Some Bubbles Are Missed, Others Embraced

Death and taxes aren't the only things that are unavoidable: you can add asset bubbles to the list. We cannot escape bubbles, because they surprise us, argues Kenneth A. Posner in a blog post for the Harvard Business Review. That's partially right, but the problem goes even deeper.

Posner starts by explaining his view of why bubbles are so problematic:

It would be nice if we could predict bubbles; even nicer if we could prevent them. Unfortunately, this would violate the laws of nature: asset bubbles occur because of the limits of our ability to process information and coordinate activity in a market setting, where no-one is in charge, and no-one has a complete view of the big picture.

Here's how it works. On occasion, the enthusiasm for some growth opportunity or new technology attracts interest from people in the capital markets. Financing is suddenly available. Sooner or later the flow of new money starts to have an impact on the value of the assets being financed. But it takes time for people in the market to become fully aware of that impact.

Let's think about an example, going back about a decade to the tech bubble. Technology is a very important concept in economics, because when a market sees a huge technological advance, the dynamics change. That's why the tech bubble was so hard to see. The Internet had appeared to have harnessed technology and created an incredible amount of potential new wealth. But a lot of that presumed value turned out worthless: not every dot-com was a pot of gold.

In that case, it's easy to see how investors got fooled. The Internet phenomenon was new, exciting, and had enormous potential. Indeed, it was profitable in the long run -- just not as profitable as tech stocks had reflected at the market's peak. There was uncertainty in the value of the associated assets, and the market got it wrong. Incomplete information paired with exuberance can create bubbles.

But it's hard to see how you can blame the same sort of situation on the housing bubble. There was no new technology. The market understood real estate. It had a hundred years of data to look at. Subprime lending wasn't new, but it had previously been a niche business and not a mainstream cash cow. It made no sense to imagine that wacky subprime mortgage products like option adjustable-rate mortgages would work out. Those borrowers didn't have the income to support the resets. But despite all evidence to the contrary, the bubble inflated anyway.

Unlike with the tech bubble, the housing bubble wasn't missed: it was largely ignored. The market disregarded conventional wisdom. Everyone began claiming historically unprecedented appreciation in real estate was a new normal. They fooled themselves and everybody else. And even if, deep down, some did worry that the housing market was a ticking-time bomb, they ignored that nagging voice because they wanted their share of the profits as the bubble expanded.

While some bubbles are missed, others are ignored. The former situation is unavoidable, and regrettable. The latter, however, is a major problem for economics. Think about the situation from an investor standpoint. You don't want to miss out on big profits, which could go on for some time before the market crumbles. And if you get the timing right, you might be able to get out early enough that you're still ahead of the game. So there aren't enough contrarians bold enough to try to reverse the bubble before it grows too large.

Consequently, bubbles are a problem that you really can't fix. As history has shown, the market isn't going to prevent their inflation. Politics, uncertainty, and mere logisticsĀ hold back regulators from letting out their air before they get out of hand.

Going forward we have to assume that bubbles are unavoidable features of markets. But so are economic cycles -- and that's okay! Things didn't go so badly when the real estate bubble popped because there was an asset bubble: it was because the financial system itself was so screwed up. As Posner suggests, the real estate bubble became bigger than an asset bubble normally would due to hidden leverage on Wall Street and government subsidization of the mortgage industry. And its fallout was so severe due to too much interconnectedness and complexity.

So it's not always the surprise of a bubble that's a problem, but also the market's willingness to embrace it. But either way, Posner is right that we have to reshape the financial system to better limit a bubble's growth and more easily sustain its pop.