Regulating Bubbles

[Kurt_and_Hunter]

This may be a heresy, but it seems to me that the more efficient the market the more bubble-prone it is.

Bubbles are emergent phenomena built from a billion individual rational actions. Buying an asset in a bubble is quite rational. If you identify a bubble buy into it. In terms of where the asset will be tomorrow you will be right a lot more often than you will be wrong. (Unless you plan to buy-and-hold.)

We try to thwart bubbles by regulating the underlying causes, even though we are regulating something we do not understand.

All regulation prevents some good. It is quicker to drive from A to B at 75 MPH and the overwhelming majority of such journeys will be accident-free. Lowering the speed limit saves some lives at the cost of preventing a lot of safe speedy trips.

We have good reason to prefer to not restrain the economy. All regulation will prevent some growth, some innovation, some freedom somewhere.

We regulate when the benefit is so much greater than the cost it is demands some tinkering, even though we know we lack perfect understanding of the system.

I believe that bubbles will thwart most regulation aimed at root causes. Regulations exist to be circumvented.

To really prevent bubbles we would need big regulations so broad and impervious that they would, in my view, also inhibit a lot of good economic activity.

The best way to prevent bubbles with a minimum of collateral inhibition of growth and innovation is, in my view, to regulate bubbles directly, not by striking at perceived root causes.

We don't know exactly what makes a stock market go up 200% in months, like te NASDAQ did in 1999. Sometimes it is a bubble. Sometimes it is because someone just invented something like a room-temperature super-conductor that has immense implications for corporate profits going forward.

My solution? Rather than thinking we can prevent bubbles, let them happen and deflate them via taxation before the get too big.

If your stock portfolio goes up more than 50% in a year you pay a stiff extra tax on profits above 50%. For profits over 100% an even stiffer tax.

This would have stifled a little legitimate activity in the 1990s based on profit expectations in light of technological productivity increases. It would have stiflled a LOT of betting on Pets.Com.

Tax the bubble itself. The net result would have been much more benign.

This would be far more humane than raising everyone's interest rates on everything in a low inflation environment just to try to indirectly target Pats.Com.

Set targets that would be super dynamic growth and would seldom be exceeded except in a bubble. Real estate appreciating over 20%/year? Tax the difference. 20% is a lot of appreciation.

A 5-year medium term capital gains tax rate of 90% on gains from a home sale over 200% would take the wind out of a house flipping mania while allowing lots of profits.

You buy a house for $100K. Four year later you sell it for $250K. A surtax takes 90% of the profit over $200K. (In addition to normal taxes.)

You have nothing to cry about. You more than doubled your money in four years.

Bubbles are driven by dreams of the high end. Simply removing the possibility of WILD profits discourages all bubble-driven investment. A component of the bubble is that you might make a short-term 300%, 400%. And that expectation, albeit a long-shot expectation, is built into bubble pricing.

People bid a worthless company like Netscape up to $200 because there was some chance of it going to $500. If you know that you will profit handsomely from large moves but will not profit much more from insane mass-psychology moves that puts a ceiling on the bubble.

I see this as more economically benign than broader regulation aimed at what might happen. Why cool off the whole economy prophylacticly just to prevent some craziness? Outlaw only the craziness itself... specifically.

Facilitate growth and tax insanity.

[ieoeja]

1. There is precedence.

Following one of the big market crashes in the past three decades (forget which one) caused by computer generated trades going into an automated cascade, the gov't introduced a new mandate that the markets shut down automatically when there is too big a drop in too little a time. That gives traders time to think about whether they want to continue selling other people's stock for a loss.

And that rule has kicked in at least once since then.

You are essentially proposing to do the same thing with a bubble that the gov't has already mandated for the burst!

You would have to continually be on the lookout for new sources of bubbles to regulate. Possibly empower the Fed to do that so we don't have Republicans in Congress trying to thwart every new one that comes along.

[Kurt_and_Hunter]

2. The trading curbs put in after the crash of '87 restrained selling, though

My proposal would have prevented the last two months of the run-up to the 1987 blow-off by reducing the potential profitability of buying into the irrational rally.

You make a good point about the multiplicity of asset classes in which bubbles can arise, but a small bubble is of no import in any event. I have seen classic bubbles in the price of certain X-Men comics, for instance, but they posed no threat to the economy.

When billions and trillions are flowing somewhere it's not going to be missed.

The running around looking for problems is exactly what I am addressing. We cannot find all the problems, plug all the holes.

But we can reduce the incentive for folks to seek to exploit the situation just by reducing their profit expectations via taxation.

A sliding scale intensely progressive short-terms capital gains tax calculated based on money at risk, versus net profit as a sum, would do the trick.

[Zynx]

3. Rationality is a tricky term, but bubbles certainly aren't the products of efficient markets.

Efficient markets have near perfect information that is fully incorporated into market prices. That is clearly not the case in the tech bubble or the real estate bubble. Information on tech stocks was lousy in terms of their future earnings. The data was either woefully incomplete or heavily slanted by analysts. In the case of real estate, the "information" that people utilized in making their decisions about the long term performance of real estate as an asset class as well as realistic future price projections was similarly horribly flawed. What's more is that information in both cases was very asymmetric. Asymmetry in information among market participants precludes an efficient market.

In terms of rationality, it depends how you define it. In a pure micro-economic sense, yes it is rational that people speculate on asset prices that apparently will be 50% higher in two weeks. However, the market in general is overtaken by some kind of emotion that has clouded what would normally take place in a rational decision making process. Insane people are technically rational in that they are probably still doing what they think is in their own self-interest, but their perception of reality is horribly deficient. In a bubble, emotion and just out of control greed lead to behavior that does not conform to reason. As such, be careful when you say that the behavior in a bubble is rational. Rationality is a tricky term to define. If defined carefully, virtually everything is rational.

That said, I agree with your policy prescriptions.

[Kurt_and_Hunter]

4. Yes. And when you can day-trade what are fundamentals?

I went belly-up betting against the bubble in 1999 and learned a stern lesson...

the value of a stock is not the value of future profits of a corporation.

The real value of a stock is what you can sell it for tomorrow. (Or in five minutes...)

I generally agree with your comments about rationality which is why I take the view of regulating extraordinary price moves without having to establish their rationality.

Maybe your house went up 300% because it was just announced a subway stop will be built near it. Or maybe it went up 300% because your neighbors are crazy.

I don't think society needs to establish whether 300% is sensible or bubbly. Tax it either way.

Some "virtuous" people get hurt a little (hypothetical genius real-estate pickers, genius companies, etc.), but many more virtuous people get hurt a lot by these bubble collapses.

[Odin2005]

5. This is a great post! K&R