

Experimental bubbles are particularly surprising because in laboratory markets that mimic the production of goods and services, prices rise and fall as economic theory predicts, reaching a neat equilibrium where supply meets demand. But like real-world purchasers of haircuts or refrigerators, buyers in those markets need to know only how much they themselves value the good. If the price is less than the value to you, you buy. If not, you don’t, and vice versa for sellers….

For those of us who invest our money outside the lab, this research carries two implications.

First, beware of markets with too much cash chasing too few good deals. When the Federal Reserve cuts interest rates, it effectively frees up more cash to buy financial instruments. When lenders lower down-payment requirements, they do the same for the housing market. All that cash encourages investment mistakes.

Second, big changes can turn even experienced traders into ignorant novices. Those changes could be the rise of new industries like the dot-coms of the 1990s or new derivative securities created by slicing up and repackaging mortgages.

This last bit helps explain this line Henry Blodgett’s article in the same issue: “In the words of the great investor Jeremy Grantham, who saw this collapse coming and has seen just about everything else in his four-decade career: ‘We will learn an enormous amount in a very short time, quite a bit in the medium term, and absolutely nothing in the long term.’ “

2 Comments

  1. The ones who saw it coming were riding the wave as well. In late Jan/Feb 09 we will start seeing investigations into stock sales, Countrywide’s aggressive push to Moody’s to upgrade their ratings, all the way down to the mortgage broker who pushes loans through with false data.

    great post. :O))

  2. I think the scariest thing about the Blodgett piece is his argument that
    people weren’t really behaving irrationally at all: that given the
    combination of factors– particularly really low interest rates, the
    everyday motivation to make money, and the fact that if you didn’t jump on
    the bandwagon your clients or bosses (in the case of people in the industry)
    would consider you a loser– the dot-com and subprime mortgage booms made
    perfect sense.

    And the Virginia Postrel piece makes a good case for how bubbles are a
    natural consequence of the complex nature of transactions around financial
    instruments (as opposed to food or other goods).

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