I’ve been surprised how much discussion has occurred in response to my neoliberalism post.  Perhaps that was because Paul Krugman responded.  In any case, I’d like to briefly discuss what I regard as some fallacies of the left and right on the subject of market reforms.  I’ll start with the left:

1.  Forgetting that things were even worse in the past.  Many developing countries have deplorable working conditions, environmental standards, income inequality, human rights abuses, etc.  If these countries have adopted free market reforms, it is easy to look at these problems and forget that conditions were even worse before the reforms occurred.  It is hard for someone who grew up in a rich country to understand just how difficult life is in a developing country.  When you see deplorable conditions, it is hard to imagine how they could have been much worse in previous decades.  But all one has to do is walk across the border from China to North Korea, to see what China was like before the reforms.  As big as China’s problems are (and they are huge) North Korea is far worse off.  China’s living standards aren’t just higher than North Korea, they are dramatically higher.  Most don’t recall that China was poorer than India before the reforms began in 1979.

2.  Assuming that Dickensian conditions implies a country must be capitalist.  Many people on the left seem to create left/right mental boxes for countries based on their perception of working conditions.  Thus a country with poor working conditions and low wages (again China is a good example) is assumed to be “capitalist” and a country with good working conditions and a high level of equality (such as Denmark) is assumed to be “socialist.”  Actually it is much more complicated.  Economically speaking, China is a half-communist country with low levels of social insurance, whereas Denmark is an extremely free market economy with a large welfare state.

3.  Assuming that economic reforms failed because real GDP growth didn’t increase after 1980.  I’ve already addressed that in another post.  Growth slowed everywhere, but the neoliberal reformers saw growth slow less than the non-reformers

4.  Assuming the Soviet Union went into a depression after economic reforms began.  Actually the real GDP of the Soviet Union collapsed before economic reforms began in 1992.  And the places that reformed the most slowly, recovered the most slowly.  Those that didn’t reform at all (such as North Korea) saw an almost complete collapse of their economies.  Economic reforms didn’t cause a Depression in the Soviet bloc.  Rather a “Great Depression” in the Soviet bloc caused economic reforms to occur.  This misconception occurred because conditions continued to deteriorate for some time after the reforms began in 1992, and this is when people began to focus on the issue in the West.  So they saw horrific economic problems, and assumed they were caused by the reforms.  In Russia, people probably had trouble distinguishing between Gorbachev’s reforms (which weren’t market reforms but rather attempts to make communism work better) and true market reforms.

5.  Assuming neoliberal reforms are associated with authoritarian governments.  Many people seem to think China adopted free market reforms after the 1989 crackdown at Tiananmen.  Exactly the reverse; the free market reformers were discredited by the protesters (who supported reform) and thus the Chinese government moved back toward statist policies.  In Argentina, the generals who ruled the country adopted statist policies, and market reforms were associated with the movement toward democracy in the 1990s.  In Chile, the generals that overthrew Allende opposed free market reforms, and only turned toward them (out of desperation) in 1975 when their statist policies put Chile into a depression.  There is an EXTREMELY strong correlation between neoliberalism and democracy.  Look at the Heritage list of economic freedom and you will see that most of the high scorers are democratic (although the top 2 countries are not, or at least not entirely.)  I plan to read Naomi Klein’s book this summer–I’m told it has some of these misconceptions.

6.  Capitalism is based on greed.  In fact, it is almost impossible to make capitalism work without altruism.  If people are not civic-minded you will not get free markets.  This is because individual producers are much better off if protected from competition.  Businesses generally do not support capitalism in their own industry.  To get a free market system you need people willing to put aside their special interests and support open and transparent economic governance.  After 1980, the countries that moved most rapidly toward free markets (Denmark, New Zealand, etc) were the countries whose citizens score highest on polls of civic-minded attitudes (and generally lowest on corruption indices.)  The most statist of the developed economies (i.e. Greece) also exhibit the least civic-minded attitudes in surveys.  If neoliberalism was a right-wing plot to enrich capitalists, you’d expect exactly the opposite pattern–you’d expect the most civic-minded or idealistic countries to be the least like to adopt neoliberal reforms.

7.  Assuming increased income inequality negates the gains from freer markets.  I’m not saying this can never occur (deregulating the gains in finance while the government continues to socialize the losses might be one counterexample) but in general there is little evidence that free markets produce lots of inequality.  If you look at the 8 categories in the Heritage index other than size of government, then Denmark is actually the most free market economy on earth.  Yet it also has the most equal distribution of income.  International differences in income equality are strongly correlated with ethnic diversity.  Even in relative equal Europe, inequality is associated with the presence of ethnic groups like the Roma (aka gypsies.)  In Australia the greatest inequality is associated with the presence of  indigenous people (aka aborigines.)

8.  European countries have more progressive tax systems than the US.  Not true.  Because supply-side problems are REAL, the more social democratic countries of Europe have found it necessary to have much more regressive taxes than the US.  They need highly efficient tax systems to raise enough revenue for their extensive social insurance programs.

Here are some fallacies on the right:

1.  Countries with big government tend to be poorer.  As Statsguy showed in a recent post, it is just the opposite.  In developed countries governments tend to spend a higher share of GDP.  I do think that, ceteris paribus, beyond 20% of GDP larger government lowers GDP.  But the effect isn’t strong enough to prevent countries like Denmark and Sweden from having high living standards, despite their large governments.

2.  Denmark and Sweden are socialist countries.  I’ve already indicated that they are capitalist countries with high levels of social insurance.  Denmark has freer markets than the USA.

3.  Singapore and Hong Kong are not really capitalist.  This is the opposite from point two.  Just as some on the right focus too much on size of government, others focus too much on  a few deviations from free markets that they have read about in these two countries.  There is a tendency to forget that in every single country in the world the government plays a major role in the economy, including the US.  Singapore and HK do some things we don’t do (for instance their governments control much of the housing stock) but we do lots of things they don’t.  There is always a tendency to notice flaws in others that we don’t notice in ourselves.  I am amazed how often people mention the $500 fine for throwing gum on the sidewalk in Singapore, but I rarely see people mention that we have 500,000 people in prison for using drugs.  Which is the greater outrage?  This isn’t to excuse abuses in other countries (I’d still rather live here), but merely to point out that no country comes close to being the sort of libertarian paradise than many on the right would like to see.  You can have a lot of markets and still be rigidly communist.  Even North Korea occasionally allows farmer’s markets.  And you can have a lot of statism and still be one of the most free market countries in the world.  The US deviates from pure capitalism in literally 1000s of ways.  You can’t even be a hairdresser or a taxi driver w/o a government permit.

4.  Europe/Canada/Australia, etc, are much more socialist than the US.  This is not true.  In the Heritage rankings the US is right in the mix, slightly more capitalist than most, but less capitalist than a few of these countries.  Bryan Caplan recently linked to a survey that showed the US government spends more dollars (PPP) on health care (per capita) than all other countries save oil -rich Norway.  Many of these countries have privatized industries and services that are still traditionally done by government in the US.  (BTW, if we are already spending so much, why do we have to spend even more to pay for Obama-care?  Answer:  It doesn’t include meaningful cost controls.)

5.  Capitalism is based on individualism.  Actually just the opposite.  Fukuyama showed that large private corporations thrive in cultures where people work well in groups, and don’t do well in cultures where people are distrustful of those outside the family.  This is why the Nordic economies are the most multinational corporation-dominated economies on earth.  The industries that are privately-owned in the Nordic countries are often state-run in less group-oriented cultures.  I admit to knowing little about Ayn Rand (and assume I’ll get pushback here) but based on what I have read about her prickly and individualistic personality, I wonder of a country of Ayn Rands could produce a successful capitalist system.

Update 5/29/10:  I hope all my discussion of culture didn’t lead you to think I am a cultural determinist.  I’m not.  Doc Merlin mentioned reverse causation in the comments, and I buy the Adam Smith/Deirdre McCloskey argument that markets make society behave better.

Before concluding chapter 5, a few comments on a recent post by Mark Thoma, who responds to my previous post on Adam Smith.  First a couple areas where I agree with Thoma:

1.  I shouldn’t have used the term ‘trivial’ to describe the list.  I should have said something like “modest.”

2.  Because I read the post too fast, I did not notice that the list was Viner’s, not Kennedy’s.  That does change things somewhat (and not just because he is a University of Chicago guy.)  In 1928 the Federal government in the US comprised 3% of GDP, as compared to nearly 25% today.  If that was the benchmark for normal, then yes, Smith’s views did not seem all that laissez-faire by comparison to the role of government in 1928.  We weren’t completely laissez-faire in 1928, but we were much closer than today, and hence Viner’s list would have seemed much more impressive back then.

Update: I just noticed the following comment from Thoma:

You say “I did not notice that the list was Viner’s, not Kennedy’s.”

You also don’t seem to realize that the latest points are from Gavin Kennedy, not me. (e.g. “Thoma ends up with this argument…”)

Let’s hope you read Smith with a more comprehension than you’ve demonstrated here.

Touche.  Yes, I did get confused by Thoma’s quotations within quotations.  But that’s my fault, as I know he often uses that format.  In any case scratch Thoma and consider all these comments directed at Kennedy.  Back to the original post:
Den ganzen Beitrag lesen…

It’s always an honor to be noticed by The Economist.  Unlike Eugene Fama, I don’t plan to cancel my subscription to the best magazine in the world, even if they say this about me:

Mr Sumner disagrees. He seems to think it’s funny that The Economists pent much of the last decade warning that, globally, home prices were rising in a troubling manner. Contrarianism is fun and all, but this strikes me as an odd way to process the experiences that led us to this point.

A few comments:

1.  I would note that Free Exchange seemed to enjoy making fun of Fama’s views.

2.  I do think it funny that Free Exchange would claim that The Economist was exactly right in its housing bubble predictions.  Then demonstrate this by linking to an excerpt from The Economist that was 180 degrees off.  That predicted American housing prices would fall 10% over the 4 year period after May 2003, when they actually rose about 30%.

3.  I do admit to forgetting that The Economist is real people, as they don’t tend to list names of reporters.  So perhaps that made me more sarcastic than I should be.

4.  I use humor to wake people up, to try to make points more accessible.

5.  The crisis of the past year has consumed all my time.  I’d much rather be reading books or seeing movies, and my school doesn’t compensate me for this.  I am deadly serious about trying to wake people up to the incredible harm done by tight money in 2008.  Unfortunately I seem to recall The Economist advocating tighter money, on the grounds it was needed to squeeze the excesses out of the US economy.  It looks like they got their way, and it looks like that monetary policy made the housing crash prediction look even more impressive than otherwise.

I don’t want to be dogmatic about this.  I’ve never denied that the EMH is merely an approximation of reality.  Or that astute observers do sometimes have insights that the markets miss.  But that doesn’t make Fama wrong.  Social science is not about the exceptions, it is about broad principles.  I presume that “the market” does gain some value from the information in The Economist.  But here is the problem; that fact doesn’t really give the anti-EMH position any real traction.  Useful insights in The Economist are just as available to “the market” as they are to “the regulators” or to me.  If I invest based on advice from The Economist, I won’t consistently beat index funds.  And if regulators try to predict bubbles based on predictions from The Economist, they’ll do no better than they would by throwing darts at a stock page.

Here is one accurate prediction I did make.  In my previous post I showed that the 2003 Economist prediction that everyone seems to think was amazingly accurate was actually almost completely wrong.  I said I expected comments that somehow it was actually correct.  They are already coming in.  People are saying something like “yes, they explicitly predicted a 10% fall over 4 years.  And yes, prices actually rose 30%, but they rose 35% in three years and then fell 5% in the 4th. So they were right.”  Well not in those exact words, but that seems to be the general view out there.  Another argument is that they were wrong in the 4 year window, but then spectacularly right in the 5th.

Yes, but if we don’t have standards, if we aren’t going to hold people to their words, then what do we really have?  Suppose I said; “I predict a major 20% to 30% drop in the S&P500 within the next 4 years.  And if it doesn’t happen, but happens sometime later, I should still get credit.” Would you take me seriously?  People don’t seem to understand that unless a prediction is both accurate and timely, it really isn’t of much value.

The Economist seems to have wanted the Fed to do something in 2003.  But what if the Fed had tightened, perhaps we would have gone into a Japanese style deflation/zero rate trap.  Then what?  I will concede that The Economist was probably right about monetary policy in 2004 and 2005, in retrospect a bit more restraint would have helped.  But May 2003?  That is still very much an open question.

We all interact with our fellow humans.  I am sure that you observe the same things I do, our acquaintances are absurdly overconfident in their predictions in sports, politics, economics, everything.  It’s human nature.  But we all go along to be polite.  I am the same.  Obviously it’s a bit absurd for me to think that a professor at Bentley has the answer to the world’s financial crisis.  But I think I do.  I act as if I do.  I am as arrogant as you expect such a person to be.

You might ask why then do I want the Fed to adopt my policies?  The answer is that I don’t expect them to do so merely on my say so.  I think Bernanke would be foolish to adopt my ideas unless other more distinguished economists have also come on board.  The goal of my blog is to start a conversation among economists about the possibilities for unconventional monetary stimulus.  Being a libertarian with slight monetarist tendencies, I have been surprised that in recent months the conversation in this direction has been more noticeable in liberal/Keynesian blogs such as Krugman/DeLong/Yglesias.  But any news is good news.

Free Exchange says we can have confidence that The Economist’s prediction was not luck, because they gave lots of good reasons for that belief.  I agree that helps.  But consider this analogy.  Suppose you have a friend who predicts his football team will lose in the first round of the playoffs.  He cites two reasons, the quarterback is inexperienced in big pressure games, and the star running back is injured.  Now suppose they win all their playoff games and go to the Super Bowl.  The prediction was wrong.  But suppose they lose in the Super Bowl because they have no running game and their quarterback looks very shaky under pressure.  I’ll bet the average fan would say “Aha!  I knew that was going to happen.”  We remember our successes and forget our failures.  Even worse, we shape the game’s narrative to fit our predictions.  The Economist could have written articles saying:

1.  A 2007 crackdown on immigration sharply slows US population growth in the Southwest.  Housing starts to slump.  High energy prices hurt commuters with long commutes.  Home prices slump in the exurbs.

2.  Tight money by the Fed in 2008 causes NGDP growth to slump 8% below trend.  Unemployment soars.  Nominal incomes fall at the fastest rate since 1938.  This further weakens an already shaky housing market.

But that’s not what most journalists wrote.  They wrote a narrative that fit their preconceived ideas about what happened.  Am I claiming that those other factors didn’t play a role?  Of course not.  But wouldn’t it be equally absurd to write a narrative that didn’t give prominent mention to the factors I just cited?  Especially since the fall in NGDP closely correlates to the housing crash spreading nationwide?  I think you’ll agree that it would be negligent.  But that doesn’t stop most financial reporters from ignoring those other factors.

[BTW, before you say “immigration doesn’t explain the other countries” consider that those crashes tended to occur later than the US.  And were correlated with falls in NGDP.  And the one country where NGDP didn’t fall?  Oh that’s Australia, the one country where The Economist’s prediction wasn’t even right in the long run.  They had no housing crash at all according to my commenter from down under.  I wonder how The Economist would explain that.]

One final comment.  When I ask people why a mutual fund run on their insights about fundamentals would not beat an index fund, they often dodge the question by talking about the difficulty of selling stocks short.  But again, if you really can know the fundamentals, there are plenty of profitable long positions in various markets around the world, and in the brief period when there might not be, just park the money in index funds.  I still say that type of mutual fund wouldn’t reliably beat an index fund.  And I still say the implication of the bubble theorists is that it would.  I can’t quite tell what the view is at Free Exchange:

I feel like this is the sort of critique that sounds lovely so long as one remains comfortably in the realm of abstract intellectualism. The price-to-income ratio has risen above its long-term trend, but how can we know that it’s a bubble? Fundamentals? Well, perhaps they’ve shifted. And if you’re so confident, why aren’t you ringing up your trader and telling him to short housing?

Yes, that is my question.  And the answer is that if you had shorted housing builders in May 2003 you would have gone bankrupt.  But then he seems to want to have it both ways:

Some people managed to make money off their models of the bubble despite the significant logistical difficulty in betting against housing markets.

Those would be people who ignored The Economist in 2003 and went short in 2007.  I do accept one part of this argument.  Housing is harder to short than stocks, bonds, commodities and currencies.  But that really doesn’t help Free Exchange’s argument.  You see The Economist is equally opinionated about these other assets.  Which does imply that an “Economist mutual fund” should reliably outperform index funds.  I say it wouldn’t.  Robin Hanson suggests we need to test this.  I don’t think so.  It’s like astrology.  As soon as you start suggesting to an astrologer that we do tests of whether personality types correlate with birth month, their whole attitude changes.  “It’s more complicated than that.”  There will never be the sort of test Hanson wants because no one has enough confidence in the musing of The Economist on fundamental values of stocks, bond, commodities and currencies to even lift a finger setting up such a mutual fund.

If this has been too negative, how about ending on this note.  What would make the world a better place is not people investing or regulating on the basis of The Economist’s asset price predictions, but rather governments around the world switching to the sort of high saving neoliberal economic model that The Economist advocates.  That’s what makes them the best and most valuable magazine in the world—their influence on policymakers.

Talk about burying the lede!  Last night I did a post discussing how the people who say “I told you so” after bubbles are often suffering from cognitive illusion.  Only right before bed did I realize that a link in a quotation provided a perfect illustration of the phenomenon.

One of the most famous pro-bubble publications is The Economist, which likes to brag about how they predicted the housing bubble.  Here is Free Exchange:

This is truly remarkable. A bubble is an unsustainable increase in prices relative to underlying fundamentals. These fundamentals are more or less observable; those who called the housing bubble did so based on historically anomalous increases in the ratio of home prices to rents and incomes. And many people did correctly identify the bubble years before it imploded, including writers at The Economist who were worrying about rapid home price increases while the American economy was still limping out of the 2001 recession. This is the reality that Mr Fama seems unwilling to confront. How unwilling?

Only when I had finished the post did I realize it provided a link to an ad for subscriptions to The Economist.  Free Exchange must have thought that was a big joke, as they had just quoted Fama as follows:

I never said that. I want people to use the term in a consistent way. For example, I didn’t renew my subscription to The Economist because they use the world bubble three times on every page. Any time prices went up and down””I guess that is what they call a bubble.

Then Free Exchange made this snarky joke (something I never do):

Obviously, we are disappointed to have lost Mr Fama’s business. But I can’t say we regret the cause.

UPDATE: An Economist correspondent notes that as a die-hard believer in the Efficient Markets Hypothesis, Mr Fama is actually being quite rational in cancelling his subscription. As all publicly available information is already reflected in market prices, there’s not much point in trying to learn anything from our paper.

But the joke is on Free Exchange.  The magazine ad he linked to says this:

I love to take a contrarian position.  The more contrarian the better.  But only if I truly think I am right.  This post will be a lot of fun because these days you can’t get much more contrarian than defending Eugene Fama on the EMH.  But I also happen to think Fama is right.  Really, I do.  Indeed I think I can show that he is right, or at least much more likely to be right than most people imagine.

This was triggered by the barrage of criticism he has been receiving.  If you read posts like this one from Free Exchange, you’d think this giant of financial economics, this future Nobel laureate, is a complete fool.  Maybe he is, but if so then I am too.  Here’s the New Yorker’s Cassidy, then Fama, then Free Exchange:

(Cassidy) Are you saying that bubbles can’t exist?

(Fama)  They have to be predictable phenomena. I don’t think any of this was particularly predictable.

(Free Exchange)  This is truly remarkable. A bubble is an unsustainable increase in prices relative to underlying fundamentals. These fundamentals are more or less observable; those who called the housing bubble did so based on historically anomalous increases in the ratio of home prices to rents and incomes. And many people did correctly identify the bubble years before it imploded, including writers at The Economist who were worrying about rapid home price increases while the American economy was still limping out of the 2001 recession. This is the reality that Mr Fama seems unwilling to confront. How unwilling?

So that is the pro-bubble argument.  We can know the fundamental prices of assets.  We can know when asset prices move away from their fundamental value.  And when they do we can predict that at some point over a reasonable period of time (say a few years) they are likely to move back toward their fundamental values.  I hope that is what Free Exchange is claiming; if not I have no idea what the argument is.  But if that is the claim, it is wrong on all three counts.  I’ll come back to housing eventually, because his assertions are incorrect, but first I’d like to look at the Fidelity Latin America fund, as this perfectly illustrates my point.

You are probably thinking “why the Fidelity Latin America Fund?”  Well first of all, if you are one of those people who believes in bubbles, and you haven’t been paying attention to the FLAF, you sure are missing the boat.  It certainly looks like a bubble.  But this is also what efficient markets look like.  They are erratic.  They have peaks and valleys.  It looks like they have bubbles, but that is a cognitive illusion.  No one really knows the fundamental value of Latin American stocks.  As a result the price can move around quite a bit, even when the so-called “fundamentals” haven’t changed very much.

Anyone who believes in bubbles should have been able to make a lot of money either shorting or going long on the FLAF.  (Maybe these stocks can’t be shorted, but my point will still hold up as there are plenty of stocks that can be shorted.  So please don’t bring up that objection.)  So let’s say The Economist magazine really knows the fundamental value of assets in the various countries it covers.  It does cover a lot of countries, and probably knows more about those countries than almost any other magazine.  Also suppose The Economist started a mutual fund that invested based on its ability to spot fundamental values and deviations from those values.  That mutual fund should outperform other funds.  And not just by a little bit, but massively outperform them.  Just look at the graph.  Did the fundamentals in Latin America (a slow growth area where RGDP grows about 4%) really increase 10-fold between the summer of 2002 and early 2008?  I am almost certain they’d say no.  So there are great profit opportunities.  And not just here, The Economist covers the whole world, and all sorts of assets.  They make predictions about real estate, about commodities, about all sorts of things.  There are always some markets that are “underpriced” and others that are “overpriced.”

At this point I’m sure that people are saying “that’s not fair, they aren’t claiming to be able to beat the market.”  But unless I am mistaken, that is exactly Fama’s point.  Unless your Nostradamus-like ability to spot fundamental values does give useful predictions of where asset prices are going, with at least more than a 50/50 chance of success, then the theory of bubbles you have developed is essentially worthless.  It would have no utility, for investors and more importantly for regulators.

Now let’s ask why people have this mistaken notion that bubbles are easy to spot, and that Fama is deluded.  I believe it is a cognitive illusion.  People think they see lots of bubbles.  Future price changes seem to confirm their views.  This reinforces their perception that they were right all along.  Sometimes they were right, as when The Economist predicted the NASDAQ bubble, or the US housing bubble.  But far more often people are wrong, but think they were right.  The most famous example is Shiller’s famous “irrational exuberance” call of early 1996.  Most people still think Shiller was right.  But he was wrong, or at least it is far from clear whether the prediction was at all useful.   (Over the last 14 years there are many times when he looked wrong, and many times he looked right.)

Now suppose you were a bubble proponent and you starting watching the FLAF when it was down around 7 in late 2002.  You watch it double to 14, and say to yourself, hmm, a bit pricey, looks like a bubble might be forming.  Then it goes to 21, nearly tripling in value.  Now you are really starting to think bubble.  It’s mostly in Brazil.  But Brazil isn’t China, it grows at about 3%.  The joke is “Brazil’s the country of the future, and always will be.”  Now it goes to 28, up almost 4 times higher than the 2002 lows.  Surely no plausible amount of profit growth can justify that rise.  Now the bubble alarms are going full blast.  Sell, sell, sell.  Except anyone who took your advice would have been a fool.  It went to 35, then 42, then 49, then 56, then 63, then over 70.

Now suppose I wrote this post in the spring of 2008.  A few months later I’d look like a complete idiot.  The FLAF crashed.  The bubble theorists would have had their worst fears realized.  They’d say “I told you so” even though they would have been wrong, even though the post crash price was still near 28.  And now it’s back to 52.  What is the fundamental value?  For a Rortian pragmatist like me that question is absurdity piled on absurdity.  Or what Bentham called “nonsense on stilts.”  There is no “fundamental value.”  There are only amounts people think it is worth.  Individual people, and the market consensus.  There are no outside referees like “God” to tell us who is right.  We are all alone.  All I can say is that the price will continue to fluctuate.  I have no idea which way.  And at times the bears will make money, and at other times the bulls will come out ahead.

But there is one thing I can predict with a high degree of confidence.  Whatever happens to the FLAF over the next 50 years, the price movements will be interpreted through this congnitive illusion, this confidence that we can see patterns in graphs, even where they don’t exist.  The “mountain peaks” will look like bubbles.  In fact, you can generate a “stock graph” by just flipping coins repeatedly.  And if you show the resulting graph to the average investor he will see patterns.  It is all a cognitive illusion.

But why is Fama’s theory now in such disrepute?  Because in the past ten years the world economy has seen two very important bubble-like patterns, indeed arguably the only two such market cycles in the US during my lifetime with macro significance.  And they were both predicted by lots of experts because they violated popular theories of fundamentals.  So start with the cognitive illusion that people have that makes them see bubbles even where there don’t exist.   People think they have made accurate predictions because an upswing is always EVENTUALLY followed by a downturn.  Then add in the fact that The Economist really did make accurate predictions in two of the most important events in modern history.  Do you think it will be possible to convince them that they just got lucky?  About as likely as a husband convincing an already suspicious wife that he is innocent after twice being caught in bed with two separate women.  So I feel sorry for Fama.  He’s probably right, but I don’t see how he could ever convince anyone in this environment.  It would be like trying to convince someone that neoliberalism was the right policy in 1933.  (Come to think of it, The Economist advocates neoliberalism.)

Now let’s return to housing, and the false claims made by Free Exchange.   In fact, it is not easy to predict the fundamental value of housing.  In a previous post I pointed out that many people screamed bubble when the tight American coastal markets began to diverge from “flatland” prices.  This occurred during my lifetime, and I know that it caught a lot of people off guard.  When I moved from the Midwest to Boston in 1982 house prices didn’t seem that high to me.  By 1987 they had doubled.  By 1990 they’d fallen 15% and I recall people in Boston saying; “see, I knew all along that house prices were completely out of whack in 1987.”  Except that there is just one problem, the prices starting rising again.  By a lot.  More recently they have fallen again in the coastal markets.  But it clear to me that in the tight coastal housing markets prices diverged from fundamentals (or Midwestern prices), and never really returned.   Free Exchange suggests you can get the “fundamental” values by looking at ratio of house prices to income.  Will that work in NYC?  How about San Francisco?  Actually, if I wanted to play that game I’d estimate the fundamental value as the cost of construction plus land prices.  And land prices really don’t have any fundamental value.

Just to be clear, I’m not trying to model housing prices, I’d be the first to admit that the sharp run-ups in Vegas and Phoenix look irrational.  My point is that housing prices are usually hard to predict, because land prices are hard to predict.  Houses can become “unaffordable” in places like NYC and SF, and stay unaffordable for decades.  Of course they aren’t really unaffordable, as people are living in them.  But they appear unaffordable according to the sort of metrics used by the bubble proponents.  These bubble criers were wrong in 1990 when they thought they were right.  Housing prices in desirable coastal markets could well stay much higher than flatland markets for many decades to come.  Or they might not.

A lot of bubble proponents say that the bubble theory doesn’t allow investors to make abnormal returns.  I don’t buy that and I don’t think Fama does either.  I think you can sense Fama’s exasperation in his answers.  Reporters like anecdotes, they think in terms of specifics.  Academics like models, generalities, principles.  Fama wants to know what exactly the bubble proponents are saying.  I don’t want to put words in his mouth, but I think that he is sort of saying the following.

1.  Either you are claiming that a mutual fund run on The Economist’s predictions would reliably outperform index funds.

2.  Or you are saying something with no meaningful implications that I can understand, and you have drained the term ‘bubble’ of any useful meaning.

I think Fama would regard the first claim as delusional and absurd, and I’d agree.   So then what is the point of bubble theories, what are they suppose to tell us that is useful?  Here’s another Fama quote from Free Exchange, see if I have interpreted him correctly:

That’s what I would think it is [i.e. a bubble], but that means that somebody must have made a lot of money betting on that, if you could identify it. It’s easy to say prices went down, it must have been a bubble, after the fact. I think most bubbles are twenty-twenty hindsight. Now after the fact you always find people who said before the fact that prices are too high. People are always saying that prices are too high. When they turn out to be right, we anoint them. When they turn out to be wrong, we ignore them. They are typically right and wrong about half the time.

PS.  My “cognitive illusions” theory doesn’t explain why smart academics disagree with Fama.  Academics who have studies “proving the EMH wrong.”  These studies have even created models that can reliably beat the market, if run backward.  Sorry, I’m not impressed.  But that is another post.  Maybe I’ll call it “t-statistic illusion.”

PPS.  I just opened the link in the first quotation.  It is the funniest thing I have read in ages.  It is an ad for The Economist that brags about a spectacularly false housing price prediction made in 2003.  QED.

HT:  Dilip and rob