Bernanke’s bubble laboratory

by on May 16, 2008 at 12:14 pm in Economics | Permalink

Manias can persist even though many smart people suspect a bubble,
because no one of them has the firepower to successfully attack it.
Only when skeptical investors act simultaneously — a moment impossible
to predict — does the bubble pop.

…Mr. Bernanke hired finance experts who had broad
interests and were eager to work with the university’s deepening bench
of theorists. He lured Dilip Abreu, known for work in game theory, back
from Yale, to which he had earlier defected. Making a virtue of an
institutional weakness, the absence of a business school, Princeton
assimilated the finance scholars into the economics department and
freed them to pursue research.

They are building on work done by the late Hyman
Minsky, whose once-ignored ideas about investing manias are now in
vogue, and the late economic historian Charles Kindleberger, whose 1978
"Manias, Panics and Crashes" is a classic. But compared with Mr. Minsky
or another student of bubbles, Yale’s Robert Shiller, the Princeton
trio focuses less on mass psychology than on mathematical models. These
they use to show how bubbles can be created even in markets that
include rational, calculating investors.

Here is the full story, interesting throughout.

1 John May 16, 2008 at 12:20 pm

I guess I didn’t know that Hayek was an efficient market theorist. I already sent an email to the author complaining.

“Under the Hayek view, bubbles don’t make sense. As soon as some group of traders irrationally pushes prices way up, more-rational traders should take advantage of the mispricing by selling — bringing prices back down.”

2 Noah May 16, 2008 at 1:03 pm

“Making a virtue of an institutional weakness, the absence of a business school, Princeton assimilated the finance scholars into the economics department and freed them to pursue research.”

I didn’t realize you can’t do research at a business school.

3 kebko May 16, 2008 at 1:23 pm

I wonder if there is a very large fudge factor in reality. As a practicing investor, I buy stocks that I think are mispriced by a factor of 2 to 20 times (priced at 5 – 50% of “intrinsic value”). To the extent that I earn excess gains, I am rationalizing the market. But, in reality, unless I am getting something with at least a 50% discount, I am not buying, so even when I’m correct, my activity doesn’t get the stock even close to a reasonable valuation. I have to depend on the corporation’s operations or on some change in the market to attract another type of investor who will come in & bid the stock up to my price.
I think, essentially, in order to make a bet that you are right & the entire rest of the market is wrong, a very bold statement, you have to demand a very high risk premium. So, I am investing because I think the risk premium that the market is demanding on certain stocks is way out of line, but I am adding my own risk premium that is a payment for betting on my own hubris that I know better than the market.
I wonder if this sort of calculus results in contrarians working against a bubble, but never really counteracting a large amount of its error until the bubble participants themselves change direction.

4 Johan Almenberg May 16, 2008 at 1:53 pm

“Because it’s so much harder to bet on prices going down than up, the bullish investors dominate.”

– is it really that hard to short stocks? To me this looks like an endogenous variable (lack of short selling) treated like an exogenous one.

5 Colin Danby May 16, 2008 at 2:06 pm

Can you give us a page reference, fundamentalist, for Kindleberger writing that “credit expansion is the likely cause of bubbles”?

6 Matt May 16, 2008 at 3:04 pm

Bubble need not occur with monetary expansion, but bubble can take liquidity from other sectors of the economy. The other sectors of the economy would depress their use of financing in favor of the economic sector that is bubbling.

7 fundamentalist May 16, 2008 at 5:28 pm

Colin, I can’t give a page reference because I read a library book and no longer have it. But it was in his last chapter, I believe, where he discussed the various theories for the causes of bubbles.

Nick: “…why do bubble investors, with too much money burning their pockets, tend to choose one kind of asset and neglect others?”

No, he didn’t. That’s a good question and I wish he had answered it. Of course, Pure Theory was published in 1941, so there weren’t as many options for speculation back then. Machlup has a good book (available at on the way that expanded credit goes to the stock market first, but that book is from the 30’s.

For the answer to that question, I think you have to go to financial experts. What little I have learned from them is that speculators tend to be contrarian. Real Estate and commodities were big in the 80’s, then collapsed, so in the 90’s they went for stocks. Before the stock market peaked in 2000, the big speculators had sold and were already into real estate and commodities. It’s usually the small and foreign investors who get stuck with collapsing markets, although many of the big ones (Bear Sterns) got hit in the real estate collapse recently, too. The big money tends to rotate between real estate, commodities and the stock market and it switches to whatever has been out of favor for a while. Kind of like value investing. Also, it seems to like innovative ideas. In the 80’s it was junk bonds. Recently it was mortgage-backed securities. Innovative financial instruments are hard to price and assess the risk, so people underestimate the risk and overestimate the profits. Speculators tend to be a very optimistic bunch.

8 Bill Stepp May 16, 2008 at 7:44 pm

I can say that Kindleberger’s 1982 _A Financial History of Western Europe_, (Oxford, 2nd ed.) which is at hand, goes over bubbles and crises in chapter 15 (264-280) with explicit reference to Minsky, and endorses (page 265) the Post Keynesian teaching that the money supply is endogenous. In that case it is logically impossible for an expansion of the money supply to cause a bubble.

The money supply is endogenous only under free banking.
Under central banking, open market operations expand and contract the monetary base; these operations wouldn’t exist in a free banking system.
Asset bubbles are caused by the kind of money and credit expansion that exists under central banking. Changes in money and credit in a free market are consistent with people’s time preferences, the natural rate of interest, and the supply and demand for investible resources. Unsustainable, systematic increases in money and credit are impossible under such a system.
The post-Keynesians are wrong on this, as was Minsky.
Can’t me as unimpressed by the Wall Street Journal article.

9 Bill Stepp May 16, 2008 at 9:10 pm


I’m not sure what you mean by “monopoly behavior in the financial industry.” Certainly commercial banks aren’t monopolies. The Fed has a monopoly of currency production in the U.S., if not of world currency production.
The ability of the Fed to cause the loan rate of interest charged by banks to sink below the natural rate of interest is a necessary condition for asset bubbles.
Under free banking, the money supply can’t vary much from that which is consistent with people’s time preferences. Economic shocks therefore can’t emanate from the monetary sphere.
In his book _The Theory of Free Banking_, pp. 104-5, George Selgin shows how such a shock is more or less inevitable when central monetary planners manipulate interest rates. Of course, interest rate targeting has been the official policy of the Fed since the 1980s.
Selgin’s book is one of the best books on money ever written.

10 Colin Danby May 16, 2008 at 11:03 pm

Thanks to rwe for an actual quotation from CPK, which you will notice is finely nuanced. I would caution that in a framework of money endogeneity, “fuel that allows the fire to spread” is not an apt metaphor.

CPK may be mistaken in his money endogeneity or his anti-monetarism. I’m not asking you all to agree with him, I’m just trying to avoid needlessly conflating him with positions he opposed.

Money endogeneity is one of those things that elicits dogmatism on both sides, so I don’t want to get embroiled. I would just say that there’s a range of institutional factors that may make money endogenous, and that it should also be recognized that in a particular place and time money may be endogenous for some actors and not others, a point I have written a little bit on.

Here’s one recent discussion with excellent references:

11 rwe May 16, 2008 at 11:47 pm

I forgot to give page numbers, but all of those quotes came from Chapter 4 as well, which is not that long. So anyone should be able to find them easily enough… I agree with Colin that Kindleberger’s ideas are quite nuanced. And his claims about the instability of credit have the ring of truth (especially in light of recent events in the credit markets).

12 nick May 17, 2008 at 3:15 pm

The scholars quoted in the original article sound like they are just engaging in a fancy form of technical analysis, which purports to capture in mathematics the psychology of the crowd, but in almost all cases turns out to be worthless numerology.

The fancy math doesn’t explain bubbles any better than Schiller’s simple driving analogy: there is a big event at an obscure location (let’s call it Burning Man, out in the middle of the desert somewhere). People driving to the event are very uncertain of the directions. At a certain intersection, on average 60% of them correctly believe they must turn right and 40% incorrectly believe they must turn left. But they can usually reduce their uncertainty by observing the behavior of others, who are somewhat more likely to be correct than wrong, and altering their Bayesian priors accordingly. Normally this works, but on rare occasions it goes wrong: for example, if the first three cars happen to turn left, the fourth, who had believed with 60% confidence that right was the proper direction, will rationally change his mind and go left. Thus a string of bad luck can make all the cars start going off in the wrong direction, except for those handful of drivers that are strongly confident in their knowledge that one should go right.

Where this analogy goes off the rails as public policy analysis is with the tacit hubris that certain academics from sufficiently elite schools are flying above the whole event in a helicopter and can direct traffic, if only their mathematical analysis is fancy enough. Rather academics and policy makers are in the traffic themselves, generally seeing information biased in ways similar to or even more extreme than the information investors see and act on. In many cases mispriced markets create arbitrage opportunities for truly knowledgeable investors, but analogs to such arbitrage opportunities, i.e. the ability to be rewarded for correctly actual misinformation, are much less prevalent in academic and political policy circles. We should thus expect political policy to be much more prone to biased political fads and herd-following than markets are. Both markets and governments may often take wrong directions, but for politics the inability to correct wrong directions may be endemic. Markets tend to correct themselves, usually in the short run and practically always in the long run, depending on the costs of arbitrage, but there is often no easy way to recognize or correct a political bubble.

Thus, applying the same rational uncertainty assumptions to politics as we do to markets, if we give political decisionmakers the power to “pop” bubbles they think they recognize, they will probably tend to make genuine market bubbles worse, will prevent markets from sending genuine supply and demand signals, and will introduce other extra transaction costs.

13 fundamentalist May 18, 2008 at 2:33 pm

More clearly, Keynesian and mainstream econ remove the problem of bubbles from the field and economics and deposit it in psychiatry. Austrian econ keeps it squarely within the field of economics. The mainstream approach to bubbles is abandoment of the question to another field of study.

14 nana May 14, 2009 at 9:38 pm

New technology is always given us surprising and life way changing.

15 peter May 14, 2009 at 9:39 pm

Every success is based on continuous efforts. It is not possible be done over nigh.

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