Bubbles: A Bit of This and a Bit of That
Two articles today are advancing the idea that bubbles are caused by a confluence of factors psychological, ethical, biological, and monetary. The first is from Forbes's Tim Hartford who cites research on male testosterone: "Profitable trading days boost testosterone levels and tend to encourage more risk-taking, more wins and more testosterone. When the risks didn't pay off, the testosterone ebbed away to be replaced by a stress hormone, cortisol. The whole process seems likely to exaggerate peaks and troughs." Another theory involves speculation about periodic mass hysterias. A final consideration that he mentions: "the Federal Reserve's policy of cheap money, and Fannie and Freddie's enormous appetite for junk mortgages."
But what overall impression does the reader gain from this? How can we weigh the relationship between these various inputs? We come away with a sense that we really don't know for sure what went wrong--it could be many things working together in some strange mix--and therefore we don't really don't for sure what to do about fixing the problem for the future.
Along the same lines is Max Borders's article up at FEE today. The strength of the article is showing how the state can't really do anything to fix a problem of this magnitude once it comes about. Its weakness is in its apparently agnosticism concerning the foundational cause of the bubble ("a confluence of events") and the financial meltdown the came after it popped. He blames not only government policy but also "willfully ignorant bankers, big shot risk-modelers, and people believing they could live beyond their means." He even seems to exempt Greenspan from responsibility: "Given the size of that task, he did pretty well for many years."
When people cite a range of factors without zeroing in on a single one, and refuse to weight their relative significance, Roger Garrison likes to use the necessary and sufficient test to show that an artificially inflated credit supply is the one factor that provides the explanation. Mark Thornton puts it another way. He points out that every financial crisis is characterized by a wide range of seemingly causal agents, but the one feature that they all have in common is an inflated money supply. It is this that the Austrian theory (Ron Paul suggests that it be called the Austrian explanation!) identifies as the core of the issue.
Comments (19)
Dennis
Without the injection of loanable funds not derived from real previous savings, and the consequent lowering of the rate of interest, the "psychological, ethical, and biological" factors could not manifest themselves as a general boom followed by a general downturn. The psychological, ethical, and biological factors may well contribute to the specific characteristics of a given boom-bust cycle (e.g., a tech boom versus a real estate boom versus a general manufacturing boom), but the fundamental causal agent is the central bank's creation of loanable funds.
Published: November 3, 2008 10:53 AM
fundamentalist
Some has written that blaming the current financial distress on greed is like blaming airplane crashes on gravity. While, true, it's not very helpful. The same could be said of the psychological, ethical, and biological factors. Like gravity, those factors are always present and working. We have to explain why they get the upperhand and cause a crisis.
Max Border's article at FEE depends on the black swan argument a lot. Black Swans are random, unexplainable events. However, mainstream econ sees black swans everyhere because their theories are so bad. Most things are unexplainable to them. The ABCT explains most of the black swans.
Published: November 3, 2008 1:19 PM
Matias
fundamentalist:
"However, mainstream econ sees black swans everyhere because their theories are so bad. Most things are unexplainable to them."
Made me laugh. But there's a truth to it, no black swan here. If you extrapolate the trajectory of a stone thrown up in the air after the first second, you might think it's going to orbit. Black swan everytime the stone falls to the ground. ABCT is based on economic laws.
Published: November 3, 2008 1:45 PM
Lester Hunt
Jeffrey, Excellent point. To "explain" something by giving an unsorted laundry list of causes is a paradigm of bad methodology. A very helpful sorting device is to ask if there is one cause that is both necessary and sufficient for the effect to occur.
Published: November 3, 2008 1:54 PM
Lester Hunt
Jeffrey, Excellent point. To "explain" something by giving an unsorted laundry list of causes is a paradigm of bad methodology. A very helpful sorting device is to ask if there is one cause that is both necessary and sufficient for the effect to occur.
Published: November 3, 2008 1:55 PM
fundamentalist
Matias: "Made me laugh. But there's a truth to it, no black swan here."
Thanks! You're right. In pre-science days people explained the difficult events by witches and demons. In modern macro, everything they don't understand is random. Random just means that we can explain something. But the whole point of science is to explain things. Austrian econ does that.
Published: November 3, 2008 3:43 PM
newson
bromide in the water-fountain...the austrian business cycle theorem collapses...focus turns to the oestrogen cycle.
Published: November 3, 2008 5:44 PM
jason4liberty
I was reading on the Kitco home page yesterday, and one article there said that we were currently in the "Austrian end game".
I enjoy reading mises.org, Kitco, and smartmoney.com. You get truth, truth with a salesman's pitch, and the truth through a kalidescope. There was at least one good author on smartmoney, but now I am supposed to pay to read him.
And I agree that bank credit expansion causes the bubbles, but not without the protection of the State.
Published: November 3, 2008 6:36 PM
Jeremy
Speaking of Black Swans, that's one of the most frustrating things about Taleb's The Black Swan.
While he repeatedly praises Bastiat and Hayek, and repeatedly hints that banks cause black swans, he never extends his ideas to government interference in the markets - probably thinking it is a neutral factor which could go either way.
Except the thinkers he lavishes much praise on didn't think so - for such a deep thinker I don't think he's read much of Bastiat or Hayek.
If he did, he might realize two things:
1) Government intervention of many types cause gray swans
2) The investing strategy he advocates - putting a small amount of money in incredibly risky investments and a large amount in 'riskless' treasury bonds - is exposed to the biggest gray swan of them all (the destruction of the dollar)
Published: November 3, 2008 8:25 PM
Deefburger
"# fundamentalist
#
Matias: "Made me laugh. But there's a truth to it, no black swan here."
Thanks! You're right. In pre-science days people explained the difficult events by witches and demons. In modern macro, everything they don't understand is random. Random just means that we can explain something. But the whole point of science is to explain things. Austrian econ does that."
Randomness itself is a misconception, and the use of it as an explaination is just as mysterious as the wichcraft you speak of. Definate patterns arise in all "random" systems. If one studies such systems for a time, there always appears to be a "causality" to the creation of these patterns. There is, but it is not due to any hidden or mysterious unseen force within the "random" system. They are inherent in the occilations of various parts of the system between states of chaos and order. The only proper way to examine the cause and effect of such a random system is to back up and look at the system's fundamentals.
What I see happen all too often is the various sub-systems will show order for a time, a black swan, and pundits point to it and say, "Well, there's your problem right there! Your swan is the wrong color!" This is like playing cards and seeing a run of flushes, and thinking, "Flushes must be more common than straights!"
Big mistake. Back up and look at the fundamentals. Recognise that the deck is shuffled, and that if hearts are predominant in one part of the deck, then the other three suits are likely bunched up as well because there is a lack of the presence of hearts in the rest of the deck. To assume that the string of heart flushes is indicative of the predominance of flushes is asinine.
Yet this type of error occurs all the time by people who have been studying the market for a long time. Not surprisingly, the same thing happens in Casinos everyday to. People who have a "feel" for the game see gains from their decisions about flushes and suddenly they are expert! "I figured it out!" they say. Forgetting that the beautiful pattern they discovered is destroyed by the next shuffle! Shuffles are fundamental. Deck size is fundamental. suits and rank are fundamental. Patterns after the shuffle are fleeting glimpses of inevitable order in a chaotic system and are NOT fundamental!
To examine the testosterone levels of investors or the effect of the color of their shirts on Monday is stupid. That would be like looking for causality in the leangth of the dealers fingernails and their effect on the placement of hearts! This is short-term thinking and is worthless in the long run. It's like looking for that "set of conditions" that signals a "jackpot comming" in the slot machine.
You want to understand how to make money with slot machines, then you have to look at the fundamentals. And when you do, you find that the only real way to make a buck with a slot is to OWN THE MACHINE. That is fundamental!
So who owns the machine? The Central Bank and the Government. Look there for enlightenment.
Published: November 4, 2008 10:28 AM
fundamentalist
Deefburger: "The only proper way to examine the cause and effect of such a random system is to back up and look at the system's fundamentals."
Exactly! And that's why looking only at data can be confusing. If you approach the data with sound theory it will make sense. There will always be some data points that theory can't explain yet and we call call them random events for lack of an explanation. If you follow bad theory, like mainstream econ, the data will make even less sense and you will be plagued by flocks of black swans as in Alfred Hitchcock's movie "The Birds." But even worse, if you try to discern theory from the data, you'll wind up seeing patterns where none exist, which I guess would cause you to see black swans as white?
Published: November 4, 2008 10:49 AM
Deefburger
LOL! No, you'll see black swans as black swans, but neglect to attribute their appearance to swan genetics! Instead, you may say, "Oh look! A new Species of Swan!" or start looking for pranksters dyeing swans black, or pointing accusing fingers at the observers and saying they had "something" to do with it.
What I'm saying is that if you are looking at anything except the fundamental forces at work in swan creation, then you are looking in the wrong place.
The error occurs when one fails to follow the attribute that showed a pattern, or a different pattern, and then follow that attribute back to the fundamentals governing the system in which the pattern occured.
Let me give you an example. Toss a Penny 100 times in a row and tally your results. I can tell you, from my knoledge of the fundamentals, that you will have one run of 7 head/tails in a row. If not one run of 7 then perhaps, in rare cases one of 8 or 2 of 6.
How do I know? You might try looking at the penny, and notice that it was heads that came up 7 times. You might say the penny is weighted more on the heads side. You MIGHT be right, even to a small degree, but you are dead wrong in the long run. Because if you choose a different coin, say a Canadian penny, and you get different results, say two runs of 6 Tails, you might then assume that Canadian pennies are more weighted on tails than heads.
But look at the fundamentals. Both coins have two possible outcomes, and the total number of tosses is 100. Those are the fundamental constraints of the system. Those are the ONLY factors that determine the outcome. The rest is chaos!
See what I mean? It's easy to start looking for non-fundamental differences in a chaotic system and completely ignore the fundamental contraints of the system itself!
And then there are magicians. The magician knows that the system fundamentals are what need to change in order to change the outcome in an appearently chaotic system OR there needs to be a control imposed on the subsystems in order to change the outcome. So he practices tossing a coin in such a way that he gets 10 heads in a row every 100 tosses. Now everyone he does this for goes, "OOOH! The fundamentals are flawed!". This magician then gets rich betting he can get more than 7 in a row every 100 tosses. Is it magic? No. It's simple skill. Are the fundamentals flawed? No. It's just the application of skill and knowledge within the fundamental constraints.
But do people examine the coin for flaws? Of course they do and if they understand the fundamentals, they will realize the existence of the magicians skill! If not, they will be awed, and fleeced!
And when the magician gets old and can't toss the coin with the same skill as he used to, the fundamentals come back into play and he tosses 7 in a row like everybody else.
Published: November 4, 2008 12:24 PM
Max Borders
A couple of things:
1. The editor and I discussed the issue of bubbles. I'd originally argued that housing was a Greenspan/interest rate-induced bubble (which added to the other factors). However, a recent study by the excellent David Henderson (and Jeffrey Hummel) suggests otherwise. So, I took an agnostic tone about a bubble in this case, as I wouldn't presume to resolve a debate between Henderson and the venerable Bob Murphy. However, I do agree that central banking can and does cause bubbles and that one guy controlling interest rates makes them more likely to occur than not.
2. I didn't want to suggest that the economy is in any way non-deterministic. However, I agree with most Austrians in saying that economies are epistemically deterministic--which is to say you can't know the full causal story of a complex system, nor predict it. That's all. Black swans are phenomena of insufficient causal knowledge, not of some mysterious 'underlying reality' -- at least in economics.
3. Finally, I did not want to absolve Greenspan. What I did want to do is take him off the lynching rope so many have put him on. Despite the knowledge problems endemic to central banking, we should, on net, feel pretty fortunate to have had Greenspan in there--relative to other people (not relative to some idealized non-existent decentralized banking system). I realize that most Misesians live in such theoretically counterfactual worlds, but sometimes we have to give a nod to people who perform okay in real contexts. Greenspan, over a span of 40 years, deserves such a nod. He doesn't deserve to be made an example of by Congress and a cabal of Monday-morning interventionists.
Thanks for reading the Freeman piece, everyone.
Published: November 4, 2008 12:43 PM
Jeffrey Tucker
Max, that study made you wonder if Greenspan was loose or tight? You can go to the Fed and look at the Fed funds rate if you want. This is controlled by the Fed. Or you can look at aggregate data. Henderson favors year on year percent change because it looks most favorable to his position, but even here we have 10-20% increases and only a declining rate of increase centering on around 8%. It's true that money supply depends on borrowing habits, but there can be no question that the Fed did its best to inflate and there is serious evidence that the market responded substantially. Again, you don't need some study to show this; you only need to look at the data.
What we are dealing with here ultimately comes down to a difference between Austrians and monetarists. Austrian think that artificially low rates matter (see the housing boom). Monetarists figure that they don't so long as money growth is more or less keeping pace with economic growth and no serious price inflation results.
Published: November 4, 2008 2:58 PM
Deefburger
So you are saying that, as magicians go, Greenspan was a pretty good one. Ok. He was. But only within the system bounded by the fundamental constraints of Central Banking and Government intervention. Fundamentally, the system is still not a "free market" system. Artificial bubbles still happened. Inflation cycles still happened. Price fixing of interest and currency, still happened. He may have been the greatest magician of all time, but he didn't do us any favors by maintaining the status quo.
It's the status quo that is objected too, and the ignoring of the role of the fundamentals in favor of "fleeting glimpses of clarity" about the nature of the subsystems that arise under those constraints as causal when they are really symptomatic not directly related to the actual cause, which is the manipulations of the Central Bank(s).
To say that any chairman of the FED is innocent or even helpful in some way is to miss the point entirely. It's like saying one casino owner is better than another because of the policies he instituted within the constraints of the economy within the walls of his Casino.
It's still a Casino! Fundamentals!!!
Published: November 4, 2008 2:59 PM
Stanley Pinchak
Deefburger,
I object to your tarring of casino owners with the same brush as central bankers. No one is forced into a casino, and one is free to leave at any time (assuming you haven't run up a debt). Everyone who enters a casino expects to obtain satisfaction by doing so. No one has a choice but participate in the monetary sham of the central bank, lest they resort to barter and the massive reduction in the division of labor that it represents. If you could point to a casino which was attached to the Hotel California then your analogy would be much closer to the actual case of the central bank. Other than this small nit, I have enjoyed your comments.
Published: November 4, 2008 4:38 PM
Deefburger
Stanley,
You're right, Casino owners definately deserve better treatment!
It's funny, now that I think about it, how similar the two really are. I mean that a casino is a mini-economy with a controlling central bank. The specie is chips and cheques, the house rake and pay-back return percentages are a form of interest rate, and matching coupons are simply the printing of stimulus incentives! Looks like America to me!
Could I be seeing a black swan?
Published: November 4, 2008 8:00 PM
Jeremy
Max,
In regards to your second point:
2. I didn't want to suggest that the economy is in any way non-deterministic. However, I agree with most Austrians in saying that economies are epistemically deterministic--which is to say you can't know the full causal story of a complex system, nor predict it. That's all. Black swans are phenomena of insufficient causal knowledge, not of some mysterious 'underlying reality' -- at least in economics.
What you are describing here is a gray swan - thanks to its scalable properties it is impossible to predict its exact effect but it is possible to see it coming.
A black swan is something that no one sees coming - like the event (and not the possibility of a large scale terrorist attack) of 9/11.
Unfortunately, thanks to their blindness to both probability theory and Austrian economics, most 'experts' see the credit crises and what is to follow (they can't see it coming yet) as black swans.
Published: November 4, 2008 9:40 PM
Max Borders
Jeremy - Gray swans. I like that. And you're absolutely right. It's a very good point... because we do know what will happen when we get the fundamentals wrong. (Of course, some argue that 9/11 was predictable, too, due to having our 'fundamentals' in foreign policy wrong. Dunno if I agree, though.)
Jeffrey - You may very well be right. You guys are much better than I at the numbers. And expect you're probably right. (My editor wanted me to be more tentative, however, so I was.)
Deefburger - Magician indeed! I agree with you from an Austrian perspective. I'm just trying to protect Greenspan from a) the accusation by the left that he was practicing laissez faire, which is clearly NOT the case, and b) that for a man operating inside the system, he did okay. But mainly I wanted to point out that G-span should not have been made into a straw man for "market fundamentalism." Hell, I'm ready to abolish the Fed.
Great points all.
Published: November 5, 2008 11:01 AM