On Bubbles and Rationality

Henry Blodget with The Atlantic, writes an article today on market bubbles and rationality. He provides a pleasant reprieve from all of the blame game going on. He thinks we each need to take responsibility. This is admirable, but it fails to recognize that as much as we like to think that we have libertine free will, our behaviors are often shaped (but not dictated) by the legal and economic framework that other people have subjected us to. Here are his two money paragraphs:

But most bubbles are the product of more than just bad faith, or incompetence, or rank stupidity; the interaction of human psychology with a market economy practically ensures that they will form. In this sense, bubbles are perfectly rational—or at least they’re a rational and unavoidable by-product of capitalism (which, as Winston Churchill might have said, is the worst economic system on the planet except for all the others). Technology and circumstances change, but the human animal doesn’t. And markets are ultimately about people.
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First, bubbles are to free-market capitalism as hurricanes are to weather: regular, natural, and unavoidable. They have happened since the dawn of economic history, and they’ll keep happening for as long as humans walk the Earth, no matter how we try to stop them. We can’t legislate away the business cycle, just as we can’t eliminate the self-interest that makes the whole capitalist system work. We would do ourselves a favor if we stopped pretending we can.

Mr. Blodget is correct in that bubbles are a normal and rational phenomenon. That we see bubbles not just in housing and tech stocks, but in Beanie Babies and baseball cards reveals that it is an inevitable human phenomenon. However, he goes too far when he claims that nothing can be done. We need to dig down and understand how a bubble starts.

There must be a first mover. A bubble can not start unless an item has gained value above historical rates of return and it must be gaining value at rates superior to most other investments. While homes were gaining 15% annually in some markets, this understates the huge rate of returns available when these homes were purchased on the margin. That is, if you put $25,000 down on a 200,000 home, a 15% increase in value increases your equity by 120%. In short, the critical mass of dupes that feed a bubble must have real data to be duped. Something has to be pushing up that value before so many fall for it like suckers.

This "unnatural" rate of return can be created by a number of forces: A restriction on supply, an artificial expansion of credit, or a government subsidy. Whenever any government policy is considered, especially one of significant scale, the potential for a bubble should be considered. These side effects can be avoided by careful analysis, or more easily through a dogged hostility to market manipulation through legislation. A bubble may be hard to stop, but we can prevent so many from getting started.

Mr. Blodget relates a tale of the thinking involved in the real estate bubble and it starts with this:

In fact, for as long as we can remember—about 10 years, in most cases—house prices haven’t gone down. (Wait, maybe there was a slight dip, after the 1987 stock-market crash, but looming larger in our memories is what’s happened since; everyone we know who’s bought a house since the early 1990s has made gobs of money.)

This is the first mover. There is a sense that unnatural rates of return are normal and that a housing bust is unlikely. Why were rates of return unnatural? The artificial restrictions of various housing restrictions. His entire tale rests on the proximate cause of government intervention.

In the end, however, Mr. Blodget is correct. The ultimate cause is us. Our desire to control the behavior of others through the force of government led us to pass these housing restrictions. Whether its to keep poor people out by banning dense housing, or to reduce the evils of urban sprawl and SUVs, so many of us want someone to make the world better for us by making it worse for someone else.