Bubbles vs. Non-Bubbles
By Arnold Kling
From an interesting Wall Street Journal item:
Bubbles emerge at times when investors profoundly disagree about the significance of a big economic development, such as the birth of the Internet. Because it’s so much harder to bet on prices going down than up, the bullish investors dominate.
The article describes academic research at Princeton. It says,
They are building on work done by the late Hyman Minsky, whose once-ignored ideas about investing manias are now in vogue, and the late economic historian Charles Kindleberger, whose 1978 “Manias, Panics and Crashes” is a classic. But compared with Mr. Minsky or another student of bubbles, Yale’s Robert Shiller, the Princeton trio focuses less on mass psychology than on mathematical models. These they use to show how bubbles can be created even in markets that include rational, calculating investors.
A couple of comments.
1. Mordecai Kurz was doing this years ago, but no one seems to want to give him credit.
2. As Kurz would tell you, there is always disagreement about asset values. Moreover, if institutional factors lead to more trading in a rising market than in a falling market, then high trading volume could be a sign of rising fundamentals, not necessarily a bubble. So I’m not sure how one detects a bubble.
3. Robert Shiller thought that there was irrational exuberance in the stock market back in 1996. My guess is that if you were to go back and check, if you had bought stocks then, you would be ahead of the game today, meaning that stocks have outperformed risk-free assets by an amount that would exceed a reasonable risk premium. To put it more strongly, if you had bought a very long-dated put option on stocks back then that could only have been exercised ten years later, that option would have been worthless. If bubbles are detectable, then such long-dated put options should be winners.
4. Paul Krugman’s incorrect reasoning notwithstanding*, there could be a bubble in the oil market today. But it is not detectable.
*I’ve thought about this some more, and I’ve decided to take a stronger view against Krugman’s claim that refiners’ inventories of oil have to rise if there is a bubble. His model is just plain wrong.
First of all, one cannot ignore forward prices. A rational market for assets that can be carried over time requires a long-term equilibrium value in order to pin down the path of expected prices going forward. If Krugman were here, I would remind him of the role of the long-term equilibrium exchange rate in the Dornbusch model.
What a high forward price (or futures price) in the oil market means is that the market thinks that we are in danger of running out of oil. The market is telling consumers to use less oil and telling producers to leave oil in the ground. In Krugman’s model, the consumers listen, but the producers just blunder ahead, not reducing oil production. For rational oil producers, that is not a plausible assumption (yes, I know, there are reasons to doubt the rationality of those who control most of the world’s oil reserves, but Krugman and I are both ignoring that here).
Incidentally, the forward price does not have to be above the spot price in order to induce producers to cut production. The impetus to cut production can arise from producers either (a) perceiving that the high price is indicative of potential future shortgages or (b) simply realizing that with the higher price, current demand will be lower, and they should cut back production in line with the lower demand.
I believe that there are bubbles. I believe that a bubble is a theoretical possibility in the oil market, although I do not think that one is occurring at the moment. But I do not think that bubbles are sufficiently detectable to make me want to have the Fed try to speculate against them.