How clever of the Fed
The Fed has come up with a clever idea, establishing an enterprise to focus on bubbles before they become crises. WSJ:
First came the tech-stock bubble. Then there were bubbles in housing and credit. Chinese stocks took off like a rocket. Now, as prices soar on every material from oil to corn, some suggest there’s a bubble in commodities…how and why do bubbles form? Economists traditionally haven’t offered much insight. From World War II till the mid-1990s, there weren’t many U.S. investing manias for them to look at. The study of bubbles was left to economic historians sifting through musty records of 17th-century Dutch tulip-bulb prices and the like.
The dot-com boom began to change that. “You were seeing live, in action, the unfolding of lots of examples of valuations disconnecting from fundamentals,” says Princeton economist Harrison Hong. Now, the study of financial bubbles is hot.
Its hub is Princeton, 40 miles south of Wall Street, home to a band of young scholars hired by former professor Ben Bernanke, now the nation’s chief bubble watcher as Federal Reserve chairman…They are building on work done by the late Hyman Minsky, whose once-ignored ideas about investing manias are now in vogue, and the late economic historian Charles Kindleberger, whose 1978 “Manias, Panics and Crashes” is a classic. But compared with Mr. Minsky or another student of bubbles, Yale’s Robert Shiller, the Princeton trio focuses less on mass psychology than on mathematical models. These they use to show how bubbles can be created even in markets that include rational, calculating investors…
At the height of the tech bubble, Internet stocks changed hands three times as frequently as other shares. “The two most important characteristics of a bubble,” says Wei Xiong, are: “People pay a crazy price and people trade like crazy.”…
Under the Hayek view, bubbles don’t make sense. As soon as some group of traders irrationally pushes prices way up, more-rational traders should take advantage of the mispricing by selling — bringing prices back down. But the tech boom reinforced an oft-quoted warning from John Maynard Keynes: “The market can stay irrational longer than you can stay solvent.” So investors who spot the bubble attack only if each is confident that other skeptics are on board. In work done with Mr. Abreu, Mr. Brunnermeier concluded that if all the rational investors could agree to bet against the bubble, they could make big profits. But if they can’t coordinate, it’s risky for any one of them to bet against a bubble. So it makes sense to ride it up and then get out quickly as soon as the bubble’s existence becomes common knowledge.
While studying bubbles with policy intent is a good idea as we have said, it remains to be seen if academic economists are up to the task. One of them noted in the WSJ piece:
“I was always convinced that there was an Internet bubble going on and never invested in Internet stocks,” he says. “My brother-in-law did. My wife always complained that I studied finance and her brother was making a lot of money on Internet stocks.”
By the way, the economic models of the economists do not presently indicate that commodities are in any kind of bubble, despite prices and trading that have doubled in the past year in the teeth of a global slowdown. History will show whether that judgment is correct.