I came across this post by Alex Tabarrok today about bubbles (hat tip: Matthew Yglesias). It's got some interesting observations about experiments involving bubbles. The bottom line: bubbles are hard to deal with. They're hard to stop once they're growing. They're hard to prevent in the first place. Still, if there's something Washington can do to prevent them, without harming the economy, I think pretty much everybody agrees that action should be taken.

First he talks about how difficult they are to deal with and that most trading mechanisms to prevent them fall flat:

Bubbles occur even as uncertainty about the fundamental value diminishes (JSTOR). We also know that once a bubble starts it's difficult to stop. Circuit breakers and brokerage fees (transaction taxes), for example, don't do much to stop bubbles (see King, Smith, Williams, and Van Boening 1993, not online.)

I agree. If investors are determined to buy into the next big thing, you are going to have a very difficult time stopping them, no matter what barriers you try to put in their way.

Education, he says, also does very little:

Investor education doesn't help (for example telling participants about previous bubbles doesn't help).

Obviously. What investor who lost money on housing bubble wasn't old enough to remember the internet bubble, less than a decade ago. I've long blamed investors for being as much emotional as rational -- if not moreso. It's that irrational exuberance that often drives bubbles. They keep believing something fundamentally different is going on in the economy this time. And the economy continues to prove them wrong.

Tabarrok's next point, I'm not entirely on board with:

Even increasing interest rates doesn't do much to stop a bubble already in progress and may increase volatility on net.

Again, if investors are determined enough, sure, they'll let a bubble continue. But Alan Greenspan is widely blamed for popping the internet bubble of the late-90s and causing the recession that followed. I would argue it would have happened eventually either way, but raising interest rates certainly can make it happen more quickly.

Tabarrok continues:

Futures markets (JSTOR) and short selling do tend to dampen but not eliminate bubbles, thus, there is a case for expanding futures markets in housing and making short selling easier (not harder!).

I also agree with this. Although Washington seems determined to put a stop to speculators, particularly in the derivatives market, they serve an important purpose. Without speculators, it's even harder to hear the voice of reason during a bubble. Investors need a way to dissent when they believe a bubble might be forming. Short selling provides a vehicle for the skeptics.

Tabarrok says the experiments have determined that experience matters:

Bubbles are also less common with more experienced traders - this is one of the strongest findings. Don't get too excited about this, however, it's experience with bubbles that counts not just trading experience.

I certainly hope traders are smart enough not to make the same mistake twice. But Tabarrok says that you can further infer that a bubble is a bubble, so if a trader has experienced one, s/he's less likely to partake in the future. I'm not so sure.

For example, if you got burned on mortgage-backed securities, you are going to be very careful when purchasing them again in the future. If you weren't, that would be like touching a hot stove a second time, after realizing it caused pain. But it's not obvious that different things might cause also pain. Some of the same traders that got burned with the internet bubble might have subsequently been burned by the commodities bubble. Remember, education doesn't matter. The first time they were burned by a stove, but didn't realize that an iron also gets very hot, getting burned again by something different.

His last point has to do with bubbles growing more easily with lots of cash being available and cheap. He appears to reference the Federal Reserve's presence here in saying:

Note that the latter experiments are consistent with the Fed having a significant role in bubble inflation (a theory I have not pushed). In other words, rather than identifying and popping bubbles already on the rise, not blowing bubbles in the first place may be easier and more productive.

Yes, Alan Greenspan is widely blamed for exacerbating the housing bubble, after leaving interest rates too low for too long. The poor guy just can't win: either he's raising rates too quickly (popping the internet bubble) or keeping them too low for too long (creating the real estate bubble). One possible solution to this could be for the Fed to only use monetary policy to control inflation and never attempt to affect business cycles. Yet, that probably would not fly politically, which is one of the problems in having a quasi-public central bank.

But either way, I'm not sure it matters. I asserted before that investors tend to be too emotional, and that helps to make bubbles worse. That's partially true, but the flip side is that investing in the asset of the day during a bubble is wholly rational. If you don't, you will fail to reap the returns that everyone else will enjoy. Whether the value is real or not, the returns are, if you get out before the crash. That's the key, of course. It's also the hard part, where most investors suffer epic failure.

Unfortunately, this is a problem that I'm not sure can be solved. You would have to essentially discourage that rational behavior. One possibility would be forcing long-term investment only. Then investors would certainly be less apt to take part in inflating a bubble, since they can't count on getting out before the crash. I just worry that such a policy would do more harm to the market through creating inefficiency than good though only allowing smaller bubbles.