Sunday, July 8, 2012

Uncertainty, bubbles and business cycles

This is based on a comments I made here and here.

I don't believe the "Greenspan caused the housing bubble" argument, as it depended where you were in the US whether there was a housing (land) bubble and the US economy was not seriously hitting capacity limits prior to the Fed-caused NGDP crash.  But that asset prices will tend to be strong if people have strong income expectations, that I believe.  (Why this is regarded as a bad thing is a bit of a mystery.)  That technological innovation causes asset-price volatility (pdf) makes perfect sense too.

If folk are so worried about housing (land) bubbles, perhaps they should look at the supply constraints that are clearly a necessary element. But too many folk want the supply constraints, because it keeps the price of their housing land up.

But we cannot abolish uncertainty (see above about technological innovation to start with), or that how people frame uncertainty (what Keynes called "animal spirits") will be unstable because it will be vulnerable to new information. What we can do is work on reducing supply-side constraints (Eurozone, I am looking at you also) and anchor people's income expectations so that uncertainty becoming negatively framed is less likely to occur across all markets--expectations being how we deal with lack of information (and there is no information from the future).

Of course, if one takes uncertainty seriously, the Austrian theory of the business cycle becomes much less plausible (but so does not thinking markets are stupid on the "fool me once, shame on you; fool me twice, shame on me; fool me again and again in the same way, I must be a real idiot" principle).

Also, surely the reason folk cannot find a definitive relationship between uncertainty and economic activity (beyond the effects of poor income expectations), is that uncertainty can be framed positively or negatively.  (Implicitly) assuming that uncertainty is always framed negatively seems an unwarranted assumption to me. For, if you do so, technological innovation is always bad, since it must raise uncertainty.  I prefer the view that technological innovation generates asset-price volatility, since it raises uncertainty.

If you frame uncertainty positively, you rate the risk of loss as being much less than the risk of gain.  The loss asymmetry (firms care more about avoiding losses than getting profits) lacks "bite".   If you frame uncertainty negatively, things are in reverse, and loss asymmetry has lots of "bite".

In a world without uncertainty, growth is at potential.  But there are also no profits.  We never live in a world without uncertainty. We do live in a world where uncertainty generates volatility because how it is framed shifts due to being vulnerable to new information (uncertainty being the area where information is insufficient to calculate risks). So, bubbles will happen, at least to some degree.

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