Behavioral Bubbles and the Business Cycle

Writing at the Project Syndicate, Yale professor of economics and author of Irrational Exuberance Robert Shiller sees bubbles in Columbia and many parts of the world.  (hat tip Zero Hedge) [all bold mine]

From the world of rational expectations and efficient market hypothesis, Mr. Shiller points out that bubbles do not exist

This raises the question: just what is a speculative bubble? The Oxford English Dictionary defines a bubble as “anything fragile, unsubstantial, empty, or worthless; a deceptive show. From 17th c. onwards often applied to delusive commercial or financial schemes.” The problem is that words like “show” and “scheme” suggest a deliberate creation, rather than a widespread social phenomenon that is not directed by any impresario.

Maybe the word bubble is used too carelessly.

Eugene Fama certainly thinks so. Fama, the most important proponent of the “efficient markets hypothesis,” denies that bubbles exist. As he put it in a 2010 interview with John Cassidy for The New Yorker, “I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.”

Contra EMH, Mr. Shiller says that bubbles are not rational

In the second edition of my book Irrational Exuberance, I tried to give a better definition of a bubble. A “speculative bubble,” I wrote then, is “a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increase.” This attracts “a larger and larger class of investors, who, despite doubts about the real value of the investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.”

That seems to be the core of the meaning of the word as it is most consistently used. Implicit in this definition is a suggestion about why it is so difficult for “smart money” to profit by betting against bubbles: the psychological contagion promotes a mindset that justifies the price increases, so that participation in the bubble might be called almost rational. But it is not rational.

The story in every country is different, reflecting its own news, which does not always jibe with news in other countries. For example, the current story in Colombia appears to be that the country’s government, now under the well-regarded management of President Juan Manuel Santos, has brought down inflation and interest rates to developed-country levels, while all but eliminating the threat posed by the FARC rebels, thereby injecting new vitality into the Colombian economy. That is a good enough story to drive a housing bubble.

Because bubbles are essentially social-psychological phenomena, they are, by their very nature, difficult to control. Regulatory action since the financial crisis might diminish bubbles in the future. But public fear of bubbles may also enhance psychological contagion, fueling even more self-fulfilling prophecies.

And bubbles eventually pop…

One problem with the word bubble is that it creates a mental picture of an expanding soap bubble, which is destined to pop suddenly and irrevocably. But speculative bubbles are not so easily ended; indeed, they may deflate somewhat, as the story changes, and then reflate.

It would seem more accurate to refer to these episodes as speculative epidemics. We know from influenza that a new epidemic can suddenly appear just as an older one is fading, if a new form of the virus appears, or if some environmental factor increases the contagion rate. Similarly, a new speculative bubble can appear anywhere if a new story about the economy appears, and if it has enough narrative strength to spark a new contagion of investor thinking.

This is what happened in the bull market of the 1920’s in the US, with the peak in 1929. We have distorted that history by thinking of bubbles as a period of dramatic price growth, followed by a sudden turning point and a major and definitive crash. In fact, a major boom in real stock prices in the US after “Black Tuesday” brought them halfway back to 1929 levels by 1930. This was followed by a second crash, another boom from 1932 to 1937, and a third crash.

Speculative bubbles do not end like a short story, novel, or play. There is no final denouement that brings all the strands of a narrative into an impressive final conclusion. In the real world, we never know when the story is over.

In the real world, speculative bubbles operate on cycles. A boom is followed by a crash. Why there seems to be “no final denouement” on these episodes has been that policy responses to bubble crashes has been to “reflate” unsustainable bubbles, ergo the repetition, the cycles. Social policies have essentially been designed to prevent the market clearing process.

The other reality is that the “social-psychological” phenomenon of every bubble is a symptom rather than a cause, since peoples actions does not emerge from a vacuum. The behavioral aspect represents a narrative of people’s reactions to a largely “unseen” stimulus which prompts the “herding or lemming effect” and thus resulting to “irrational exuberance” or speculative bubbles.  

Yield chasing actions, thus are “rational” from an individual’s ex-ante point of view and “irrational” from an “ex-post” (hindsight is 20/20) perspective or from a third party interpretation of an evolving bubble, similar to me or to Professor Shiller.

In other words, "rationality" represents the time inconsistent dilemma on the individuals and on the markets. And that the yield chasing dynamic attendant to these events signify as the immediacy effect or temporary discounting.  

Another reality is that grand bubbles will hardly exist WITHOUT resources fueling them.

Thus the limitations of people’s highly exuberant behavior and actions or “speculative bubbles” will ultimately depend on the limits of resources that enables and facilitates such activiites. 

As Austrian economist Roger W. Garrison explained, first "you can’t just spend expectations" and importantly, (bold mine)

individuals who are in possession of increased money balances and who have correct, or rational, expectations still may not spend in a pattern consistent with the New Classicist view. A spending pattern that is internally inconsistent on an economywide basis does not necessarily imply inconsistency for the individual. That is, macroeconomic irrationality does not imply individual irrationality. An individual can rationally choose to initiate or perpetuate a chain letter—sending one dollar to the person on the top of the list, adding his name to the bottom, and mailing the letter to a dozen other individuals—even though he knows that the pyramiding is ultimately unsustainable. Similarly, it is possible for the individual to profit by his participation in a market process that is—and is known by that individual to be—an ill-fated process. So long as it is possible to buy in and sell out before the process reverses itself, rational expectations may exacerbate rather than ameliorate the misallocation of resources induced by monetary expansion.

To repeat, people’s actions doesn’t operate on a vacuum. 

Social policies are hardly neutral, they shape people's incentives and action. Monetary policies via credit expansion serve as the fuel for every bubble.