Sunday, January 24, 2010

Bubbles: going where angels fear to tread ...

There has been a lot of discussion about "bubbles" post the global financial crisis and the great recession. I believe bubbles exist: I believe that they are only clear in retrospect. (A useful discussion is on Scott Sumner's always worth reading blog.)

I believe bubbles are only clear in retrospect as an application of the efficient market hypothesis (EMH). If it was obvious prices were going to crash, people would not invest in ways which led to the price rises in the first place.

(BTW, like other things in economics, such as rational expectations, EMH needs a better name. It is really something like the "all-information-is-incorporated hypothesis" just as rational expectations is really consistent expectations. If they had more descriptive names, people would not misconstrue them so easily and there would be less argument about them.)

It is all very well to argue that people do know they are going to crash they just get their timing wrong, but that flatly does not work for the one area I have some detailed knowledge, which is housing bubbles. People invest so much of their wealth in them because they have become established as inflation-beating assets. People are not taking out decades-long mortgages and moving in because they "know" the prices are going to crash.

I also really dislike macro-explanations of housing bubbles which do not incorporate the micro-economics. Paul Krugman's moderately famous 2005 piece on Zoned Zone versus Flatland is correct. Housing bubbles are typically crucially on constrained supply of housing land, usually due to regulation of land use (i.e. zoning). Though there are exceptions: Ireland was a case of privately constrained housing land supply. While, at the peak of the Freddie Mac/Fannie Mae/Community Reinvestment Act madness in the US, there was clearly oversupply of housing in some housing markets not suffering constrained land supply. But generally, constrained land supply for housing is the key to housing bubbles.

Which is why some US housing markets had bubbles (notoriously California) and others did not (notoriously Texas). Internationally, Australia is all "Zoned Zone". Since Australia did not have (apart from the minor nonsense of the First Home Buyer's Grant) governments encouraging risky lending and our prudential regulation of financial markets worked, Australian housing prices have stayed up, apart from some adjustment in Sydney a few years ago.

Germany, on the other hand, is all "Flatland". The federal German constitution incorporates a "right to build". It is very hard for officials to stop people building what they want when they want [provided they follow the established laws: the discretionary power of officials is very limited and the tax system penalises local authorities who block movement into the locality]. The consequence is that German housing supply responds directly to German housing demand, so German house prices move at about the rate of inflation (less, when the substandard East German housing stock was added in after reunification).

New Zealand is "Zoned Zone" country. As an indication of how much zoning affects land prices, a study found that growth limits are elevating Auckland land prices:
… land just inside Auckland’s MUL, or growth limits, was valued at approximately 10 times land that is just outside the boundary.
Britain is also "Zoned Zone". Indeed, it was from Britain that Australia (and I presume New Zealand) "caught" zoning. The madness that is British housing prices follow directly from its zoning regulations (as the comparison with Germany shows quite clearly). Regarding zoning in the US, there is quite an enlightening paper on the economic history of zoning (pdf).

The point that one has to start with micro, not macro, explanations of housing bubbles comes quite clearly in this recent US Federal Reserve Chair Ben Bernanke speech, which reviews the evidence across a range of countries.

Part of what gets in the way of thinking about bubbles is that people often have some notion of "correct" prices. (Rajiv Sethi's piece I linked to above talks about that.) The notion of "correct" prices is a notion that is not able to be "cashed out" in advance. [There is a nice discussion here and another here.) If we could, it would be obvious that prices had "overshot" and people would not invest in ways which create the price rises in the first place. Certainly, prices can have long term trends and a surge in prices well above long term trends may make one suspicious. But long term trends also change.

In other words, if there was some reliable way of predicting bubbles, they would not occur.

All of which makes me sceptical about adding "bubble popping" to the task of central bankers. Trying to get them to attend to deal with things that are clear only in retrospect seems to me a policy nonsense.

This is not to say bubbles do not matter. They do. It is clear, particularly from the Australian Treasury's series on net private wealth, that Australia had a "bubble economy" during the mining boom of the late 1960s to early 1970s. Australian markets, particularly labour and financial markets, were highly regulated in a policy regime designed to suppress risk. Given the apparent lack of "downside" risk, the addition of mining income to a risk-suppressed economy led to a huge surge in share prices. After the mining bubble crashed in 1973, Australia had a "flat" economy for the next decade until economic reform got underway from 1983 onwards. A generation of economic reform has since led Australia to have one of the most flexible economies in the world, which has led it to be able to deal with the Asian Economic Crisis of 1997 and the more recent global difficulties relatively easily. (Though there is a respectable argument that monetary policy was Australia's big advantage in the recent downturn.)

Japan notoriously had a "bubble economy" which crashed spectacularly in 1991. It had highly regulated land and financial markets where downside risk was apparently suppressed. Australian journalist Peter Hartcher wrote some revealing analysis for The National Interest which he turned into a book. Since the collapse, Japan has had a "flat" economy where enormous amounts of "pump priming" have failed to restart serious economic growth.

Various commentators have made comparisons between Japan of the lost decade and the current situation, particularly in the US (Krugman does here, for example). Indeed, Federal Reserve Chair Ben Bernanke has consistently failed to do what American commentators (such as himself) told the Japanese they should do. I think it is fair to say that US policy should not be attempting what was tried and failed (again and again) in Japan.

So, that bubbles cannot be reliably identified in advance (indeed, one can happily identify pundits who failed to do so) means that they are only clear in retrospect. But that does not mean they do not occur (indeed, they occur because we do not know they are going to crash) and it certainly does not mean they are not a problem.

The solution? Get your micro economics right to start with. Do not regulate markets so as to give one-way bets. Do not (pdf) inject moral hazard with "too big to fail". Do not expect fiscal stimulus to work as any sort of [ongoing] solution. As for monetary policy? Perhaps Scott Sumner is right and it should simply target a set growth rate in NGDP (nominal GDP).

ADDENDA As a result of comments here, just to clarify, by 'bubble' I mean when asset prices surge and then collapse. Part of what has made housing prices surge is the belief that housing is an inflation-beating asset (otherwise more people would rent, as in Germany). So expectation of future rises is what drives the investment. Now, whether that expectation is well-grounded, or only grounded in the experience of rising prices, that is why bubbles are clear only in retrospect.

I have also amended the post to delete a sentence on the objectives of central banking which I now strongly disagree with. (It was only an aside, so does not change the argument at all.) I have also clarified how the German system operates.

FURTHER ADDENDA: I liked the comment here, about the EMH, that:
... when arguments have such structure, it is an indication that we are asking bad questions. Its similar to the Calvanist vs. Anabaptist debate in Protestant Christianity. They debated whether or not we have free will, when that isn't the real question. The real question is if we have responsibility or not.
In the same way EMH answers are bad question. The question shouldn't be "are markets efficient," the real question is "Can certain individuals given power consistently make better choices for a society than a market."
A friend who takes a generally "Austrian" line on economics also made the point about the EMH that Markets are dynamic. So they have pockets of disinformation and un-information. What government intervention typically does is to "stir the pot", creating a “fog of war” with regulation and intervention being “gamed”.

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