Tuesday, September 22, 2009

Economists should stop ignoring bubbles

Yale economist Robert Shiller has constructive criticism for his own profession:
The widespread failure of economists to forecast the financial crisis that erupted last year has much to do with faulty models. This lack of sound models meant that economic policymakers and central bankers received no warning of what was to come.

As George Akerlof and I argue in our recent book Animal Spirits, the current financial crisis was driven by speculative bubbles in the housing market, the stock market, energy and other commodities markets. Bubbles are caused by feedback loops: rising speculative prices encourage optimism, which encourages more buying and hence further speculative price increases — until the crash comes.

You won’t find the word “bubble,” however, in most economics treatises or textbooks. Likewise, a search of working papers produced by central banks and economics departments in recent years yields few instances of “bubbles” even being mentioned. Indeed, the idea that bubbles exist has become so disreputable in much of the economics and finance profession that bringing them up in an economics seminar is like bringing up astrology to a group of astronomers.

The fundamental problem is that a generation of mainstream macroeconomic theorists has come to accept a theory that has an error at its very core — the axiom that people are fully rational.

16 comments:

  1. Mr. Shiller should be taking his own advice. He has one of teh faultiest models around with his Index that led to optimism which led to price increases.

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  2. accuriz verifying Shillers premise that people are not fully rational.

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  3. accuriz, if you're refering to the case shiller index, its not a predictive model at all. Its an index of the most recent data on a large set of same home sales. Saying his index led to price increases is like saying the S&P500 led to the stock bubble or a seismograph led to an earthquake. These are all observations of actual activity. If idiots say "prices went up in the past so they definitely will continue to go up" that's because they are idiots, not because of shiller's very useful housing index.

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  4. http://en.wikipedia.org/wiki/Behavioral_economics

    They can't either understand or view it as a threat to their profession. Specifically behavioral economics does not directly validate a lot of their mathematical modeling which they spent many years developing as PhD candidates. Time to break out your old VHS tapes of the movie Trading Places starring Murphy and Akroyd.

    Warren Buffett has an incredible grasp on this concept.

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  5. where the hell is Clarence Beeks?

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  6. In the US nationally, incomes are falling. But because its different here, incomes just keep going up up up!!!!

    http://www.washingtonexaminer.com/local/D_C_-region-incomes-hold-strong-in-recession_-census-data-show-8275086-60082327.html

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  7. DC and the surrounding areas have no character, no soul. It's as generic as it can get. Everyone dresses the same; the people have that expressionless look on their faces; and they have no personalities. When you think about the emptiness within, it really is a sad place to live. Let's buy a place near Capital Hill so we can tell our friends we made it. But make sure you carry comprehensive insurance for those weekly auto claims! Go to Crate and Barrel and make your home look just like the catalog. Follow, follow, follow you sheep.

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  8. "In the US nationally, incomes are falling. But because its different here, incomes just keep going up up up!!!!"

    My salary alone is above the average household income in Maryland(factoring in my wifes income and blow away the median)...

    funny thing is, I just took a 10% paycut due to the recession and our government contracts holding off until they are sure of their funding. However the nice thing is homes in maryland took a larger drop than 10% so Im still ahead! Im just glad home prices keep going down down down!!!!

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  9. Yep good thing for Mo. Co. Anon and myself that prices arent done falling here in MD. You guys looking in NOVA arent so lucky unfortunately.

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  10. I wouldn't argue that the existence of a bubble implies a lack of rationality. People act as individuals, and not everyone is aware of the macro things going on in the world.

    And as an individual, investing in a bubble can be rational as long as you believe you will get your money out in the end.

    http://en.wikipedia.org/wiki/Greater_fool_theory

    The thing that they can't reconcile is that rational individual behavior can yield irrational phenomenon in society as a whole.

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  11. Saying that people believed they would get their money out does not imply rationality. Of course they thought that. The question is was there clear and easily available evidence that this wasn't a reasonable conclusion. Certainly there were investors who were tryng to time the market and understood the risks, and they could arguably be called rational actors. But that group account for a small fraction of those involved in the current housing bubble.

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  12. DC and the surrounding areas have no character, no soul. It's as generic as it can get. Everyone dresses the same; the people have that expressionless look on their faces; and they have no personalities. When you think about the emptiness within, it really is a sad place to live.

    I hate peas!!! Lookit you stupid morons stuffing your maws with peas!!! I hate all of you!!! Don't you know that carrots are Teh BEST!?!

    SHEEP!

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  13. "DC and the surrounding areas have no character, no soul. It's as generic as it can get. Everyone dresses the same; the people have that expressionless look on their faces; and they have no personalities. When you think about the emptiness within, it really is a sad place to live."

    Hopefully after spending 35 years in DC you can retire with your sanity to a better place. That is what a vast majority of DC folks want to do. The question is this: do they suffer irreparable damage whereas they cannot enjoy retirement?

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  14. Clever spam...

    Post comments everywhere advertising your page but do it in such a way that they don't get deleted...

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  15. The Shiller story sounds like a very lengthy story which appeared in the NY Times Sept. 6:

    How Did Economists Get it So Wrong?

    http://www.google.com/url?q=http://www.nytimes.com/2009/09/06/magazine/06Economic-t.html

    The main point in that article is that economists came to believe bubbles couldn't exist. That "markets" of willing buyers and sellers truly reflect prices, and therefore a "bubble" can't occur.

    NOTE: The article is 8 pages requiring subscription. However, NY Times allows articles to be read when viewed through Google. Therefore, to page forward you need to manually construct a URL using the above Google redirect (and the URL to the next page).

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  16. The main point in that article is that economists came to believe bubbles couldn't exist.

    And yet...somehow there *were* economists who *did* predict the incipient shit-storm.

    I think what you meant to say was that "Chicago-school economists came to believe bubbles couldn't exist", which is not the same thing.

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