Economist Vernon Smith has said that most bubbles do not bring down the entire economy when they pop. So what happened this time?
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.
Recorded on December 17, 2009