Bubbles are caused by asset prices crashes, just as mountains are caused by valleys

Start with a flat plain.  How could you get a bunch of steep mountains?  One way would be to pile rocks up in some areas, but not others.  Another approach would be to cut deep valleys, such as those created by the famous four parallel rivers slicing through the East Tibetan plateau.  (Well they’re not famous, but they ought to be.)

Pretend the DJIA rose smoothly and steadily for 100 years.  Assume the level is theoretically “appropriate.”  How could you get bubbles?  One approach would be to have stocks occasionally rise far above their theoretically appropriate level. That’s probably how most people envision bubbles. Another would be for stocks to occasionally plunge far below fair market value. Then the “normal” looks like a bubble. I believe that if the EMH is not true, the latter is actually the most likely cause of bubbles.  Risk adjusted stock returns have been way too high for the past 100 years, according to standard finance models.  This implies stocks are only valued fairly at peaks like 1929 and 2000, and are otherwise greatly under-priced.

So we have have stock “bubbles” for the same reason the Tibet/Sichuan border area has lots of mountains—deep valleys have been cut in the appropriate stock price path.

TravisV recently asked me an interesting question:

At the AEI event with Avent and Pethokoukis, you suggested as an aside that there is an association between volatile NGDP and asset price bubbles. Could you please clarify that reasoning? I don’t see the connection, given that NGDP was very volatile during the 1970″²s and there weren’t any major asset price bubbles.

I see his point, but I think people tend to focus too much on the big rise in prices during a “bubble” and forget that the big fall is equally important.  If prices rise and stay high, as with San Francisco or Manhattan housing, then people eventually stop thinking of it as a bubble, and start thinking that it’s “normal” that housing would be expensive in highly desirable areas like San Francisco or Manhattan.

The 1920s and the Great Moderation both saw relatively stable NGDP growth. So why the big bubbles?  Because NGDP growth crashed in 1929-30 and 2008-09. In 2008-09 NGDP growth slowed by 9% relative to trend, nothing like that happened in the 1970s.  It was the crash that (partly) created the bubble.  Without the crashes, we wouldn’t even be talking about the great stock bubble of 1929, or the great housing bubble of 2006.  I don’t hear people talking about the Australian housing bubble of 2006.

Keep in mind I am not claiming any sort of deterministic relationship between NGDP instability and bubbles.  Merely that asset prices are more likely to be unstable when NGDP is highly unstable.  And people see bubbles when asset prices are highly unstable.  Certainly there are other factors at work during the 1970s—such as the fact that rising trend rates of inflation can depress real equity prices.  This is one reason the 1970s inflation showed up in gold prices rather than stock prices.

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47 Responses to “Bubbles are caused by asset prices crashes, just as mountains are caused by valleys”

  1. Gravatar of Morgan Warstler Morgan Warstler
    27. March 2013 at 11:57

    Assume we have 20 yrs of NGDPLT at 4.5%, where the Fed has basically been Chuck Norris, a series of early doubters got their asses handed to them, and over time, everybody lives as certain of fed determination at 4.5% NGDP as they are of taxes and death.

    Every month like clock work, the Fed is moving the ship wheel a little to right of left but always at the near term 4.5%.

    Here’s my question:

    What exactly is still a shock?

    Say the largest Natural gas reserve in recorded history is found off the coast of Florida.

    How does that shock?

    We’ve had 20 years of deflationary price pressures from technology gains, we’ve seen the cost of college and private school tumble because of video coursework online, we’re stopped owning cars – see the sharing economy and robots. Most or the productive class in the top 20% works from home.

    Meaning IF the fed is actually successful at this, doesn’t that mean that over time, they have proven shocks are not shocks?

    I know economists say “assume a shock” and then blah blah blah, look at my graph.

    But if a game strategy beats shock X, and then shock 3x and then shock 7x…

    Isn’t the headline “NGDPLT: 90% less shocks!”

    I have another point, but I want to make sure this is right.

  2. Gravatar of southofthe49th southofthe49th
    27. March 2013 at 12:02

    This is exactly why monetary policy should focus on broad aggregates (NGDP) and not bubbles in particular sectors. If we are concerned about housing or tulips we need to use macroprudential policy.

  3. Gravatar of Doug M Doug M
    27. March 2013 at 12:20

    “Mountains are caused by valleys” is geologically false. The grand canyon is not a mountain. However, it may be a suitable metaphor.

    “Risk adjusted stock returns have been way too high for the past 100 years.”

    No they haven’t. Risk-adjusted stock returns run way behind risk adjusted bond returns. Kelly Criterion says that expected excess return over expected variance should always be greater than one. Historical excess returns over historical variance for the equity markets is very near one.

    “How could you get bubbles? One approach would be to have stocks occasionally rise far above their theoretically appropriate level. That’s probably how most people envision bubbles. Another would be for stocks to occasionally plunge far below fair market value.”

    This would suggest that the EMH is invalid. It is still possible to get bubbles without invalidating the EMH.

    Suppose that we say that the value of equities is derived from potential future earnings discounted by the cost of money and risk. However, equity valuations themselves alter perceptions of future earnings and perceptions of risk. AAPL’s rising stock price begets buzz about AAPL’s products. And steady to rising prices, encourage investors to lever to buy more stock (Minsky).

    There is a feedback loop rising prices lead to rising prices. This cycle can continue until it doesn’t. A small change in perceptions leads to a large change in valuation. The market can bubble and crash, with the level rational at both extremes, and the market maintaining efficiency.
    “How could you get bubbles? One approach would be to have stocks occasionally rise far above their theoretically appropriate level. That’s probably how most people envision bubbles. Another would be for stocks to occasionally plunge far below fair market value.”

    This would suggest that the EMH is invalid. It is still possible to get bubbles without invalidating the EMH.

    Suppose that we say that the value of equities is derived from potential future earnings dicounted by the cost of money and risk. However, equity valuations themselves alter perceptions of future earnings and perceptions of risk. AAPL’s rising stock price begets buzz about AAPL’s products. And steady to rising prices, encourage investors to lever to buy more stock (Minsky).

    There is a feedback loop rising prices lead to rising prices. This cycle can continue until it doesn’t. A small change in preceptions leads to a large change in valuation. The mareket can bubble and crash, with the level rational at both extremes, and the market maintaining efficiency.

  4. Gravatar of Doug M Doug M
    27. March 2013 at 12:21

    Sorry for the double post there, some sort of copy/paste error.

  5. Gravatar of Geoff Geoff
    27. March 2013 at 12:50

    Bubbles have to be understood in real terms and nominal terms, not just in nominal terms.

    If we just considered “monetary shocks”, then there would be a lack of explanation for why central banks repeatedly find themselves in a position where they have to suddenly act more than usual to prevent falling AD. In other words, a lack of an explanation for why cash preferences throughout the market suddenly rise at the same time, that would seem to necessitate more central bank activity in order to offset the fall in AD that otherwise would take place, given that the Fed isn’t destroying money.

    If we just considered “real shocks”, then there would be a lack of explanation for why investors repeatedly find themselves in a position where there is a shortage of sufficient real resources that would make the prices of capital low enough to enable profits to be earned on existing investments. In other words, there would be a lack of explanation for why investments throughout the market suddenly become in need of real capital that does not exist, given that investors aren’t destroying real capital.

    Each factor is the missing explanation of other factor. The nominal shocks are the missing explanation for why real shocks occur, and the real shocks are the missing explanation for why nominal shocks occur.

    Market forces work at regulating the expansions of private industries because of the profit and loss brought about by the market process itself. If an industry is monopolized and immune from profit and loss, then the communication signals between that industry and all other industries become jammed. It doesn’t matter what specific industry is monopolized when it comes to signal jamming. Protection and security services, which are typically viewed as provinces of the state, are not immune from this. Money is also not immune from this.

    Without those profit and loss signals, there is no possible way for the issuer of said good or service to know if it is expanding too much or too little, relative to the plans of those market participants who utilize said good or service. Everyone uses resources out of the same total resource pool. Each individual can only know if its expansion of resource usage is justified, if it is acting within the confines of market profit and loss.

    So we can see why nominal shocks and real shocks are related phenomena, and why explanations of bubbles must include both. There is no such thing as a non-market monetary “rule” that can avoid problems between money and real goods. There is no such thing as a non-market production “rule” that can avoid problems between money and real goods.

    It’s not enough that we say “The recession occurred because AD fell.” We have to find out the causes for why AD fell, and that requires real side analysis. It’s also not enough to say “The recession occurred because AS fell.” We have to find out why the causes for AS fell, and that requires nominal side analysis.

  6. Gravatar of Geoff Geoff
    27. March 2013 at 12:51

    Dr. Sumner:

    “The 1920s and the Great Moderation both saw relatively stable NGDP growth. So why the big bubbles? Because NGDP growth crashed in 1929-30 and 2008-09. In 2008-09 NGDP growth slowed by 9% relative to trend, nothing like that happened in the 1970s. It was the crash that (partly) created the bubble. Without the crashes, we wouldn’t even be talking about the great stock bubble of 1929, or the great housing bubble of 2006. I don’t hear people talking about the Australian housing bubble of 2006.”

    You aren’t setting up a fair game with this comment, Dr. Sumner. For even if people DID talk about US housing bubbles pre-2007, and even if people DID talk about Australian bubbles now, you would dismiss that talk as rubbish, pseudo-scientific “predictions” that can never be wrong, in violation of EMH, etc.

    There were people talking about a US housing bubble pre-2007. Still nonsense, because bad subsequent (and avoidable) Fed policy “proved” them right? That would seem to imply that the right inflation can stop bubbles, because it can (allegedly) stop the crashes that reveal said bubbles.

    That is a Keynesian claim, dressed up in new garb:

    “Thus the remedy for the boom is not a higher rate of interest but a lower rate of interest! For that may enable the so-called boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.” – Keynes, The General Theory.

    Permanent boom! Inflation is the new normal. Busts are not any objective price to pay. They are avoidable errors from stingy/ignorant/malicious central bankers.

    Nothing can go wrong with this thinking.

  7. Gravatar of Links for March 27, 2013 | AEIdeas Links for March 27, 2013 | AEIdeas
    27. March 2013 at 12:54

    […] “We have have stock “bubbles” for the same reason the Tibet/Sichuan border area has lots … – The Money Illusion […]

  8. Gravatar of Geoff Geoff
    27. March 2013 at 12:58

    Doug M:

    The mountain analogy was not a positive claim that valleys cause mountains. It was a claim that bubbles are caused by asset price crashes LIKE mountains are caused by valleys.

    It’s like someone saying “One of Dr. Sumner’s readers understands his arguments like a pigeon understands chess”, and then you say “False, pigeons don’t understand chess.”

    Now, the “standard finance models” Dr. Sumner was referring to, that holds risk adjusted stock returns are theoretically “too high” is in fact correct, meaning that’s what standard finance really holds. It’s known as “the equity premium puzzle.” I suggest you look it up.

    Your rejection of this just means you aren’t privy to “standard finance models.” Dr. Sumner isn’t wrong for saying standard models hold stock returns to be “too high.” Whether or not it’s true is another issue.

    Also, he didn’t argue that stock returns are higher than bond returns, which is not even true anyway. Over 100 years of data, risk adjusted stock returns have exceeded risk adjusted bond returns by a few percentage points. Again, the “puzzle” alluded to above.

    I don’t often agree with Dr. Sumner either, but you got to get his arguments right.

  9. Gravatar of John Hall John Hall
    27. March 2013 at 12:59

    I have long been dissatisfied with bubble thinking. It all comes back to the notion of a just or objective price, which is non-sense. I’m much more comfortable with quantitative statements about the expected distributions of prices in the future than I am about qualitative determinations of whether some asset is in a bubble. Saying something is a bubble isn’t actionable advice for investors.

    More practically, the argument about bubbles is usually about contrasting stock prices with some measure of fundamentals, e.g. that there is a relationship between earnings and stock prices or rents and home prices. The bubble argument isn’t simply about rising prices or the following crash, it is about prices rising more than fundamentals support and then reverting. In this sense, it is possible to estimate vector autoregressions (and other more sophisticated techniques) and predict their distributions in the future (the difficulty is when you don’t have sufficient data to know what grounds fundamental prices, like forecasting tulip prices in Holland before tulipmania burst).

    That being said, what would it mean to say that NGDP is in a bubble. That implies that it is far away from some fundamental value, but NGDP is a flow, not a stock variable. If you had some variable that represented the discounted value of future NGDP, then that could have a bubble or not.

  10. Gravatar of Fed Up Fed Up
    27. March 2013 at 13:13

    “The 1920s and the Great Moderation both saw relatively stable NGDP growth. So why the big bubbles?”

    Debt levels. When debt is used to prevent price deflation or to prevent NGDP deflation, there is probably an “imbalance” buidling up. Debt levels are a MOA/MOE problem.

  11. Gravatar of Geoff Geoff
    27. March 2013 at 13:13

    Johgn Hall:

    “I have long been dissatisfied with bubble thinking. It all comes back to the notion of a just or objective price, which is non-sense.”

    Not if you understand bubbles in real terms. Then bubbles can be understood in objective terms. E.g. A house builder is building a home that requires 50,000 bricks, but he only has 40,000 on hand, but he doesn’t know it. This is an objective problem, not just an opinion.

    Relating this to prices, we can say that the nominal demand he is putting forth for the bricks, is different from what he otherwise would have put forth, had he known how many bricks he was buying. Thus we can say that the prices he is paying are objectively “wrong”, given his subjective plans. If he realized his error in brick inventory, he would agree that he put forth the “wrong” demand for the bricks.

    You are dissatisfied with bubble thinking, because you are trying to rationally conceive of bubbles in monetary terms only, which is impossible to do.

  12. Gravatar of Fed Up Fed Up
    27. March 2013 at 13:32

    “I don’t see the connection, given that NGDP was very volatile during the 1970″²s and there weren’t any major asset price bubbles.”

    One of the few things geekspeak (greenspan) gets right. Asset price bubbles tend not to happen with high interest rates.

  13. Gravatar of John John
    27. March 2013 at 13:38

    You can’t quantify expected risk or expected return. All you can do is look at the past and spin a bunch of numbers out of it. However, the future is not going to be the same as the past. They couldn’t foresee the Great Depression in 1928 because it hadn’t happened before just like the finance quants couldn’t see what happened in 07-09 because nothing like that had ever happened before.

    EMH tells us that markets move randomly and what moves randomly is almost by definition not predictable by looking at the past. That’s where the finance theories fail. Just because stocks delivered 6.6% real returns over the past 200 years says nothing about their returns over the next 1, 10, or 100 years. All you can really say is that they are likely to have a better return than bonds because of the greater amount of risk assumed.

  14. Gravatar of W. Peden W. Peden
    27. March 2013 at 13:51

    The UK tightens monetary policy:

    http://www.bbc.co.uk/news/business-21948429

    I think that the key causal factors behind the squeeze on the UK money supply (which began in late 2010 for non-financial businesses and early 2010 for households) are (1) the Eurozone and (2) bank recapitalisation.

    At a time when, to stabilise NGDP in the face of the Eurozone crisis, the UK needed offsetting measures, we’ve instead had a policy-induced credit squeeze as banks have shrunk their deposit liabilities to the general public.

    And things are just starting to look positive for the UK-

    http://www.bankofengland.co.uk/statistics/PublishingImages/fm4/2013/Jan/chart3.GIF

  15. Gravatar of Doug M Doug M
    27. March 2013 at 14:08

    “Over 100 years of data, risk adjusted stock returns have exceeded risk adjusted bond returns by a few percentage points.”

    Alas, I don’t have 100 years of data at my fingertips.

    Over the last 40 years, stocks have outperformed bonds by about a 2.5 percent / year. However, this has come with 3 times the volatility. The Sharpe Ratio for bonds is nearly double than what it is for stocks. For porfolis of equal risk (i.e. stocks + cash vs bonds) bonds kick the butt off of stocks.

  16. Gravatar of ssumner ssumner
    27. March 2013 at 14:33

    Morgan, There’d still be small shocks, like the Japanese tsumami, which did not cause a recession.

    South, I agree.

    Doug, All the finance models that I’ve seen suggest there is an equity puzzle, returns have been far to high relative to risk over the past 100 years.

    Geoff, I don’t think they need to act far more than usual to prevent crashes, I think crashes cause them to act far more than usual.

    John Hall, Good point.

    Fed up, I don’t see debt as a monetary problem. It only becomes a problem when the central bank foolishly lets NGDP growth crash.

    And both the 1929 and 1987 bubbles happened during a period of relatively high real interest rates.

    John, I agree.

    W. Peden, Let’s hope Carney changes the direction of policy.

  17. Gravatar of Petar Petar
    27. March 2013 at 14:34

    So, basically, if I got it right, its sort of a plucking model for assets too?

  18. Gravatar of Rajat Rajat
    27. March 2013 at 16:08

    “How could you get bubbles? One approach would be to have stocks occasionally rise far above their theoretically appropriate level. That’s probably how most people envision bubbles. Another would be for stocks to occasionally plunge far below fair market value. Then the “normal” looks like a bubble. I believe that if the EMH is not true, the latter is actually the most likely cause of bubbles.”

    Sorry, did you mean to say “if the EMH is true..”? If not, then I have misunderstood.

  19. Gravatar of Rajat Rajat
    27. March 2013 at 16:14

    Sorry, I think I get you. Do you mean that if the EMH is not true, there are no actual ‘bubbles’, only ‘craters’ that make the normal look like bubbles? And those craters are the buying opportunities that enable people to make excess returns.

  20. Gravatar of Britmouse Britmouse
    27. March 2013 at 16:33

    W. Peden, off-topic, (and did we have this debate already?) but I don’t understand your views there; you sound like something between a broad monetarist and a creditist. Why do you think the bank recap programme affects UK monetary policy? It doesn’t affect the demand for money (BoE reserves/currency), surely.

  21. Gravatar of Fed Up Fed Up
    27. March 2013 at 17:07

    “Fed up, I don’t see debt as a monetary problem.”

    I know. You are not the only economist who would say that. That leads economists to say NGDP is “on target” or price inflation is “on target” when actually an economy is not “on target” because of the debt.

    It matters how MOA/MOE is created, how it is distributed between the major economic entities, and how it is distributed in time.

    “And both the 1929 and 1987 bubbles happened during a period of relatively high real interest rates.”

    I don’t consider 1987 a bubble, so I’ll skip it.

    You need to look at interest rates in terms of asset prices not just goods/services prices for the 1920’s.

  22. Gravatar of Gene Callahan Gene Callahan
    27. March 2013 at 18:35

    Off topic but important: Svott, I think you should try to unpin your main text from the far left side of the browser window: get some margin over there! It really is difficult to read the way it is now.

  23. Gravatar of Paul Andrews Paul Andrews
    27. March 2013 at 20:35

    More epicycles from Ptolemy.

    People buy assets with rising prices because if the rising trend continues they can make a profit. Often their only reason for buying is that the price is rising. This causes prices to rise further and a positive feedback loop ensues. This lasts until there are no people left willing and able to buy. That’s a bubble. It’s not rocket science, and the inevitable crash is by no means a “valley in normal”.

    In the late 1980s I attended “Golden airplane” parties and witnessed 95% of attendees purchase shares in a pyramid scheme, all certain that they would multiply their money by 16 in a few short days. The outcome was not efficient – a lot of people wasted a lot of time, and thousands of dollars were redistributed from 15/16 of participants to 1/16 of participants. Read this for a description from someone who had a similar experience: http://people.ucsc.edu/~rosewood/writing/essays/pyramidgames.htm

    I don’t think anyone would suggest that the short period where people were actually earning 1500% per week, was “normal” and the aftermath was a valley.

    Free markets are somewhat “efficient” – in the long run. In the short run the momentum effects described above create temporary inefficiencies. “Short run” is a relative term and can mean years or even decades before a correction is achieved. Distortions in free markets (such as ill-conceived monetary policy and bank bailouts) exacerbate the size and longevity of these short run momentum effects.

  24. Gravatar of John John
    27. March 2013 at 21:14

    I find these theories about inefficiency somewhat implausible. If you’re buying something just because it went up, you’re an idiot and people that are smarter are going to end up with your money.

    One of the purposes of capital markets is to take money from the people who are misallocating their savings, like people who buy whatever is hot, and into the hands of the more sensible. This is a daily continuing process.

    Also, I think one of the big contradictions I see with people making Austrian type arguments is a lack of belief in market prices. They are quick to call “bubbles caused by the Fed” then point out the wisdom of markets and the price formation process compared to the inefficiencies of central planning. Those are mutually exclusive positions. Either markets are smarter than individuals, and hence you can argue things like central planning can’t work, or they aren’t and you can’t make those same arguments.

  25. Gravatar of Benjamin Cole Benjamin Cole
    27. March 2013 at 21:36

    Excellent blogging, IMHO.

    Notice how few people ever talk about the commercial real estate bubble? Yet there was a parallel bust.

    Aggregate demand collapsed. Anybody extended got cranked.

    Better underwriting standards would help; but preventing AD collapses is even a better idea.

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    27. March 2013 at 21:49

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  27. Gravatar of John John
    27. March 2013 at 21:51

    That being said, perfect market efficiency is impossible. The ultimate limit is the speed of light, but besides that computer programs have been able to come in and arbitrage out tiny price differences that arise from order placement. For instance if Coke is trading at twice the price of Pepsi and a big order of Pepsi stock pushes the price up, the computers will sell Pepsi and buy Coke as a pair trade. This has been very successful but requires technology that is outside the capacity of the general public.

  28. Gravatar of Paul Andrews Paul Andrews
    27. March 2013 at 22:03

    John,

    “If you’re buying something just because it went up, you’re an idiot and people that are smarter are going to end up with your money.”

    Yes in the long run most of the idiots will lose their money. In the short run, many people will make a lot of money. The short run can last many years, especially if the market is distorted or propped up. There is no daily cleanout of the idiots – the cycle is much longer, especially with a large population. A question for you – the last batch of people to make money before the price stops rising – are they idiots or not? What about the first batch of people to lose money? What about the batch who got in early?

    “Either markets are smarter than individuals, and hence you can argue things like central planning can’t work, or they aren’t and you can’t make those same arguments.”

    It’s a lot more complicated than your aggregated formulation.

    On the question “is the market smarter than individuals?”. There is no simple yes/no answer. It may be smarter than some individuals but not as smart as others. Smart individuals may sometimes beat the market and at other times not. Individuals who beat the market when driven by personal profit motives may not be able to achieve the same when driven by a desire for public benefits. A market distorted by central planning intervention may be less smart than one that is not distorted.

    Even if some individuals are smarter than markets from time to time (i.e. they are able to achieve personal profit through market activities), this does not mean that a small group of smart individuals can create a better economy through central planning than that which can be achieved by a free market.

    The aims of central planning – theoretically to boost the well-being of everyone – are infinitely more difficult to achieve than the aims of an individual investor – to increase only his own well-being.

  29. Gravatar of Doug M Doug M
    27. March 2013 at 22:18

    I can say say that there is no equity premium puzzle and you can say yes there is and we won’t really get anywere.

    Fama and French say that there is no equity premium.

    And the equity premium puzzle isn’t consistant with the CAPM model. In fact many CAMPM theorist wonder why the slope of the security market line is as flat as it is. A flat security market line suggests a lack of a risk premium of absorbing the risk of equities.

  30. Gravatar of Gene Callahan Gene Callahan
    27. March 2013 at 23:40

    Excellent, Paul Andrews!

  31. Gravatar of Greg Ransom Greg Ransom
    28. March 2013 at 00:47

    Longer production processes are choice only if they promise superior output.

    Scott constantly write as if this fundamental fact of choice over production goods — as fundamental the the logic of choice applied to consumption goods — does not exist.

    Acknowledge this fact of choice, and Scott’s story of the plain and the valleys makes no sense — it’s incompetent economics — becaus there is no homogenous class of production goods “K” with one price and *zero* internal relative price structure,

    This is economics 101.

  32. Gravatar of J.V. Dubois J.V. Dubois
    28. March 2013 at 00:56

    As for the relationship between NGDP growth and asset prices I thought that this is an obvious one: one of the main components of an asset price is expected future income from an asset. So for a long-term asset in an environment where aggregate income (NGDI) is volatile – but still rising asset prices should be OK.

    Problem happens if we see a sudden plunge of expected future income. It is only logical that assets will experience fall in prices.

  33. Gravatar of Bubbles are caused by asset prices crashes, just as mountains are caused by valleys | Fifth Estate Bubbles are caused by asset prices crashes, just as mountains are caused by valleys | Fifth Estate
    28. March 2013 at 03:29

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  34. Gravatar of ssumner ssumner
    28. March 2013 at 05:48

    Petar, Yes, but keep in mind I don’t believe the model.

    Rajat—Yes to your second comment.

    Gene, In my computer there is a fairly large margin on the left side. Is this because I have a widescreen monitor?

    Paul, Maybe, but don’t you need to address the evidence in my post–such as the fact that equities have earned big excess returns over the past 100 years, which is completely inconsistent with your view.

    Ben, Good point, and notice that after commercial real estate crashed some said there must have been a bubble in 2007!

    Doug, I’m happy to go with Fama on this, as he also says markets are efficient.

    JV, I agree.

  35. Gravatar of Greg Ransom Greg Ransom
    28. March 2013 at 07:42

    If you ignore the logic of choice over production processes of alternative lengths with alternative outputs, you *neve* engage that Hayek / Bohm-Bawerk argument on the nature of disequilibrium movements in production goods of alternative types and their prices across time.

    You simple DON’T.

    Stop pretending that you do.

    IT’S DISHONEST.

  36. Gravatar of John John
    28. March 2013 at 07:48

    Paul Andrews,

    Most of the people who get involved in assets that appreciate sharply and then crash lose their shirts. For instance, the tech stocks rose an average of 1.1% per year from 1997-2003 but investors ended up losing more than 70% of what they invested. Why is that? Most people didn’t buy in 1997 and hold, they bought late in 99 or 2000 and sold in disgust two years later. Either way, the majority of people in those investments would have been better off never getting involved. They were misled by the idea that fabulous riches were available to all in the stock market and should have at least read about the EMH.

    To clarify what I said about Austrians, they should be more careful to say that downwardly manipulated interest rates make longer term projects more profitable, and since it’s impossible to tell what interest rates should be (where the market would have set them without interference), market participants have no other real information to use than the actual rate structure. Going around making claims that it is easy to spot bubbles everywhere and to go short bonds and long gold because of the coming hyperinflation is exactly the kind of thing that discredits their position.

    Regardless of whether you think prices are messed up by the Fed or not, it still makes sense to pay attention to what prices are and to treat them with respect.

  37. Gravatar of Suvy Suvy
    28. March 2013 at 10:11

    Asset markets are not like markets for goods and services; they are fundamentally different due to a few factors. Those factors are:
    1. Asset values are dependent on our expectations of the future–an asset is the discounted present value of all the future earnings
    2. Assets are usually financed either by the sale of an existing asset or by an increase in leverage(sometimes assets can be financed by savings or by income)
    3. Usually, but not always, there is a positive feedback between the demand for assets and asset prices both on the way up and the way down

    Due to the way assets are financed, leverage plays a critical role in determining asset prices. This means a rising amount of leverage could be a major factor in rising asset prices. This also means that the rising asset prices coming from rising leverage could easily increase the demand for assets and thus increase the amount of leverage and create a positive feedback loop; the same thing could happen on the way down. These behaviors are what primarily determine the price of the asset–whether that is what the price “should be” is a different issue.

    The price that an asset “should be” is equal to the discounted present value of the future earnings; the problem is that we don’t know what the future earnings are. However, if those expectations of future earnings are unsustainable or far too high, this does mean that there will eventually be some sort of a reversion to the mean; however, this reversion could happen suddenly or gradually. That same reversion may not even come in real terms, but in nominal terms. Either way, the behavior of the asset markets is fundamentally different and far more volatile than the markets of goods and services.

    Due to the very nature of the asset markets, we will see behavior that is far more volatile, but the markets will have to exhibit some sort of a reversion to the mean at some point. Psychology also plays a vital role in asset markets as do future expectations. The potential for bubbles and wild swings are in the very nature of asset markets based on the things I stated above. Asset price crashes usually resemble some sort of a reversion to the mean(although they usually overshoot in the downward direction).

    I do think that it may be important to make sure asset prices don’t get too out of control as it could be a sign of a future increase in volatility–which can create problems. We should also not mistake apparent stability of an asset market as a healthy one as one small trigger could cause the entire market(and the economy with it) to completely explode.

  38. Gravatar of TravisV TravisV
    28. March 2013 at 11:04

    Prof. Sumner wrote:

    “Risk adjusted stock returns have been way too high for the past 100 years, according to standard finance models. This implies stocks are only valued fairly at peaks like 1929 and 2000, and are otherwise greatly under-priced.”

    In other words, “the stock market is never overvalued. It’s just that monetary policy often screws up.”

    Something just feels wrong with this line of reasoning……

  39. Gravatar of Jason Jason
    28. March 2013 at 17:02

    I am thinking about one class of assets increasing in value rapidly then collapsing (essentially all the air flows out of the bubble and is mixed with the general economy).

    In general, when this happens you should get a loss from what might be called friction in economics (I am not really sure what it is called). Sort of like mismatch in employment. It could be more pronounced when the collapse is more sudden. I think this is what people think of when they think of bubbles.

    When the deflation happens slowly enough, the rest of the economy is unaffected, reaching zero effect when it is so slow no deflation is occurring at all.

    I think the idea of the existence of bubbles is a question about whether there is a smooth continuum between the former (sudden collapse) and the latter (“adiabatic” collapse), or that there is a genuine regime change when the timescales go from weeks to decades. Can the proper action from the Fed make all collapses seem lossless/adiabatic (or make it so there is a smooth continuum), therefore recessions are failures? Or is this too hard to accomplish in reality?

    This has nothing to do with the “appropriate” level of the DJIA as the same mechanism could occur with overall overvaluation or undervaluation. It is whether or not you go from a higher state to a lower one with losses. (There could also be losses from allocating resources to that particular asset class during the bubble inflation! Maybe that is what people mean by bubbles: losses in both the allocation and de-allocation.)

    In thinking some more — this may be connected to your “why no mini recession” question. Mini-recession devaluations could be adiabatic (no losses).

    Just thinking out loud here. I don’t have any answers.

  40. Gravatar of Paul Andrews Paul Andrews
    28. March 2013 at 17:30

    John,

    “For instance, the tech stocks rose an average of 1.1% per year from 1997-2003 but investors ended up losing more than 70% of what they invested. Why is that? Most people didn’t buy in 1997 and hold, they bought late in 99 or 2000 and sold in disgust two years later.”

    Yes – there was a bubble, caused in part by those people. The peak of the bubble and the lead-up to it was a temporary mispricing. These temporary mispricings are an inherent part of real asset markets. They can be exacerbated by monetary stimulus.

  41. Gravatar of Paul Andrews Paul Andrews
    28. March 2013 at 17:50

    Scott,

    “Paul, Maybe,…”

    So do you agree with what I wrote or not? If not, which parts do you disagree with?

    “… but don’t you need to address the evidence in my post-such as the fact that equities have earned big excess returns over the past 100 years, which is completely inconsistent with your view.”

    You don’t present any such evidence in your post other than to refer to “standard finance models”.

    In addition, your post denies the existence of bubbles in any asset market, not just equities.

    My comment demonstrates why bubbles can occur in any asset market. Yes, “valleys” can also occur, as some people will always sell just because prices are dropping. However there are always more people not holding a particular asset than there are holding that asset, so a bubble has much more potential to be explosive than a valley, as the stock of potential buyers is always more than the stock of potential sellers. This is particularly so in very large populations.

    Your NGDPLT mission seems to have burdened you with many plates spinning on sticks. This one is tottering even worse than the others.

  42. Gravatar of Geoff Geoff
    28. March 2013 at 21:22

    Dr. Sumner:

    “Geoff, I don’t think they need to act far more than usual to prevent crashes, I think crashes cause them to act far more than usual.”

    The point is that they have to act more than usual.

    The 1950s were a time of great NGDP volatility:

    http://research.stlouisfed.org/fredgraph.png?g=gY7

    Where were the stock bubbles?

  43. Gravatar of ssumner ssumner
    29. March 2013 at 03:42

    TravisA, No, stocks could fall for many reasons, monetary policy is just one. Taxes are another factor–especially during the 1970s.

    Paul, I assumed that people were familiar with the academic studies showing excess returns in equities. It’s a huge puzzle in finance.

    Obviously anything is possible, but when I look at the total return on stocks vs bonds since 1926, stocks look like the far better investment, even accounting for risk.

    Geoff, During the 1950s NGDP growth declines were quickly reversed—investors knew that.

  44. Gravatar of Geoff Geoff
    29. March 2013 at 13:11

    Dr. Sumner:

    “Geoff, During the 1950s NGDP growth declines were quickly reversed””investors knew that.”

    How do you know they knew that? NGDP wasn’t even on anyone’s radar until the 1980s, and still today most investors don’t even consider it.

    Are you sure you’re not just reversing the order of deduction here so that you get to the answer you want, which is that you are assuming that investors just had to know, because you observe an absence of significant stock bubbles and busts?

  45. Gravatar of ssumner ssumner
    30. March 2013 at 10:52

    Geoff, If investors understand inflation and RGDP growth, then they understand the sum of the two.

  46. Gravatar of Frannzy Frannzy
    31. March 2013 at 19:21

    In my opinion it would be more meaningful to focus on wealth instead of merely asset prices.

  47. Gravatar of Geoff Geoff
    1. April 2013 at 13:21

    Dr. Sumner:

    “Geoff, If investors understand inflation and RGDP growth, then they understand the sum of the two.”

    I don’t see how that follows. One, RGDP is calculated from nominal NGDP and inflation, which of course begs the question. Two, even if investors understand prices and RGDP, it doesn’t necessarily mean they are actually taking NGDP into account when making investment decisions.

    The majority of investors don’t even care about NGDP. Most economists don’t care about it either. NGDP analysis is in a definite, but growing, minority.

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