What goes up must come down, but it need not come “back down”
I am constantly amazed that so many highly intelligent economists and finance-types seem incapable of understanding something as simple as an asset price bubble. There seems to be a common perception that bubbles are inconsistent with the EMH, and that you identify a bubble by noticing when an asset price has risen sharply, and then fallen. But suppose that asset prices never fell back after large advances? Suppose that at worst they leveled-off. In that case investors would have a surefire way of making money. Buy assets that were soaring in value. In that case only one of two outcomes could occur:
1. No price change.
2. Further increases in price.
A no lose proposition. That means that if bubbles are big price advances followed by substantial declines, then a world without bubbles would violate the EMH. Which means asset price bubbles do not violate the EMH.
People have trouble discriminating between prices going down, and prices going “back down” to a specific earlier level. A good example occurred in 2005, when bubble-mongers all over the world proclaimed bubbles in the residential real estate markets. Since that time a few markets have seen prices plunge. Others have seen prices move much higher. And in many markets prices have moved sideways since 2005. This is exactly the pattern one would expect if the housing market were efficient.
A commenter named Wadolowski recently asked:
What if prof. Keen’s analysis is correct, and you’re making mistake by totally ignoring the level of private debt and there will be bubble burst in Australia:
http://www.debtdeflation.com/blogs/2012/08/02/australian-house-prices-update-june-2012/
Would you change your mind, if the facts change?
My answer is as follows. If prices in Australia drop, then I will consider that a vindication of the EMH, which predicts that house prices should fluctuate, and not go straight up. If prices in Australia drop back down below 2005 levels, which the bubble-mongers thought were excessive at the time, then I will admit that the Australian housing market circa 2000-15 is one data point in favor of bubble theory, and one data point against the EMH. That’s not to say any single example is dispositive, but it would help the bubble argument.
My fear is that we’ll see a 10% or 20% drop in Australian housing prices, which is perfectly consistent with the EMH, and people will see it as confirming their anti-EMH prejudices.
Now if people want to define the highest price before a substantial decline as a “bubble,” then we have entered the land of tautologies.
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9. August 2012 at 15:04
Ben Bernanke is becoming a philosopher:
http://www.businessweek.com/articles/2012-08-06/bernanke-to-economists-more-philosphy-please
Maybe he’s being influenced by Austrians?
9. August 2012 at 15:42
A 10-20% drop in Australian house prices? It isn’t going to happen unless the RBA really drops the ball. They have orchestrated a fall in NGDP growth from 8% to 4% over the last few years, and with headline CPI running below 2% and the labour market weakening, there is no need for any more. Apart from recent data showing an uptick in Oz house prices, the ECRI have called a recovery in the Chinese housing market and Australia normally follows China.
9. August 2012 at 16:22
There appear to be two main varieties of EMH (if not more):
1) Prices are correct. For this to be meaningful, there must be some definition of correct, which implies the existence of an asset pricing model.
2) It’s very difficult to beat the market. This is empirically true, but not very exciting.
By EMH do you mean one of these, or something else? If the later, how are you defining EMH? Apologies if you’ve covered this before.
9. August 2012 at 17:19
This has NOTHING to do with the economic logic and causal mechanisms involved in malinvetmets in long period production goods like houses.
And EMF stastistical ‘insights’ are all about the statistical predictability of future price streams in the stock market based on prior streams of numbers, eg price to earnings ratios, etc.
Fama is direct in saying any application beyond that sort of context has nothing to do with his EMF.
9. August 2012 at 17:22
The variation I really love the most is when people boast that they predicted the bubble even earlier when, in fact, had anyone invested at that point they would still have made a killing even at the bottom of the bust. Unlike most predictions, predictions of bubble bursts can be as wrong if you call them too early as when you call them too late.
9. August 2012 at 18:22
“But, as many of you will discuss this week, aggregate statistics can sometimes mask important information. For example, even though some key aggregate metrics–including consumer spending, disposable income, household net worth, and debt service payments–have moved in the direction of recovery, it is clear that many individuals and households continue to struggle with difficult economic and financial conditions. Exclusive attention to aggregate numbers is likely to paint an incomplete picture of what many individuals are experiencing. One implication is that we should increase the attention paid to microeconomic data, which better capture the diversity of experience across households and firms. Another implication, however, is that we should seek better and more-direct measurements of economic well-being, the ultimate objective of our policy decisions.
Although the field is still young, there have been interesting developments in the measurement of economic well-being. In a commencement address two years ago titled “The Economics of Happiness,” I spoke about the concepts of happiness and life satisfaction from the perspective of economics and other social science research.1 Following the growing literature, I define “happiness” as a short-term state of awareness that depends on a person’s perceptions of one’s immediate reality, as well as on immediate external circumstances and outcomes. By “life satisfaction” I mean a longer-term state of contentment and well-being that results from a person’s experiences over time. Surveys and experimental studies have made progress in identifying the determinants of happiness and life satisfaction. Interestingly, income and wealth do contribute to self-reported happiness, but the relationship is more complex and context-dependent than standard utility theory would suggest.2 Other important contributors to individuals’ life satisfaction are a strong sense of support from belonging to a family or core group and a broader community, a sense of control over one’s life, a feeling of confidence or optimism about the future, and an ability to adapt to changing circumstances. Indeed, an interesting finding in the literature is that the overwhelming majority of people in the United States and in many other countries report being very happy or pretty happy on a daily basis–a finding that researchers link to people’s intrinsic abilities to adapt and find satisfaction in their lives even in very difficult circumstances.”
It is going to really piss off liberals if the Happiness Index becomes an argument for not worrying to much about AD.
9. August 2012 at 18:22
[…] program from another planet, sent to destroy the dollar and soften up Earth for the invasion. Today he writes: I am constantly amazed that so many highly intelligent economists and finance-types seem incapable […]
9. August 2012 at 20:29
I put together a little piece on my view on the Lesser Depression:
http://socialmacro.blogspot.com/2012/08/the-balance-sheet-recession-hypothesis.html
9. August 2012 at 20:58
Of course, the EMH holds water, a great deal of it, and is a foundation for economic analysis and prescription.
Ever does EMH fail? Perhaps, and maybe some devils can outsmart EMH, briefly, in certain economic netherworlds.
But how do we make economic policy? Some springs it runs cold, and sleety, and the crops fail. Do we stop planting in spring?
More great blogging by Sumner, btw.
9. August 2012 at 21:49
Scott,
I usually agree with you, but this time I’m not so sure. The EFH says that prices reflect current information. Extreme price changes without a change in information would seem to violate the EFH.
It makes sense to me to understand a bubble as price changes that are endogenous to the market rather than reflective of changed external conditions. I don’t think the EFH allows for such endogenously driven price changes — and especially not endogenously driven price changes at the scale usually associated with bubbles.
9. August 2012 at 22:40
Scott,
Why is minimizing swings in NGDP good for the economy, but minimizing swings in financial asset prices bad for the economy?
I suppose my answer would be “We have a good idea how to stabilize the NGDP path without real distortions. But we have no equivalently nondistortionary idea for stabilizing financial asset price paths, assuming you’ve already stabilized NGDP first.”
But I think your answer would be more interesting.
10. August 2012 at 00:20
That means that if bubbles are big price advances followed by substantial declines, then a world without bubbles would violate the EMH.
and
If prices in Australia drop, then I will consider that a vindication of the EMH, which predicts that house prices should fluctuate, and not go straight up.
So during conditions of hyperinflation where EVERYTHING is increasing in price over time, EMH is being violated!?
——————
If prices in Australia drop back down below 2005 levels, which the bubble-mongers thought were excessive at the time, then I will admit that the Australian housing market circa 2000-15 is one data point in favor of bubble theory, and one data point against the EMH. That’s not to say any single example is dispositive, but it would help the bubble argument.
and
My fear is that we’ll see a 10% or 20% drop in Australian housing prices, which is perfectly consistent with the EMH, and people will see it as confirming their anti-EMH prejudices.
First off, why do you characterize those who reject the EMH as holding a “prejudice”? That is unfair. There are many of us who have painstakingly and open mindedly thought it out and have come to the conclusion that it is not tenable. One could just as easily characterize you as having a pro-EMH prejudice. And why do you call them “bubble mongers”? They aren’t advocating or promoting bubbles by merely labeling a market as in a bubble. Fear mongers are those who spread fear. War mongers are those who spread war. Bubble mongers would have to be those who spread bubbles. Analysts aren’t spreading bubbles by calling a market as in a bubble. In fact, if anyone can be called “bubble mongers”, it’s central banks, for central banks create the inflation that spreads bubbles!
Second, 2005 was not the only year that “bubble-mongers” were saying the housing market was in a bubble. There were independent “bubble mongers” saying the housing market was in a bubble in every year since at least the late 1990s. Since a given individual “bubble monger” cannot be held responsible for every other “bubble monger”‘s opinion, and does not speak on behalf of any monolithic “bubble monger” crowd that has one specific set of ideas, then why can’t we say that if the housing market declines X%, then those who were right would score points against the EMH?
Oops, I forgot. Prejudicial EMHers would say “EMH predicts correct expectations!” EMH can’t lose. People make gains, then EMH. People make losses, then EMH. People making short term gains, then EMH. People make long term gains, then EMH.
—————–
What is really happening is that those who guess right would, intentionally or unintentionally, in part be correctly anticipating the central bank’s future choices, which by the way is scientifically impossible to predict based on physical constants (and is the kernel of truth to EMH). You are banking on the hope that the RBA would inflate enough to prevent a significant fall in nominal prices, at least not back to 2005 levels.
But suppose the RBA suddenly became hawks, and let NGDP plunge, which makes home prices fall 50%? Would that be a vindication of EMH or would it be consistent with EMH?
It’s funny how you say EMH makes predictions about prices fluctuating, when prices are contingent upon central bankers choosing to inflate or not that has nothing to do with EMH.
It’s amusing to watch where EMH logic takes you.
10. August 2012 at 01:23
Scott,
The anti-EMH position you are describing is too extreme for my taste.
I find it more useful to compare EMH with more sophisticated anti-EMH positions, such as Lo’s Adaptive Markets hypothesis:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1977721
10. August 2012 at 02:03
Price fluctuations and even “bubbles” are not inconsistent with the EMH. The EMH works on all available public information, but it does not presume that information is complete or correct. If that information is incomplete, or even wrong, prices will fluctuate and bubbles will occasionally form. It’s that simple.
Here, we can even agree with Keynes (and maybe even Keen):
“When the facts change, I change my opinion. What do you do, sir?”
On a different level, the EMH is really a philosophical theory of objective reality. It presumes that all members of the market viewing the same data collectively come to a statistically more accurate view of reality than randomly chosen members. That has, in a way, been expressed, but much more eloquently, as follows:
Let us take three types of men walking through the same landscape. Number One is a city man on a well-deserved vacation. Number Two is a professional botanist. Number Three is a local farmer. Number One, the city man, is what is called a realistic, commonsensical, matter-of-fact type: he sees trees as trees and knows from his map that the road he is following is a nice new road leading to Newton, where there is a nice eating place recommended to him by a friend in his office. The botanist looks around and sees his environment in the very exact terms of plant life, precise biological and classified units such as specific trees and grasses, flowers and ferns, and for him, this is reality; to him the world of the stolid tourist (who cannot distinguish an oak from an elm) seems a fantastic, vague, dreamy, never-never world. Finally the world of the local farmer differs from the two others in that his world is intensely emotional and personal since he has been born and bred there, and knows every trail and individual tree, and every shadow from every tree across every trail, all in warm connection with his everyday work, and his childhood, and a thousand small things and patterns which the other two””the humdrum tourist and the botanical taxonomist””simply cannot know in the given place at the given time. Our farmer will not know the relation of the surrounding vegetation to a botanical conception of the world, and the botanist will know nothing of any importance to him about that barn or that old field or that old house under its cottonwoods, which are afloat, as it were, in a medium of personal memories for one who was born there.
So here we have three different worlds””three men, ordinary men who have different realities””and, of course, we could bring in a number of other beings: a blind man with a dog, a hunter with a dog, a dog with his man, a painter cruising in quest of a sunset, a girl out of gas”” In every case it would be a world completely different from the rest since the most objective words tree, road, flower, sky, barn, thumb, rain have, in each, totally different subjective connotations. Indeed, this subjective life is so strong that it makes an empty and broken shell of the so-called objective existence. The only way back to objective reality is the following one: we can take these several individual worlds, mix them thoroughly together, scoop up a drop of that mixture, and call it objective reality. We may taste in it a particle of madness if a lunatic passed through that locality, or a particle of complete and beautiful nonsense if a man has been looking at a lovely field and imagining upon it a lovely factory producing buttons or bombs; but on the whole these mad particles would be diluted in the drop of objective reality that we hold up to the light in our test tube. Moreover, this objective reality will contain something that transcends optical illusions and laboratory tests. It will have elements of poetry, of lofty emotion, of energy and endeavor (and even here the button king may find his rightful place), of pity, pride, passion””and the craving for a thick steak at the recommended roadside eating place. So when we say reality, we are really thinking of all this””in one drop””an average sample of a mixture of a million individual realities.
10. August 2012 at 06:50
Two short pieces by some German economists on sticky wages;
http://www.voxeu.org/person/christian-merkl
From one;
‘Without the wage moderation before the Great Recession [2008], the German miracle would have been impossible. This is a point that is often ignored in the German public debate. The German Hartz reforms, which made the unemployment benefit system less generous, were certainly one of the reasons for the wage moderation. The reform was initiated in 2002 by a governing coalition, led by chancellor Schröder and the ruling Social Democrats. For some reason the Social Democrats are currently ashamed of this reform. If only they were to look at the facts from the Great Recession, they would surely be proud.’
But, from the other, things aren’t looking to stay so good;
‘This column has argued that sclerosis and large volatilities may be two sides of the same coin. The connection is clear-cut in theory. The data for Germany and the US from 1980 to 2004 support this story and cross-country evidence points into the same direction. Obviously, the labour market experience in Germany and in the US during the Great Recession (2008/2009) tells a completely different story as the volatility of the labour market in Germany was small (i.e. (un)employment was basically flat). But, as Gartner and Merkl (2011) argue, this may be due to a transition period in Germany caused by the labour market reforms and the ensuing wage moderation. The trend of declining equilibrium unemployment was offsetting the effect of the adverse macroeconomic shock. There are signs that the transition period is coming to an end. Germany may be back to normal soon. Thus, we expect that future recessions are associated with job losses again.’
10. August 2012 at 08:10
I often wonder, if economists claim to able to spot bubbles, then why aren’t they millionaires? I think we should ask the Steve Keen’s of the economics profession to have some stake in their market predictions.
I still don’t see how the recent financial crisis disproves the EMH. Assuming we are defining the EMH as “prices reflect available information,” then obviously once new information floods the market, such as the realization that mortgage-backed securities were not rated soundly by rating agencies, we would expect a drop in those prices.
Scott, I often hear you discuss the importance of returning to the pre-financial crisis NGDP growth trend line. What do you think of those who say that we shouldn’t try to return to the trend line because it represented “phantom” growth due to a “bubble?” I always felt that this was a weak argument since the housing market is only one segment of GDP, but I would be curious to hear your thoughts.
10. August 2012 at 10:05
To me a bubble is identified by the fact that people are buying an income or service providing asset not based on the value of the income or service and way above the value of the service or present value of the income but are buying it because it recent increased in value. Bubble markets full on momentum players.
10. August 2012 at 11:04
“A no lose proposition. That means that if bubbles are big price advances followed by substantial declines, then a world without bubbles would violate the EMH. Which means asset price bubbles do not violate the EMH.”
Scott, this is really bad. What you did was *define* bubbles so that they fit into the EMH, and then used that definition to reach the “conclusion”: “See, bubbles fit into the EMH!”
10. August 2012 at 12:31
I wouldn’t simply define a bubble as an increase in prices followed by a decline. There’s several reasons why assets prices will fluctuate without necessarily being associated with a bubble.
The key mechanism behind a bubble is when an increase in the price of an asset increases the demand for that asset. This, in turn, will cause a further increase in price which will cause growing demand. You get a positive feedback loop. Note that demand isn’t responding to the level of price but to the change in that level, so there’s no static tradeoff between the level of price and the level of demand, it’s a dynamic process.
If the demand for assets could only come from income, the process would be self defeating and a bubble could never occur. Credit provides the soft budget constraint neccessary for that process to unfold. Debt is therefore an essential variable you need to look at in order to identify bubbles. A bubble will be caracterized by a runaway in both the ratio of price and debt to income and the causal relation between debt acceleration and the change in prices is the reason why it has to burst.
10. August 2012 at 17:24
Scott, not even Houdini could get out of the corner into which you’ve painted yourself. Go ahead, surprise me.
10. August 2012 at 17:48
Morgan,
“It is going to really piss off liberals if the Happiness Index becomes an argument for not worrying to much about AD.”
You don’t understand the hippies you want to punch at all.
11. August 2012 at 03:15
This sounds like a good book: http://econlog.econlib.org/archives/2012/08/randal_otoole_o.html