How To Pop Bubbles

The Fed’s view has been that bubbles can be identified only in hindsight, and that all the central bank can do is prepare to clean up after they burst. The current crisis shows that policy is mistaken, [New York Fed Chief] Dudley said.  “Asset bubbles may not be that hard to identify,” he said. “This crisis has demonstrated that the cost of waiting to clean up asset bubbles after they burst can be very high.” Dudley did not specify what tools the Fed should use. Analysts have suggested that central bankers might raise reserve requirements or amp up restrictions on margin lending.

That is from the Post.  My problem with such approaches is that they aren’t very accountable; i.e., they don’t let us see very easily if past regulator actions helped or hurt on net.  Two years ago I suggested a more accountable way for regulators to reduce bubbles:

Congress could give some well-regarded “best and brightest” regulators a big pile of cash, say $100 billion, and have them correct prices by trading, buying when they think prices should rise and selling when they think prices should fall.  If regulators really do know how to choose good price pushes, then not only will they correct “biased” stock prices, they will increase their pile of cash, and we won’t need to give them any more.

I’m still game; are they?  My approach could also allow a more accountable correction of “excess volatility.”  The Post reports today:

The [US CFTC] will consider new measures to curb speculation in the markets for energy and other commodities … The move aims to reduce the volatility of prices but faces resistance from top Wall Street firms, which fear the efforts could cut into profits.  Regulators and lawmakers increasingly worry that these firms have used their size and power to inflate the prices of commodities, booking profits in the process. … Firms have introduced new ways to speculate on rising or falling values of commodities by betting on batches of futures known as indexes. … The CFTC is planning to announce today that it will consider … limiting the size of an investment any single firm could make in a particular commodity.

It regulators think they know when commodity prices are too volatile, they should just buy low and sell high; if they are right they’ll reduce volatility and make a profit in the process.  And if they are wrong, we’d hear about their losses. So why aren’t regulators interested in more accountable regulation?   The obvious explanation:  they expect their accounts wouldn’t look very good.

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  • http://brokensymmetry.typepad.com Michael F. Martin

    Your suggestion would seem to substitute one centralized group of bad actors for another.

    I think the only way to pop bubbles is to change the time horizons of the average market actor from shorter to longer term. To do this, I think the information about the sustainability of some moving average rate of growth (i.e., of the time-derivative of the growth in some security) against a range of projections of market size should be more easily available. Buyers of CDOs and CDO^2s, for example, had little transparency into how much money was flowing into the subprime market altogether.

    To pop a bubble, you have to dig beneath the market price signals to see the broken conservation of cashflows that’s raising the prices.

    • Michael Bishop

      First, I don’t think the current actors (investors) are centralized. Second, Robin isn’t suggesting anyone gets replaced. He’s suggesting we add a specialized type of investor who uses government money.

      What do you mean by “broken conservation of cashflows” and how do they raise prices?

  • http://www.intrade.com John Delaney

    Robin,

    For many traders who are finding it hard to make ends meet at the moment I bet they would rub their hands with glee if your idea gets legs. Only time would tell of course.

    If your best and brightest” regulators knew “when commodity prices are too volatile” or when to “just buy low and sell high” perhaps some would be traders potentially generating incomes that even the brightest regulators would never. Oh, that is of course if income is important.

    Best regards to all from Dublin.

    John Delaney
    CEO
    Intrade

  • Janet Brown

    This is really scary. Even the economic “experts” don’t seem to know what’s going on. In the mean time, average Americans are filled with anxiety over whether they’ll lose their jobs, their homes and their retirements.

    This is just one more reminder that the only real way to keep our economy strong is not by raising taxes, but by keeping taxes low, fair and simple. I’ve been looking for a way to take action and contact our legislators and sign petitions and found some good policy the U.S. Chamber of Commerce backs (here). I don’t have a lot of money or time, but I figure this will help other people do good.

    • ShardPhoenix

      “This is just one more reminder that the only real way to keep our economy strong is not by raising taxes, but by keeping taxes low, fair and simple.”

      That’s a complete non sequitur whether from your first paragraph or the blog post.

    • Mike

      It’s a non sequiter, it’s obviously not true in general, and so far as I know no one has put forth any practical guide for when it’s true and when it’s not.

  • daginikkafa

    Let’s assume these regulators can identify bubbles. They have two conflicting goals. If the goal is to prevent the bubble, it is better to do it as soon as possible. However if they are trying to increase their pile of cash they would wait until close to the peak of the bubble. This would also decrease the size of the bubble, but less than the first case.

  • http://brokensymmetry.typepad.com Michael F. Martin

    Another proposal for bubble popping/avoiding bubble inflation that seemed to make sense was the Kashyap/Rajan/Stein mandatory capital insurance proposal. See here.

    Suppose every investor in public or private markets had to purchase a capital insurance policy that would payout to secured creditors of the investor in the event of their own bankruptcy. To ensure positive returns, insurers would raise premiums and/or decline coverage as flows to particular markets grew larger.

    The point is that a higher-frequency negative feedback mechanism has to be introduced into market prices — bubbles and crashes result from a mismatch between a higher-frequency of growth in cash-flow into particular securities and lower-frequency of decay/damping through local failures or losses.

  • Norman

    The problem I see is that even if regulators have such foresight now that they can see bubbles as they happen, a sort of Verschränkung effect would prevent them from controlling movements as you suggest.

    If regulators have successful indicators of when to “buy low and sell high” and thus are able to reduce volatility, other market actors are likely to notice. Since this is also a money-making strategy, market participants will begin to mimic the regulators decisions, thus buying when regulators buy, selling when regulators sell. Thus the very fact that regulators can reduce volatility would mean they would eventually generate *more* volatility because of the endogenous reactions of other agents in the market. The only way this wouldn’t be the case is if regulators have access to information about determinants more powerful than the profit motive. Seems unlikely.

    So maybe regulators don’t think their accounts would be good at first. Even if they would be, though, by necessity it wouldn’t last.

  • anon

    The most dangerous kinds of speculative bubbles are real-estate bubbles (see the 80’s crisis in Japan and the 2007-2009 global economic crisis).

    These bubbles can be easily curbed by levying a tax on the assessed value of land, much as China does and Japan used to do before they got rid of it in the 1980’s. Since land is not going anywhere and no one’s making any more of it, such a tax poses no excess-burden issues.

    See the work of Mason Gaffney, Fred E. Foldvary and other geo-libertarian economists.

  • Jim Babcock

    Congress could give some well-regarded “best and brightest” regulators a big pile of cash, say $100 billion, and have them correct prices by trading, buying when they think prices should rise and selling when they think prices should fall.

    You might as well take that money, put it in bags, and write “embezzle me” on each one. Any information that leaked out of the regulatory group would be worth lots of money, and insiders could easily arrange bad trades to send the money to accomplices. Besides, private banks, in principle, are supposed to correct prices themselves; and there’s no reason to think that this group would perform any differently than a normal investment bank.

    • Jayson Virissimo

      Yes, but if we used this scheme we would only be out $100 billion, not $1 trillion.

  • http://persistentitch.blogspot.com Joel

    I have to assume Robin was being facetious about “best & brightest regulators,” who would make money while dampening market volitionality. Since the “best and brightest” players are already in the market, and this dampening strategy is guaranteed to make money (by “buying low and selling high”) the market should be self-correcting! (Granted, it mostly is.) The point is that human nature tends to create and exacerbate bubbles despite individual players’ intelligence and sophistication. Witness how the portfolio of nearly every individual and institution has lost value since last year.

  • jsalvati

    Two points:

    1) Just to point out the obvious, this strategy would have been very hard pressed to prevent (or ameliorate it) because the bubble was in the housing market, which is not a liquid market with low holding costs. It would have been difficult for regulators to short housing.

    2) I hear lots of speculation about how bubbles are important for various macroeconomic phenomena (here and elsewhere). What I don’t hear very much of is discussion of the experimental (and observational) research on bubbles. Which I am not very familiar with, but I know enough about it to know that there’s quite a bit of it. People seem to prefer their “gut feelings” about what makes bubbles important and how they come about to actual research.

    • gwern

      > 1) Just to point out the obvious, this strategy would have been very hard pressed to prevent (or ameliorate it) because the bubble was in the housing market, which is not a liquid market with low holding costs. It would have been difficult for regulators to short housing.

      And if I understand it, even if they could short housing, such shorts or bets against the bubble would look ever more disastrous as the bubble inflates. The markets can stay irrational longer than the regulators’ losses can stay politically palatable…

  • Pingback: Breaking news: Regulators are (re)discovering that maybe speculation CAN be excessive - The Curious Capitalist – TIME.com

  • Name

    Leave the markets alone. Western civilization is a bubble.

  • Doug S.

    There’s a fundamental problem here.

    When you bet against a rising bubble, you’re basically betting that the prices of the underlying asset are going to fall. In other words, you won’t make any money until after the bubble bursts. Even if you know for sure that a bubble exists, and, indeed, you’re right that a certain asset is significantly overpriced, there’s no way to make any money on that belief until other people start agreeing with you and the price drops.

    It’s also possible that a bubble could simply fail to burst at all; the prices could simply stabilize at a high level for non-rational reasons. For example, what’s the intrinsic value of a Mickey Mantle rookie card? After all, it’s just a piece of cardboard with some ink on it. It’s value comes almost entirely from the fact that people believe it is valuable – yet there’s no particular reason why the “baseball card bubble” should burst. What makes a canvas painted on by Picasso valuable while a flawless reproduction of the same painting is a worthless “forgery”? They both look the same when you hang them on a wall. Bits don’t have Colour.

    The defining characteristic of a bubble is not that asset prices are irrationally high. Lots of things are priced well above any “rational” measure of their intrinsic value, and stay that way for what might as well be forever. It’s the sudden, precipitous drop in prices that makes a bubble a bubble; much like you can never be absolutely sure that something is mortal until it dies, a bubble isn’t a bubble until it bursts.

    • http://hanson.gmu.edu Robin Hanson

      It sounds like you disagree with the regulators who claim they can spot bubbles. I didn’t claim they could; I said that if they could, here was an accountable way to have them use that info.

      • Doug S.

        The defining characteristic of a bubble is that, someday, it pops.

        There are ways to predict that something is a bubble, and they’re often right. However, these methods are really bad at predicting when bubbles are going to pop – and in order to make money by shorting a bubble, you have to know when it is going to pop.

        Look at this graph of the NASDAQ Composite index during the dot-com bubble.

        If you were a regulator with a pile of cash in 1999, what could you have done to pop the bubble?

      • Doug S.

        Hmm, the img tag didn’t work. Trying again…

        Original source: http://upload.wikimedia.org/wikipedia/en/d/de/Nasdaq2.png

    • Randall Randall

      “After all, it’s just a piece of cardboard with some ink on it. It’s value comes almost entirely from the fact that people believe it is valuable – yet there’s no particular reason why the “baseball card bubble” should burst.”

      I think you just don’t care about baseball cards.

      It would be a bubble if the value really did come almost entirely from what people thought they could sell them for, but the reason the prices stay high is because there are people who actually want the cards enough to pay those prices, in and of themselves, rather than because they can sell them to someone else. In this case, it’s not a bubble — it’s just what people value those things at.

  • David L

    It regulators think they know when commodity prices are too volatile, they should just buy low and sell high; if they are right they’ll reduce volatility and make a profit in the process.

    In the comments, Michael F. Martin here and
    here and
    Doug S. point out very correctly why your reasoning is unsound.

    • Michael Bishop

      Lubin?

  • David King, Ph.D.

    We already HAVE a government agency consisting of the “best and brightest” at least looking at offsetting bubbles in one market – foreign exchange. That agency is the US Treasury, and its operating agent is the Federal Reserve Bank of New York. Taking positions in the FX market when the dollar is deemed to be too low or too high is of course called “intervention”, is almost always done in concert with other central banks, and it has been consistently profitable since floating started. However, it is very rarely done, because we still live under a paradigm, ingrained in the Washington Consensus, that the market knows best, that intervention is bad, and that FX rates should freely float. That’s why we’ve seen 2 1/2 huge swings in the dollar’s value over the past 35 years, despite complete convergence of inflation rates and basic harmony in macroeconomic management policies.

    • Michael Bishop

      Wait, for each buyer their is a seller. So if the U.S. profits from an intervention, doesn’t that mean someone else is losing?

  • http://shagbark.livejournal.com Phil Goetz

    If that would work, the market would already regulate itself and eliminate bubbles, since all traders are trying to do exactly what you want the regulators to do.

    • http://shagbark.livejournal.com Phil Goetz

      It sounds like you disagree with the regulators who claim they can spot bubbles. I didn’t claim they could; I said that if they could, here was an accountable way to have them use that info.

      Oops. Never mind.

  • Rob Hicks

    Jsalvati pointed out one of the most obvious objections to this in terms of asset classes. Another (speaking as an ex-regulator) is that “the best and brightest” don’t tend to stick around in regulation very long as they’ll typically be poached by firms in the private sector willing to pay them *much* more to do the same job.

    Also, you could also run this experiment cost free by getting regulators who thought they were up to to create dummy portfolios of “bubble” assets to check there was any credibility to these claims without taking a massive speculative bet. Then you’d only be stuck with the almost insurmountable probably of separating skill from judgment, which would take a good couple of decades of data to establish. THEN, I’d say you ideas a goer.

  • http://www.intrade.com John Delaney

    Robin,

    The Wash. Times has a good Ed. piece today.

    Here is the link…

    http://www.washingtontimes.com/news/2009/jul/12/in-defense-of-speculators/

    And for a bit of shameless self promotion from the article…

    To help decide whether speculators or politicians know better, Americans don’t have to go any further than intrade.com, a futures market. This is one place where people place bets on what will happen not only on economic outcomes but on current political or entertainment events, such as who will win an election or an Oscar. In 2004, speculators on Intrade correctly predicted which presidential candidate would win the electoral votes of every state in that year’s U.S. presidential election. In 2006, Intrade predicted who would win each and every Senate seat up for election. You would think such accuracy would earn some respect among politicians.

    Cheers,

    John

  • JayM

    Hasn’t George Soros already proved that this can be done?

  • brendan_r

    This idea generalizes big time. All sorts of claimed inefficiencies imply enormous unexploited profit opportunities, i.e. women are underpaid or lenders are racist. The women one in particular, if the size of the unjustified wage gap is anything like what they say it is even an inefficiently run state owned enterprise should be able to make fat profits hiring nothing but women, reinvest, expand into new businesses, spin em off, and ultimately eliminate the thing.