Saturday, January 23, 2010

Blowing Bubbles: everybody's wrong except me

Back in September I posted some of my Bubble Thoughts about the housing bubble pop which I had anticipated and the "resulting" crash which I had not, saying

Personally, I did see the bubble as such, earlier than some...I sent a message titled "Housing bubble warning" on June 5, 2003. Was I prescient? No, I was just quoting the Economist of that time...
I didn't mention (last September) that I'd become a semi-Sumnerite, a believer in much of the theorizing of Scott Sumner at The Money Illusion, who claims that
even a major misallocation of resources such as the housing boom of 2003-06 does not cause a big enough misallocation to create a recession. That’s why the initial downturn in housing was handled well, with only a minor bump in unemployment between mid-2006 and mid-2008. The big jump in unemployment more recently was caused by a sharp fall in NGDP, i.e. tight money.

I've come to believe him about that, to a large extent, so I owe both of them an intellectual debt of sorts. But today I think they're both wrong...well, also they're both right, and I think they both exaggerate the real differences between them. Sumner is saying in reference to the same article (I think) that I quoted,

Back in May 2003 The Economist said that many countries were in the midst of a housing bubble:
and that
in all 6 countries their predictions were wildly inaccurate for the 4 year time window they specified.
He really doesn't believe in bubbles. Or does he? As quoted above, he does believe in "a major misallocation of resources such as the housing boom." The Economist rebuts that they were giving "Good housing market advice", and that
the story The Economist was telling about what was happening was fundamentally correct

My current view is that the Economist was and is praiseworthily right to call "bubble", but the Economist of 2003 was mildly blameworthy in making the specific predictions it made (I didn't even take these seriously, remembering how "irrational exuberance" had gone on for years) and is mildly blameworthy now to evade the flat admission that anybody who believed those specific predictions and invested accordingly would have lost money. The 2010 Economist sounds like an astrologer or psychic claiming credit for being almost right, which is another way of saying wrong. But that doesn't mean bubbles don't exist; it just means that when markets are irrational it's really hard to outguess them (The market can stay irrational longer than you can stay solvent.) I mostly like Bill Woolsey's response:

I believe bubbles exist. Vernon Smith's experiments provide enough evidence for me. The basic problem is "momentum" traders. They buy into a rising market and sell into a falling market. They have naive expectations, projecting past price changes into the future.

Like Woolsey, I do think bubbles are real, like the Economist I think bubble-probability is worth thinking about from an investment standpoint.

I think Sumner could respond (and maybe has responded) that if you can detect this, then you're free to make money from it -- but I don't think that's an adequate response. I didn't and don't know any good way to bet that "I think this asset is priced above trend" apart from staying away from it: selling short doesn't work unless you have a time-frame in mind. I didn't believe the Economist's specific predictions, but I do think the Economist helped me (and my son) avoid losing money. We avoided investing in stuff which the Economist (and then Shiller) had suggested was risky. Shiller does better, trying to invent financial instruments which I've interpreted as ways in which to make money from such information, so that the markets will in fact become more efficient. But they're far from perfect, and always will be.

Or maybe not?

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