Over-thinking bubbles

[Kurt_and_Hunter]

I just read the housing section of Warren Buffet's Letter to Stockholders (http://www.berkshirehathaway.com/letters/2008ltr.pdf ) and it is full of sound observations about lending practices, regulation, buyer attitudes, etc., showing how we got into this mess.

But though all that stuff is true it's kind of side-ways to the problem.

Asset bubbles are not the product of wall street criminality, the collapse of the Calvinist work-ethic, going off the gold standard or sun-spot activity.

Bubbles are a natural state of markets following productivity increases or other sources of "free" growth. (Like exploiting the newly discovered Americas or railroads, radio, transistors and the internet) Bubbles are the macro expression of the intersection of free markets, novel economic growth and innate human psychology.

For centuries, for as long as we have had markets in future activity, bubbles arise, follow the same form, collapse in the same way, cause roughly the same havoc. And every time there are commissions and studies and new but backward-looking regulations that would have prevented the last bubble but may or may not prevent the next one.

Regulation can limit natural bubble formation but only at a cost to growth. I believe that bubbles are so damaging that sacrificing a fair amount of growth may be correct (this is hypothetical conceptual thing, no a specific policy proposal) in the very long term but it's obvious why that's a tough sell.

The search for scape-goats and "causes" is, IMO, less useful than it seems. "Unscrupulous" banks stretched sensible lending practices to loan Dutch people money against bubble-priced tulip bulbs. "Greedy" shipping companies drove up the price of shares in the South Sea Bubble. "Wicked" robber barons created the railroad bubbles. And so on... every bubble is the same, and each time people react (quite naturally) to find the witches and well-poisoners responsible. In the span of a life-time bubbles appear to be unique events demanding specific explanation. In the run of history, however, they are a standard, albeit disastrous, feature of a sophisticated economy.

And the one way to guarantee we keep having bubbles is to engage in the sort of ad hoc analysis we are engaging in. If we think that villainy is at the heart of these things then our corrective task is as simple as it is impossible: the moral perfection of humanity. That's not a useful economic program.

Greed and villainy are constants and probably essential features of a robust economy. Market actors are supposed to maximize gains using any legal tools at their disposal. This is why the idea of "responsible" corporations is asinine. A corporation is a mathematical input-output system, not a person. (Our laws notwithstanding.) Our corporate show trials make as much sense as trials for sharks or mud-slides.

It is the job of corporations to find ways around the intention of regulations. Ad hoc regulation will always be like whack-a-mole. Bubbles will find a way much like rain will "find" the hole in your roof.

It is possible that the only way to restrain bubbles is to not pretend to understand or out-think their malignant elements but rather to simply regulate against bubbles themselves.

If bubble happened a couple of times per decade we might be able to learn how to deal with them in narrow ways but they don't. Coincidence? Probably not. Bubbles are spaced out they way they are because we are able to deal with short-term stuff. (It's like why Ebola wasn't a big threat before air-travel. It kills the host too quickly to spread well.)

I believe the right course might be, as crazy as this sounds, targeting growth the way we target inflation. Set generous growth caps and restrain overly-strong growth regardless of whether it looks like good growth because it seems that the marketplace is adept at creating false growth in ways we keep missing, about once per generation. Accept that free lunches are, at very least, exceptionally rare. If we treat robust productivity driven "good" growth like inflation we will miss some growth but also avoid the bubbles that leveled the US economy many times in the last 100 years. (Adjusted for inflation the bear market of 1965-1982 was as deep as the stock market decline of the great depression.)

Just say: The problem is the bubble itself, not the thousand venal acts that led to it.

What if the capital gains tax on stock profits had been doubled in 1998? Not because someone was being bad, or because a government panel concluded the internet isn't all-that, but simply because such large and rapid increase in asset valuation has a terrible track record. "Warranted? Unwarranted? Who knows? But we do know that 90% of the time this kind of appreciation leads to utter disaster so we are not interested in arguing about the speciffic merits of this latest spasm."

Well, we might have missed some benign activity along the way but our current situation would probably not have arisen. (Tax policy targeting the specific area of "growth" which was stock prices would be more useful and humane than raising interest rates to slow down the entire economy.)

Of course, any society that bubble-proofs itself would have lower growth in many years. 90% of missed growth will be illusory and dangerous, but it will look like real growth at the time. So a nation that allows bubbles will put incredible competitive pressure on its neighbors. The fact that the fast-growing economy will collapse at some point this generation (and that people should not feed capital into that unstable economy without huge interest rates that off-set the true systemic risk) will not be persuasive to people who, quite naturally, wants gains TODAY. So this is probably as impossible as any other approach. But it's still worth talking about.

This chart is tangential to the OP but it's so interesting I wanted to post it somewhere:

[phantom power]

1. He's right, but he's still wrong.

He's wrong because Wall St specifically dismantled existing regs that prevented them from doing certain stupid things that we had already learned were stupid from previous experience.

He is right that business will generally try to find ways around any given set of regs, even if they are on the books.

[Kurt_and_Hunter]

2. Dismantling regulatory schemes is part of the evasion effort

You cannot separate the two.

Propaganda, lobbying and seeking to elect compliant leaders is as much a part of the natural regulatory evasion process as taking advantage of tax loopholes.

Of course they will seek to dismantle regulations.

And they would try to raise any broad appreciation cap mechanism in congress every year as well. But simpler/broader regulation may be easier to defend. A web of regulation is only as strong as it's weakest strand so scatter shot regulation offers thousands of targets, any one of which can, if undone, provide the gap through which delusional appreciation can flow into the overall market. Thus my suggestion, offered only as a basis for discussion, that there may be some sense to targeting effects rather than presumed causes. It is all but impossible to identify every cause but the effect is an overt target.

[fasttense]

3. Ahhh, the "free" market solution to bubbles.

I say this is nothing but BS.

"Greed and villainy are constants and probably essential features of a robust economy."

"It is the job of corporations to find ways around the intention of regulations."

Corporation are not unthinking, dispassionate beasts. They are run by people, sometimes greedy nasty little people, and sometimes by people with a sense of right and wrong. Corporation can and have been made to do the bidding of society (with or without bubbles), or society can do the bidding of the corporations. When gubermint holds hands with corporations and let them do whatever very, stupid things their owners allow, then you get fascism. And that is exactly what we got with the bush.

Really, really, big bubbles seem to have a habit of bursting whenever the US plays at Laize-faire, "free" market, or neoliberal capitalism under Republicon rule. It's A OK for businessmen and fanciers to cheat and swindle (heh, heh, we'll look the other way). But don't let the average Joe steal your car or smoke dope, that's bad, we'll lock you up for that. But a con job by senators and bankers, no problem. Bernie Madoff it's only $50 billion (or so), gets to spend time in his luxurious penthouse apartment while you and I ge real jail time. Because for some magical, mystical reason, businessmen who lie, cheat and steal while working with corrupt government officials is just the Republicon way.

[Kurt_and_Hunter]

5. Reading the OP might make your analysis of the OP more germane

If there was a contest to pick the most opposite possible title for the OP it would be, "A Free-market approach to bubbles."

The conceptual proposal laid out in the OP is the biggest government, least laissez-faire, most draconian approach to bubbles possible short of total state control of the economy.

Larry Kudlow would punch me in the mouth just for writing it.

[pinto]

4. 'Though I didn't understand half of it, at best, Buffet's letter to the shareholders is a good read.

I like his observation on how to guarantee government assistance - fail *big time*.

Massive failures get government attention, small time failures just fail.

[asphalt.jungle]

6. "If bubble happened a couple of times per decade"

"If bubble happened a couple of times per decade we might be able to learn how to deal with them in narrow ways but they don't."

look at the chart ... tech and this current bubble. just five years in between the end of one and the beginning of another.

[Kurt_and_Hunter]

7. They are the same bubble

The chart is of stock market sell-offs so it's appropriate to separate the two as particular stock market moves, but I wouldn't show it that way. The internet and housing bubbles are facets of one huge 1997-2007 asset bubble. (As was the oil bubble and food bubble.... we've had tens years of crazy gains in one thing after another as all the fake stock-bubble money thrashes around trying to stay alive.)

Had the stock bubble actually collapsed in 2000-2001 we would have had 10% unemployment and -6% GDP years ago. It actually just corrected, selling off down to a "bottom" that was still crazy-high while moving some bubble money in an orderly fashion from stocks to housing, and then went right back up.

A unique feature of the internet bubble sell-off is that it's the smoothest, slowest sell-off on the chart--no crash. There was no rush for the exits... no day when 5 trillion dollars simply vanished, which there should have been.

Then 9/11 made a fake crash which allowed a fake sense of capitulation and provided the take-off point for the S&P to go back to the same $$$ level as 1999. (Though a little lower adjusted for inflation.)

A sudden crash destroys money before anyone can get it out to put into something else. You can see how orderly the internet sell-off was compared to today or 1929. (In the current move we have lost more money is half the time)

The 200-2001 correction was more like unloading bales of money from a sinking ship and loading them onto another ship, Housing, then patching the sinking ship and moving half the counterfeit money back into the stock market. Only today are all ships sinking and taking that fake money to the bottom.

(Since all asset classes are sinking the jig is up... there is no seaworthy boat to load the money onto.)

[TahitiNut]

8. I disagree in a couple of points.

I regard a "bubble" as inflation ... too much cash chasing too few values. From the equities 'bubble' in the late 90s to the housing 'bubble' in the 2000s, we have an economy tilted towards the top 1% where wealth is "trickling up" and poverty is "trickling down."

We have an economy tilted towards populist consumerism ... and not infrastructure (like China) nor leisure time (like Western Europe). What we call "investment" is really a casino in secondary market equities -- Greater Fool Theory redistribution of wealth. The "corporate engines" of the economy are syphoning off 20% of the wealth created by labor for the management and ownership class ... and NOT in compensating labor. (By my estimate, the working class is currently only receiving about 1/4th of the value its labor.) IMHO, American labor is long past due in receiving compensation in terms of Quality of Life -- national health care, 36-hour work week, 6 weeks of paid time off.

Government has starved the infrastructure ... through privatization and failure of investment. Cable (communications) SHOULD be a municipal facility -- fiber to the curb. Instead, it's privatized and over-priced and under-facilitated. Levees, dams, roads, rail, mass transit ... all are starved of investment. Why? Because of the "casino-style" get-rich-quick-without-creating-value attitudes of our culture.

[Kurt_and_Hunter]

9. I don't see the disagreement

I read your reply without substantial disagreement so we are probably saying similar things in different ways.

The top driver of systemic inflation is wages, not commodities or assets.

Our post-1982 low-inflation economy is weak on jobs and weak on wages. We have bought low inflation by preventing full-employment type tight labor markets.

Asset bubbles involve stealth inflation. As long as asset inflation can be segregated from commodities and wages an asset bubble can roar away without ever triggering the reigning-in mechanisms we have for conventional inflation. And that is not a coincidence. Of course bubbles can only develop if they evade our inflation-control mechanisms so that's the form they take.

So the idea I am putting forward is accepting that the market is far to clever at disguising inflation and speculation as "growth" to out-guess it. We cannot hope to distinguish 'good' growth and malignant growth on the fly, so regulate bubbles themselves, rather than their causes which are a moving target.

"We cannot say for sure whether this is inflation or growth so we have to, in simple self-defense, not take chances. We will treat any run-away phenomenon as a bubble rather than fretting about the quasi-religious arguments about how it would be the end of the world for the government to ever restrain supposedly 'good' growth. The damage done by bubbles is fifty times the harm of missing/slowing a little tech-driven productivity so we treat any run-away price action in any asset with skepticism."

The fed and/or congress should have brought the hammer down on the stock market at least by fall, 1998.

Instead, in October 1998 we had a dramatic short-term dip brought on by a financial crisis in Asia and one week after the market started back up Greenspan cut interest rates!!!... in the middle of a bubble.

It was a much needed correction and sign of the sort of problems that would arise going forward and should have been accepted as a welcome relief from runaway stock prices, but Greenspan cut rates... incredible.

Actually capping a market is crazy because the bubble will flow around the cap, chasing other assets or inventing whole new asset class (like credit-swap derivatives, for instance).

So I would use taxation as a cap... "You guys can party on if you want but the government is going to rake more and more money at the casino until this becomes too unattractive."