Sunday, March 02, 2008
Even Robert Shiller, noted housing bubble observer, Yale economics professor, and co-inventor of the acclaimed S&P Case-Shiller Home Price Index, sounds too much like an economist from time to time (well, he is an economist) lending further weight to the argument that the dismal set just needs to get out more.
Had they collectively pulled their noses away from studies written by other economists and mixed in with the public - just for an afternoon or two back in 2003, 2004, or 2005 - they could have asked real people relevant questions and maybe they could have spotted the housing bubble in real time.
Questions like, "Why have you camped out for the last week to buy a condo?"
Or, "Why don't you have to verify that borrower's $20,000 per month income and why don't you need a down payment from him?"
Writing in the New York Times, the good doctor attempts to explain how the housing bubble "stayed under the radar" for so long by citing the work of ... other economists.
ONE great puzzle about the recent housing bubble is why even most experts didn’t recognize the bubble as it was forming.The theory of efficient markets doesn't seem to function very well in a "bubble economy" like we've had in the U.S. over the last 15 years or so and which we'll probably continue to have until something really bad happens.
Alan Greenspan, a very serious student of the markets, didn’t see it, and, moreover, he didn’t see the stock market bubble of the 1990s, either. In his 2007 autobiography, “The Age of Turbulence: Adventures in a New World,” he talks at some length about his suspicions in the 1990s that there was irrational exuberance in the stock market. But in the end, he says, he just couldn’t figure it out: “I’d come to realize that we’d never be able to identify irrational exuberance with certainty, much less act on it, until after the fact.”
With the housing bubble, Mr. Greenspan didn’t seem to have any doubt: “I would tell audiences that we were facing not a bubble but a froth — lots of small local bubbles that never grew to a scale that could threaten the health of the overall economy.”
Three economists, Sushil Bikhchandani, David Hirshleifer and Ivo Welch, in a classic 1992 article, defined what they call “information cascades” that can lead people into serious error.
Mr. Bikhchandani and his co-authors worked out this rational herding story carefully, and their results show that the probability of the cascade leading to an incorrect assumption is 37 percent. In other words, more than one-third of the time, rational individuals, each given information that is 60 percent accurate, will reach the wrong collective conclusion.
Thus, we should expect to see cascades driving our thinking from time to time, even when everyone is absolutely rational and calculating.
This theory poses a major challenge to the “efficient markets” view of the world, which assumes that investors are like independent-minded voters, relying only on their own information to make decisions. The efficient-markets view holds that the market is wiser than any individual: in aggregate, the market will come to the correct decision. But the theory is flawed because it does not recognize that people must rely on the judgments of others.
As Eric Janszen noted in his recent article at Harpers, The Next Bubble:
Bubbles were once very rare—one every hundred years or so was enough to motivate politicians, bearing the post-bubble ire of their newly destitute citizenry, to enact legislation that would prevent subsequent occurrences... Nowadays we barely pause between such bouts of insanity.Will any of the experts spot the next bubble?