A conversation with the 2002 Nobel Laureate in Economics.
Question: What are your findings about asset market bubbles?
Vernon Smith: Money is a problem both in the world and in the asset trading markets in the laboratory. Now of course asset market bubbles are much older. They started centuries ago in the economy. We didn’t get around to doing any experiments on them until you know the early 1980s and one of the things that was so amazing about these experiments is that we thought we were creating an environment where it would be transparent what the fundamental value was and that people would trade at that fundamental value and far from being based on asymmetric information in these experiments everyone had the same information and they had complete information and in spite of this we got the bubbles and that surprised us. At first we thought there was something wrong with the experiments and but it turned out that they replicated very easily and not only with undergraduate subjects, but also business people and at one time in frustration we went into Chicago and recruited some over the counter traders in the stock market and we put them in an experiment and they gave us a nice bubble. So these are very robust and money is at the core of both bubbles in the field and bubbles in the laboratory. And in fact we did see in an asset market trading experiment we give people endowments of cash and shares and then tell them what the dividend range is, the dividend distribution, the realizations at the end of each period and in terms of the dividend draws and this is what determines the fundamental value or holding value of the shares and you can do an experiment where you’d give group A say subjects given endowments of shares and cash and then group B you can give them twice of three times as much cash, but the same endowments of shares and you’ll get a much larger bubble in the second case even though there is nothing changed about the fundamental value of the shares. So the laboratory results make it very clear that it’s cash flopping around in the system that tends to give you these runaway asset market bubbles.
Question: You go on to note that historically most bubbles do not bring down the entire economy when they pop. What happened this time?
Vernon Smith: I think of the housing bubble as the asset bubble that blindsided the economy. If you look at bubbles in stock markets they do not cause general problems in the economy. We had the dot com stock bubble that ran all through the nineties and peeked out in 2000 and crashed and you had about 10 trillion dollars loss in asset market value as a result of that stock market bubble and it had a minor affect, small affect on the banking system and the economy generally. On the other hand, if you look at 2001 when we lost about three trillion dollars in value in the housing market it devastated the banking system and the reason for this is really I think quite clear. In the stock market going clear back to the late 1920s we have always had brokers themselves require margins when you buy stocks. If you go back even to the late 1920s brokers were requiring 45 and 50 percent margin requirements when you bought securities and in the case of risky stocks they would require as much as 70 or 75 percent margin requirements and what that means is that you simply cannot buy stocks on margin the way you can buy homes or you could buy homes on margin with very low down payments. Even with loans in the stock market you have to keep in mind that those are essentially call loans. Now what that means is if you have a 50% margin requirement if you buy securities, meaning you have to put half the cash, if those stocks that you buy decline in price and the total value of your portfolio becomes less than 50% of the stocks that you borrowed on your broker will simply sell some of your shares in order to cover that loss and you can’t even prevent that. You sign a contract that gives him that right if you are a margin buyer. And so what that means is that bubbles in the stock market if there is a problem the problem is borne by the investors in the market. On the other hand if you have people buying houses with very low or zero down payments and the prices of homes starts to decline right away those homes, those loans that the banks have made are underwater, the banks start then to get into trouble. They have a balance sheet problem and as soon as the banks are in trouble it puts all kinds of people into difficulty that may have had nothing to do or they may not have had anything to do with what was going on in the stock market. So if the banks are under pressure and not making loans all sorts of people may be hurt and they may not even be homeowners. They rent and they haven’t been contributing to the problems, but they nevertheless may suffer. So there is a big difference here between asset market bubbles where people are required to collateralize all of their borrowing and cases as in the housing market where they’re inadequately collateralized and so there is no cushion, no nothing to protect sort of the systemic risk in the banking system if those asset prices decline.
Question: How has the government response to the crisis impacted household incomes, housing policies, and tax changes?
Vernon Smith: Larry Summers, who is the chief economic advisor to President Obama, gave a speech to the Brookings Institute last March in which he referred to the paradox we now had in financial markets. He said in the last few years we’ve had the problem that there has been too much greed and not enough fear, to little saving and too much spending and too much borrowing and he said that our problem now is the opposite. In other words there wasn’t enough borrowing. There wasn’t enough spending. There was too much savings. And of course what the administration is doing is the same thing any administration would do in this crisis and that is to try to prevent the price of homes from falling, so they’re shoring up the demand for homes by more subsidies. Now if you think about that you realize that the proposed solution now is exactly what the problem was, so the solution is the problem, more of the same and the question is how do you get out of this sort of vicious circle and I think what’s important is that you try not to get there in the first place because you once you’re in this kind of a downturn all of the political pressures are to further artificially expand the demand for homes and to shore up those prices even though what we really need is for those prices to come down relative to the prices of other things in the economy because they’ve been blown up; they’ve grown all out of proportion. Home prices are way out of proportion to increase of other prices in the economy and this was entirely due to funny money to basically home financing through credit much in excess of the kind of home buying that would normally occur out of income. See normally we spend about… Developed countries people spend about 30 percent of their income on housing and when you have prices doubling and tripling in a matter of 10 or 15 years it means that those prices are way out of proportion to the ordinary ability to finance them and something is going to have to give. These prices are going to have to or that credit bubble will have to go through an adjustment.
Question: What would Hayek say about this crisis?
Vernon Smith: Hayek emphasized and the Austrians did, that credit bubbles would always create difficulties for the economy, that whenever you had an expansion of investment capital by businesses that was very much dependent upon credit extension that that would always tend to create unsustainable market conditions and you would tend to have an expansion that could not be continued without a painful readjustment. The thing that was I think sort of not made explicit in most of the Austrian discussions was that the importance of consumer durables. Although certainly any durable good would fit into the Austrian argument that if those were being bought out of credit expansion rather than ordinary savings generated in the economy there was the possibility that you would have the need for some adjustment, so I think although Hayek didn’t really discuss or consider the kinds of special circumstances we’ve seen in the housing market I don’t think he would be surprised at what happened and what we observed.
Question: What is the proper role of regulation in these markets?
Vernon Smith: I don’t think there is anything you can do to prevent bubbles. I think we’ve had frequent stock market bubbles that have self corrected and the burden of those bubbles and the pain is basically borne by the investors in those markets and you do not have collateral damage to the economy from bubbles in stock markets like you have in bubbles with housing and generally with consumer durables and I think the solution in the housing and the consumer durables markets is the same as the solution that we’ve worked out institutionally in stock markets and that is require these purchases to be reserved, collateralized. You have to put up a margin, a respectable margin if you’re buying, making a commitment to buy a long lived asset and you can’t be sure that you’re going to be able to maintain your job and maintain your income and meet those payments and the way you protect against that is to require reasonable down payments and also loan amortization. Now we learned all of this. We learned all about amortizing loans. We learned about having 25 or 30% down payments for homes. We learned that in the 1920s and 1930s because if you go back to the 1920s there were lots of bank loans being made. The state banks were making loans on real estate that were interest only loans. They tended to be short term loans, three and four years. You paid only the interest and then when they came due you rolled them over and that turned out to be part of the difficulties, certainly not all of them. A lot of them the problems in the twenties were not only credit financing of home sales, but all sorts of consumer durables. You had for the first time in the twenties the development of buy now pay later for all sorts of durables like furniture and automobiles and that credit binge in the twenties was an important part of the collapse that took place in 1929 and 1930. And one of the things that you saw in the 1930s was the disappearance of the unamortized housing loan. If you compare for example 1928 and 1938 mortgage loans by banks. In 1938 they’re amortized and in 1928 many, half of them were not amortized, so there is an example where we had institutional learning, but somehow that memory faded. We forgot that lesson in the case of the housing markets and that’s what gave us a recurrence you see of a lot of the same conditions of the 1920s and ’30s. We’ve seen repeat of that from about 1997 to 2006 was the boom period in the housing market and then the collapse since then. And you know we have kind of a nice controlled experiment in one of the states. I don’t think it’s generally realized that Texas law (and this law dates back I think to about 2001 or 2) prohibits lending, making unamortized loans on a home. They prohibit balloon payments. There is a provision requiring that whatever the payment and loan stream conditions are the principle has to rise. That is as you pay of a loan you more and more of the money is going in to reduce the amount of the loan and what is interesting is that when if you look at the Case-Shiller Housing Index and how it blossomed up from 2000 to 2006. It was rising 75 or 80%. In Texas prices only rose 30 percent. And so it’s clear that this Texas law made a substantial difference there and it seems to me those are very reasonable kind of property type regulations in which you say that people don’t have a right to buy homes without putting up some, a reasonable cash down payment and that the loan be amortized. And so that’s not a heavy handed regulation. It’s a very reasonable benign type of regulation: give people rights to take action that are consistent with sustainability and stability.
Question: What implications does this have for the regulatory treatment of commodities markets versus securities markets?
Vernon Smith: I think you probably can make a case of having just one regulatory agency. The CFTC was formed probably because it had a rather different political constituency. It was commodities and commodities futures and markets and that political constituency was in the Midwest, the agricultural states where as the FCC was a much broader and more comprehensive sort of constituency, but with the development of derivatives markets really a lot of the distinction between securities and commodities I think have disappeared. It’s interesting though that the style of the CFTC and the style of the FCC have been rather different. The CFTC has always been somewhat more a freewheeling regulatory agency. They’ve not been a heavy handed regulator and it’s particularly interesting that Chairman Born, who was chairman of the CFTC in 1998, her agency issued a concept release in 1998 in which they were proposing to reexamine the exempt from regulation status of the derivatives market and they were not necessarily proposing that there be some sort of heavy handed regulation be introduced. In fact, they left open the possibility of some sort of self regulation, regulation by the industry. That was opposed. Their concept release was opposed by a joint statement that came from the Federal Reserve System, Federal Reserve banks. That was Greenspan at the time in 1998. Treasury Secretary Ruben in the Clinton administration, he joined in opposition to that and also the FCC chairman.
In retrospect, Born is seen now as something of a hero because she wanted to reexamine the question of the exempt status of those instruments and I think actually a fairly simple regulatory change for those derivatives is all that is called for and that is simply require them, derivatives to be listed on exchanges. If you did that the exchanges then would require them to be collateralized and that is to me the main problem in the derivatives market, particularly that was true in the housing mortgage derivatives market because those are essentially markets where people are making bets on whether a certain class of mortgage backed securities are going to suffer default and the providers of that, the seller of those contracts. You see that’s a form of insurance in the sense the person who buys those contracts sees that as a way of hedging their risk of default, but it’s not insurance if the sellers of those contracts are not required to collateralize the contract and generally those contracts were not required to be collateralized. This is basically how AIG go into trouble. They bought a whole lot of these mortgage backed securities contracts and they weren’t collateralized although they agreed that if they lost their triple A rating they would then start collateralizing those contracts. Well they lost their triple A rating and of course they couldn’t begin to come up with amount of cash it would take to collateralize them. So as I see it the defect in those markets was the fact that there was no provision that required them to be collateralized and you know if if A’s promise to pay B can’t be performed upon because A has got a contract with C and C has not delivered on his promise to pay A you have a systemic risk problem and that’s the sort of thing that was created in the derivatives market and at every point in the network, the financial network it’s important that every node that the individuals who are making supply commitments collateralize those commitments, so that if prices turn down there is a cushion in there. There is an inventory cushion to prevent an escalating slide in prices and defaults. So to me it’s what is needed here is not some kind of heavy handed regulation, but simply an application of principles that we’ve already learned a lot about in other markets.
Question: How do derivatives markets help businesses manage risks and how do they help the common man?
Vernon Smith: They’re a form of hedging risk and they’re essentially what in experimental economics what we call an information market and you know our colleagues at the University of Iowa innovated information markets back in the 1980s. They introduced the kind of market where people could make for example trade shares on the outcomes of political elections and that created a market in which the price of the traded shares gave you a market estimate of the chances that a particular candidate would win a political election. It was call the Iowa Electronic Market and the first one actually was a presidential market and it was the 1988 election and that started then a movement toward creating markets on all kinds of political and economic events and in particular it provides you see a form of market that can make a forecast or a market indication of what the chances are of a particular event happening like a default on bonds, default on mortgages, default on the for example the sovereign bonds. You have now markets that, derivatives markets that give you an idea of the chances that the Spanish government will default on its bonds or the UK government of the U.S. government and it seems to me these entirely legitimate forms of markets, but they ought to be collateralized. And I think that’s the most important lesson we’ve learned from the housing market debacle.
Question: What do you believe might be the next application of derivatives and how might this change the way we live?
Vernon Smith: So far as new applications of derivatives markets I think one possibility is we may see more people making, creating derivatives markets, betting markets on policy, public policy outcomes. We’ve already seen that with regard to the Federal Reserve. There is a market now in which people are able to make, take positions on the likelihood of a change in the Federal Reserve Bank policy at their next meeting of the Federal Open Market Committee, so and these markets are concerned with the question of what the Federal Reserve Bank rate will be set at. So I think we may very well see more of these kinds of markets and this could very well provide some indication of how the participants in these markets evaluate some of the policy proposals that governments are making.
Question: What implication does ignorance or blindness have for policymakers responding to this crisis?
Vernon Smith: The main point is that policymakers have to deal with a lot of uncertainty and a great deal of developments and events that are basically not predictable. The point about Bernanke is that it’s hard to think of a central banker who was better informed and more knowledgeable of the problems of the Great Depression. He has written extensively and had good understanding of what was considered to be the failures of the central banks particularly in the 1930s after the Depression got underway, but in spite of that knowledge it’s very clear that the Federal Open Market Committee under Bernanke did not see the mortgage crisis coming. They did not see the housing crisis. They were aware that the housing industry was going through an adjustment and this was repeated in the press releases by the Federal Open Market Committee all through 2007. If you go through the press releases clear up through August 7, 2007, Bernanke and the committee is still has some concern about inflation. They’re holding the federal funds rate at a relatively high level at that time and they did not anticipate the almost complete collapse of the mortgage market in early August 2007. Well the evidence that the Federal Reserve System, the Federal Open Market Committee and Bernanke did not anticipate the kind of trouble we were in is indicated by looking at the difference between the press release they put out in August 7, 2007 and the one three days later on August 10th. On August 7th they were reiterating that they would hold the federal funds rates steady and I think at that time it was five and a quarter percent and that they still anticipated the possibility of inflation and then three days later the press release points out that a number of financial markets are likely to experience considerable stress. And well, tell me about it. The mortgage market had completely collapsed and it was the derivatives market that was the tipoff. And its collapse was the first indication that the whole mortgage market was in serious trouble and no one has I think better expert econometric and economic analysis than the Federal Reserve, but it doesn’t mean that they can predict was is not predictable and so it’s clear that the experts were surprised and blindsided by that development, but I think it’s to Bernanke’s credit that he moved in what seemed to be a pretty decisive way at that time to dramatically enhance the liquidity of the banking system.
The problem is that what was happening I think in the mortgage market indicated that what the banks faced was a solvency problem, not just a liquidity problem. Now sometimes of course it’s hard to tell the difference. You have a solvency problem you see if the fundamental value of your assets are less than the value of your obligations that’s different from a liquidity problem in the sense that you just have a short term need for funds and of course you can have if you have a short term need for funds and a lack of liquidity that can cause distress sales and create a solvency problem, but and I think that’s the way that Bernanke saw the situation he was in, in August 2007 and it’s also I think pretty much how he saw the developments in the early thirties, in the early part of the Great Depression that the Federal Reserve System had simply not supplied sufficient liquidity to keep the system from creating an insolvency problem. I don’t really agree with this. I think in both cases that both in 1930 there is evidence that the banks had a solvency problem because of the loans that had been extended on residential and also commercial properties and those prices had started to, had come down and in fact that had been developing for already for three or four years in the late 1920s just as it had been developing, the defaults were starting to move up in our economy already by 2005, 6 and 7. It started to become then critical in 2007. But I think the point about personal knowledge. Polanyi and also Hayek emphasize this, that there is a difference between knowing that knowing how.
Academic knowledge tends to be based very much upon knowing about things, being able to analyze conditions after the fact, but that doesn’t necessarily give you good capacity to predict in advance and in particular it’s just like those of us that do experimental economics. We realize that, and this is true generally in all of experimental sciences and you find this in Polanyi when he talks about personal knowledge, that there is a lot of human capital involved in the experimental sciences and this is kind of an operating knowledge. It’s a form of can do knowledge that you learn by being involved and doing lots of experiments. You don’t learn about it by reading about it. It’s like learning to play the piano. You don’t learn to play the piano by reading about it. You learn by practicing and the same thing is true through much of the economy. A lot of the knowledge in the economy is this kind of can do practical knowledge learned by practice and the same thing is true at the level of experts and formulating central bank policy. It’s a matter of practice and you can have a good understanding of say the 1930s about what happened then, but it doesn’t mean that when you’re in the middle of a storm you will recognize that it’s happening around you because it’s just a different kind of understanding based upon practice and not necessarily the kind of academic analysis and knowledge that we get through econometric analysis and studies. And I think that’s basically a problem, and it means that you shouldn’t have too high expectations as to what the ability of our experts to deliver is. They’re going to be fallible and what we’ve seen I think and throughout this crisis is both in the Federal Reserve and also in the U.S. Treasury and other agencies of government you’ve had people learning as they go and a lot of the policies are being made up as they go. And that’s I think and inevitable consequence of the imperfection of our knowledge and the limits of our ability to practically manage complex systems like the U.S. economy.
And so what is important is really to avoid these kind of crisis situations in the first place and because they’re so difficult to deal with once we get into them because if nothing else the politics of these situations will drive policy and the politics is not necessarily good long term economic policy and of course the way to have avoided this kind of a problem in the first place was to have better collateralization of the kinds of loans that we’re being made in the housing market and generally in consumer credit markets. It’s not only the housing market, but it’s also credit card debt, student loan debt, automobile loans, all of those credit markets, which ended up being the kinds of private credit instruments that the Federal Reserve found itself necessary to make loans on in 2008. It ended up that the liquidity enhancement moves that the Federal Reserve made in August of 2007 didn’t prevent the economy from declining and we had then in September, October 2008 the Federal Reserve felt it necessary to intervene on a far more massive scale than they had done early earlier to shore up not only the mortgage backed security market for housing, but also the market for student loans, auto loans, credit cards and everything in order to prevent the banking system from what could have been a major collapse.
Question: Explain your statement that new precautionary institutional controls are required at this advanced stage in the development of consumer capitalism just as our predecessors developed institutions to manage the risks of industrial capitalism.
Vernon Smith: The main thing to do is to resurrect the learning from the twenties and thirties and that is that credit markets, particularly consumer credit markets need to involve amortized loans and reasonable down payments, so that when you borrow to buy automobiles and you borrow to buy homes there should be a requirement of a reasonable down payment and amortization of those loans. And we got into the business of, particularly at the federal level, the Community Reinvestment Act in the 1990s became a means by which the federal government enabled, wished to enable people of modest means to buy a home and so as a result that act created scoring system for private lenders whereby if they got good scores by aggressively, more aggressively making loans to people whose incomes were below 80% of the median those scores helped them, gave them, enabled them to more easily get approval for making expansions in regional banks and these scores were used in helping to decide whether to approve mergers, this sort of thing. Various devices were used to encourage private lenders to more aggressively make loans on homes to be purchased by people of modest income and what we got from that was a particularly strong demand for homes at the low end of the pricing tier. If you look at the Case-Shiller Housing Index and if you divide that index into three tiers, the low price tier, the middle price tier and the high price tier from 2000 to 2006 the prices that went up the most were the low price tier. The low price tier of homes rose the most, the greatest percentage and fell by the greatest percentage after the collapse and so those policies didn’t actually help those people in the sense that it ended up in many ways we hurt the people we most had a most heartfelt desire to help and the middle price tier homes rose less rapidly than the low and the higher priced tiers rose the least. So the impact of the housing bubble was felt disproportionately in the lower income buyers of homes, so I think I would begin not with any notion that we need a radical reexamination of the regulatory framework, but just introduce some of the institutional learning that we’ve already achieved and let that institutional learning stand and not interfere with it.
Question: What are the constraints on the Fed that prevent it from moving beyond its typical role as inflation fighter to address employment, another key part of its mission? (Ryan Avent, The Economist)
Vernon Smith: Well the Fed has already I think taken actions in roughly the last year. The excess reserves have risen by about a trillion dollars and that has huge inflationary potential depending upon what kind of endgame strategy the Fed follows in getting us out of this huge potential expansion in credit in the private economy. Of course it’s not been a problem because those excess reserves have not led to any kind of undesirable credit expansion in the private economy because there is just no demand for loans right now. The reason my coauthor Steve Gjerstad and I said that some inflation might be a good thing at the present time is that it is one way to get the relative price of homes up. If you inflate basically the rest of the economy by 6 percent then you correct that imbalance between the price of homes, which have gone way up during the boom went way up out of proportion to other prices in the economy, so it’s important for the relative price of homes now to come back to more standard historical levels if you’re going to get a natural resumption in the demand for housing. And of course the problem in setting about and creating a 6 percent inflation rate to give you that relative price change is simply that you might not be able to control those forces once they’re unleashed, so in a way our recommendation is somewhat tongue and cheek. I think that a little inflation now would be a good thing. Yes, it would, but the question is how do you achieve just a little bit of inflation and not get too much.
Question: One of the problems with TARP was an inability of the treasury to come up with an auction design that would correctly reveal the value of the toxic assets and fear of overpaying led them to be cautious to the point of never actually implementing the program to any significant degree. Is there any way to design an alternative market mechanism that will value these assets next time? (Mark Thoma, Economist’s View)
Vernon Smith: I really can’t answer that. It would require a pretty extensive experimental examination of the issues here to really come up with the question of whether you could design an auction for the treasury to dispose of these toxic assets. You know the problem people have described it as just a reverse auction where instead of the treasury being a seller of treasury securities as they have had a lot of experience with. See, the treasury sales securities to multiple buyers in treasury auctions and here you have the treasury buying from multiple sellers of these toxic assets, but the problem is that these assets are not homogeneous. When the treasury is issuing securities to multiple buyers there isn’t any difference. Every one of these securities is exactly like every other one, so that the buyers do not have the problem of valuing a mix of heterogeneous items. It’s a homogeneous set of items that are being offered up for sale. Private auctions don’t have any difficulty valuing heterogeneous assets. What they do is put them up to for sale one at a time. If you got to Christie’s or Sotheby’s, the auction houses, they auction items, heterogeneous items either singly or in very maybe very small groupings that are relatively homogeneous and if you’re going to do a multiple unit auction of dissimilar items that’s a challenging problem and the whole… You know the original proposal didn’t make any sense to me and of course they quickly found out what I think is obvious, which is that the treasury is simply not practiced at all in running that kind of auction and they backed off to as well they should have.
Recorded on December 15, 2009
