
Why asset bubbles are a part of the human condition that regulation can’t cure - robg
http://www.theatlantic.com/doc/print/200812/financial-bubbles
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jerf
Traditional differential equations is not one of the more useful college math
classes(star), but a few useful things can be extracted from it. One of the
most interesting is that under certain circumstances, oscillation is
_inevitable_ , by the very nature of how the system reacts to its own changes.

A classic example is the well-known "simple harmonic oscillation", where the
only solution that doesn't oscillate is to start right at 0.

The market is more complicated. If simple harmonic motion is caused by
negative feedback (the further you get from the origin, the stronger the force
pulling you back), market instability is caused by positive feedback and the
fact that there is a cap in how far bubbles can inflate. Excitement engenders
excitement, so bubbles inflate. Depression engenders depression, so
contractions also tend to overshoot vs. the "true" state of the economy.

Stripping this effect out of the economy would take more than just making it
"smarter", you'd have to rewrite the whole foundation of it.

Mitigating recessions (and depressions) may be possible. Trying to stop them
just makes them hit harder.

((star): DiffieQs are of course themselves useful; it is the class itself that
is considered a bit of a waste by professors. Closed form solutions to
diffieqs are the exception, not the rule, and mathematicians in general are
not very interested in further pursuing the problem.)

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jderick
Bubbles may be inevitable, but that doesn't mean we can't do anything to
mitigate them. To me, it seems clear that the "Trader's option" -- big bonuses
in good years, no downside in bad -- is a recipe for disaster in any market. I
doubt this bubble would have been nearly as bad if the banks were still owned
primarily by their management.

~~~
Tichy
What I don't get is why should we expect the government to do a better job at
managing banks than the banks themselves? If "trader's options" are bad, why
can't the banks figure it out for themselves?

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mattobrien
Because trader's options are good for bankers, but not good for the public.
These options create incentives for bankers to take large risks to maximize
short term profits, and hence year end bonuses. But if risky trades blow up, a
banker merely loses his job - not exactly nontrivial, but certainly mitigated
by getting to keep bonuses from past years. And if enough risky trades blow up
within a firm, sending it into insolvency, it can always get government
bailouts because of the systemic risk its failure would produce. Essentially,
gains are privatized and losses are socialized. This is why the government
needs to restructure bank pay incentives, with a key probably being making
banks privately held again, as well as reducing leverage and regulating the
system better (or at all).

Granted, some firms, like Morgan Stanley and UBS, are beginning to experiment
with clawback provisions, that have longer 3 year horizons for bonuses. But
until we reform the system, this won't be in banks', or bankers', interests,
except from a PR angle, which clearly matters. And government pressure can
help us get there faster.

~~~
Tichy
Good for bankers, yes, but not good for banks, or are they? And banks employ
bankers.

Remembering Joel's writings on performance measurements, I am simply skeptic
that there can be any remedy, short of people watching out for themselves. I
suspect even with longer windows for bonuses, there will be ways to game the
system.

~~~
mattobrien
Good for bankers and bad for banks. Bankers who took more conservative, longer
term views during the bubble would have been more likely to lose their jobs,
because their short term profits would not have been as large as their peers'
who engaged in groupthink/stupidity. So this pay structure effectively weeded
out bankers who actually looked out for the long term health of their banks.

Simply making banks privately held companies, so the bankers have their own
capital on the line in their trades, eliminates this moral hazard. Banks do
not have some natural right to be publicly traded companies.

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pragmatic
The author makes the mistake of equating efficient markets with rational
markets. The market is not rational (whatever that means) but rather
efficient. All known information (whether it is correct or not) is reflected
in the price of a security.

Rational markets lead us to the communist/central planning trap. If the market
can be shown to not be "rational" the government can assume control
(nationalize) of the market.

Does the weather/climate appear "rational" on a large scale? No of course not.
It consists of the local weather at each measurable point on the planet.
Assuming we can make systems "rational" is plain foolish.

See "The Systems Bible" by John Gall.

~~~
create_account
_The market is not rational (whatever that means) but rather efficient._

Oh boy. Careful to whom you say that.

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Tichy
Is it possible that the expected gain is not the proper measurement for the
value of the shares? For example, the expected value of the national lottery
is negative (-50% in Germany), but I can understand people who play
nevertheless: if you lose, you only lose 1€, but if you win, you can win a
million €.

Similar for the experiment, maybe the chance on the 90cents yield was enough
to warrant higher prices? It is simply gambling?

Phrased differently (using example from other comment): if you had to choose
between 10$ and a 50% chance to get 0$ or 20$, which would you chose?
Depending on your circumstances, either option might be more valuable to you?
If you are about to starve in the next minute, you'd probably take the 10$
(50% chance of dieing is too much), but if you already have enough money, why
not take a 50% shot at earning 10$? What if the choice is between getting 1
million $ and a 50% chance between 0 and 2 million $? I definitely don't think
the two options have the same value, even though the expected outcome is the
same.

Spontaneously I would take the 1 million, otoh I have read somewhere that in
TV game shows, participants routinely gamble away such sums (the kind of game
show where you can either quit and take the money you already won, or put it
all at stake for the next question, with a chance to double it).

I wonder, in the experiment of the article, if prices rose even above the
maximum possible value of the shares?

~~~
schtog
Well they are not the same because your first million has a lot more utility
than the second for most people, unless say you need 2million to start he
company you always dreamed of starting or to do a surgery in a foreign country
on your child that is superexpensive and if not the child will die.

~~~
Tichy
Yes that is what I mean - it seems "expected value" is not equal to real
value.

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mattmaroon
"These lab results should give pause not only to people who believe in
efficient markets..."

The author is mistaking why markets trend toward efficiency. The 10% who don't
overvalue the equities will have enough money (if not at first, but later as
their realism makes them much more profit) to keep the price in line.

Just because 90% of people overvalue something doesn't mean the markets can't
be efficient.

~~~
muerdeme
"Bubbles start to pop when the momentum traders run out of money and can no
longer push prices up."

She states credible evidence that the market is efficient, then claims that
the evidence undermines those who believe in efficient markets... Weak.

~~~
stcredzero
_Why asset bubbles are a part of the human condition that regulation can’t
cure_

"Human Condition" is sometimes a code word for something people don't want you
to fix. There are those who have the means to profit from the large scale
business cycle certainly want you to think that it has to be this way. They
want the forced selling so that they can profit "on the buy." There are those
out there who want to blow up bubbles and ride valuations up, then get out
before the fall.

Death is inevitable. The inevitability of taxes is propaganda.

~~~
DLWormwood
> "Human Condition" is sometimes a code word for something people don't want
> you to fix. _snip_ Death is inevitable. The inevitability of taxes is
> propaganda.

Dang, that's kind of profound. Are you quoting somebody?

~~~
stcredzero
Nope. I wrote that.

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DLWormwood
Wow. Given the common complaint here and at other news sites about economics
lacking scientific vigor, I assumed that it was because it was impossible to
experimentally isolate human economic behavior. Not only does this article
point out one way to do just that, but that it even has a "stereotypical" base
experiment used for decades that future scenarios can be derived from. I need
to bookmark this article as rebuttal or "ward against trolls" in the future...

~~~
eru
Our university even has its own lab for 'experimental economics', where they
do nothing else but run such games.

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helveticaman
I would like to point out that Chile has less regulation than US _and_ fewer
bubbles.

~~~
mdasen
So, what is a bubble? I would define a bubble as when we get irrationally
exuberant just to come crashing down when reality strikes. Such a bubble could
be measured by looking at the up and down of the GDP growth rate. Does that
sound fair?

The WorldBank actually keeps track of a lot of economic data. So, what does
data say? Well, the United States (in the period of 1961-2007) has had fewer
bubbles and those bubbles have been smaller.

When counting bubbles, I used this methodology: a bubble is a decline in the
growth rate of at least 3.5%. When a decline is continuous without a growth of
at least 1% in between, it is considered part of the same bubble (so that I
wasn't counting several years that Chile had large declines in a row as
multiple bubbles). Under that assumption, the US has seen 6 bubbles. Chile, on
the other hand, has seen 8. Move that assumption to 4% and the US has seen 5
and Chile has still seen 8. Moving the assumption up doesn't help Chile.
Moving that assumption to 2% and the US has seen 7 and Chile has seen 10.
Moving the assumption down doesn't help Chile.

The facts show that Chile has more bubbles and the bubbles are larger in size.
The US bubbles average at around 5% while the Chilean bubbles average around
10%.

So, Chile has more bubbles and their bubbles are much greater than the US'.

You can see it in a cool chart: <http://mda-cxxtx.posterous.com/>

A basic look at the chart and you can see that Chile fluctuates a lot more
than the US.

~~~
nradov
GDP isn't a useful way to analyze bubbles. Bubbles are asset price inflation
significantly above the trend line.

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time_management
Great article.

I wonder how the experiments would have turned out if people were allowed to
short-sell. My guess is that the bubbles and crashes would be a lot less
common. When people can only go long, there's a desire to buy in order to be
"participating", and there's also the effect of the Winner's Curse.

One interesting result I read about in Aaron Brown's _The Poker Face of Wall
Street_ involved a mock security that would mature either to $0 or $20, with a
50% chance of each. The participants would be given index cards; half of the
cards had the security's correct value, and half were blank. The price would
start around $10 (since those who have information don't want to show it by
bidding $19/$1) but rapidly converge to the fair value.

When the experiment was done with everyone receiving blank cards (but no one
knowing that all cards were blank) trading would start, as usual, right around
$10. In many cases, it would converge to $0 or $20 as the market "figured out"
the fair value.

~~~
eru
Does anybody care to set up the experiment with short-selling enabled? Would
be interesting to watch.

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zandorg
I haven't read the article, but Isaac Newton once fell prey to the South Sea
bubble, showing that even geniuses get hit.

~~~
mynameishere
I haven't read your comment, but there's no way our shirt cured AIDS.

