Bubbles

I just stumbled on this post from a few months back by Noah Smith. Like all his stuff it is a fun and informative read. Essentially, he looks back to the famous experimental paper of Vernon Smith and colleagues which found clear evidence for strong and sustained bubbles in an artificial market with students trading a fictitious asset with real value. The novelty of the experiment was that this asset had a clear and perfectly well-known fundamental value (unlike real financial instruments), and so it was easy to see that the market value at first soared way above the fundamental value, and then crashed down again.

Noah's post looks at why this result, for financial economists, didn't nail the proof that asset bubbles can exist and ought to be expected in real markets. Most of the arguments seem to be centered on the idea that the people acting in real markets are far more sophisticated than those students, and so would never pay more than the true fundamental value for anything. Suffice it to say this argument doesn't hold together at all well in the face of empirical evidence on real trading behavior, some of which Noah reviews.

One thing caught my eye, however, and is worth a short mention. As Noah writes...

If bubbles represent the best available estimate of fundamental values, then they aren't something we should try to stop. But many other people think that bubbles are something more sinister - large-scale departures of prices from the best available estimate of fundamentals. If bubbles really represent market inefficiencies on a vast scale, then there's a chance we could prevent or halt them, either through better design of financial markets, or by direct government intervention.

 I am certainly someone of the latter camp -- convinced that markets often depart from fundamentals (even such values even exist) for long periods of time. But I think the third sentence on what we might do about bubbles needs to be refined a little from a logical point of view.

Bubbles aren't necessarily totally bad things. Perhaps we may find that they are a useful and necessary part of the collective learning process. The foraging of a flock of birds is highly irregular; it moves this way and that, following the lead of different birds at different times, sometimes moving on large excursions in a single direction. A market might be somewhat similar as a collective social process for searching and exploring. We shouldn't expect that what it has found at any one moment is optimal; it may often make huge mistakes. But the process of exploration may be useful anyway.

In that case, we may find that we don't want to stamp out bubbles, unless they get really big. Or if the bubble is one driven by a systematic increase of leverage by investors which sets the stage for a certain explosive episode of de-leveraging, with subsequent long term consequences.

What we do want to stamp out, however, is the dangerous idea (still supported by many economists) that bubbles don't exist. That's the one idea that can make our markets really prone to disasters.