Experimental economics and financial-market bubbles | Business

Alex Tabarrok offers a handy summing-up of what experimental economics has taught us about bubbles:

In the lab we can create artificial assets with known dividend streams and thus known fundamental values. Since Vernon Smith’s classic experiments (JSTOR), we know that even in these cases efficient markets fail and bubbles are common. … Circuit breakers and brokerage fees (transaction taxes), for example, don’t do much to stop bubbles (see King, Smith, Williams, and Van Boening 1993, not online.) Investor education doesn’t help (for example telling participants about previous bubbles doesn’t help). Even increasing interest rates doesn’t do much to stop a bubble already in progress and may increase volatility on net.

Futures markets (JSTOR) and short selling do tend to dampen but not eliminate bubbles, thus, there is a case for expanding futures markets in housing and making short selling easier (not harder!).

Bubbles are also less common with more experienced traders – this is one of the strongest findings. Don’t get too excited about this, however, it’s experience with bubbles that counts not just trading experience.

Now, as Tabarrok points out, we’ve all got lots of experience with bubbles. Yay for us.

Stocks Rally Further in Run-up to EU Summit

MOSCOW — Global stocks enjoyed one of their best days in weeks on Tuesday ahead of a summit of European leaders that’s expected to be dominated by calls to boost economic growth.

Europe remains the focus of attention across all financial markets in the run-up to the June 17 Greek election that could go a long way to determining the country’s membership of the euro as well as the future of the single currency zone.

donthelibertariandemocrat

http://www.dallasfed.org/research/ei/ei0501.html

“In his book 100% Money, Fisher begins by setting himself the following small task:
Designed to keep checking banks 100% liquid; to prevent inflation and deflation; largely to cure or prevent depressions; and to wipe out much of the National Debt.

In this book, produced during the middle of the Great Depression, Fisher endorsed the so-called Chicago Plan put forward by leading economists at the University of Chicago. The plan included 100 percent bank reserves, and Fisher endorsed it because he believed the system in place before 1935 had been far too unstable. He writes here about the 1920s but could just as well be predicting the late 1990s:

The over-indebtedness hitherto presupposed must have had its starters. Over-indebtedness may be started by many causes, of which the most common appears to be new opportunities to invest at a big prospective profit, as compared with ordinary profits and interest. Such new opportunities occur through new inventions, new industries, development of new resources, opening of new lands or new markets. When the rate of profit is expected to be far greater than the rate of interest, we have the chief cause of over-borrowing. When an investor thinks he can make over 100 per cent per annum by borrowing at 6 per cent, he will be tempted to borrow, and to invest or speculate with borrowed money. This was a prime cause leading to the over-indebtedness of 1929. Inventions and technological improvements created wonderful investment opportunities, and so caused big debts….

When the starter consists of new opportunities to make unusually profitable investments, the bubble of debt, especially bank loans, tends to be blown bigger and faster than when the starter is some great misfortune, like an earthquake causing merely non-productive debts….

The public psychology of going into debt for gain passes through at least four more or less distinct phases: (a) the lure of big prospective profits in the form of dividends, i.e. income in the future; (b) the hope of selling at a profit, and realizing a capital gain in the immediate future; (c) the vogue of reckless promotions, taking advantage of the habituation of the public to great expectations; (d) the development of downright fraud, imposing on a public which had grown credulous and gullible.

When it is too late, the dupes discover scandals like the Hatry and Kreuger scandals. At least one book has been written to prove that crises are due to frauds of clever promoters. But these frauds could seldom, if ever, have become so great without the original starters of genuine opportunities to invest lucratively. There is probably always a very real basis for the “new era” psychology before it runs away with its victims.

—100% Money, 130–32 (original emphasis)”

We might want to look at this plan.
pneogy

“If an asset is worth $10 in expected value then it’s worth $10 whether you have $20 in your pocket or $200. But in practice bubbles are bigger when cash relative to asset value is high.”

If that is true in experimental economics, think how much more force excess cash has in producing bubbles in real world economies. Didn’t you find a strong correlation between periods of high income inequality (that is periods in which well-off investors have excess cash to start an asset buying binge) and asset bubbles?
skepticalmax

Futures markets (JSTOR) and short selling do tend to dampen but not eliminate bubbles, thus, there is a case for expanding futures markets in housing and making short selling easier (not harder!).

Hmm … I wonder whether it is legitimate to generalize from this to the real world. In an experiment one knows the experiment will end sooner or later. There really is no long run.

During a real bubble betting on prices correcting in the future can be very risky. The bubble can last for much longer than one anticipates. It is usually a much safer bet to go with the herd.