As our economy slides into the abyss, people are naturally trying to identify the culprit. The root cause of the crisis, of course, was the real estate bubble and its enabler, the over-leveraged financial industry. But what specifically triggered the bubble? Was it Greenspan's lax monetary policy? Banks' overly lax lending standards? The feds' failure to regulate CMOs and CDS's and other exotic financial instruments? Or can we pin the blame on some jurisdictions' overly restrictive zoning laws that allowed real estate prices to spike in the first place?
Perhaps bubbles simply arise out of our brains' funny wiring. According to this interesting piece by Virginia Postrel, experimental economists have concluded that they do:
For more than two decades, economists have been running versions of the same experiment. They take a bunch of volunteers, usually undergraduates but sometimes businesspeople or graduate students; divide them into experimental groups of roughly a dozen; give each person money and shares to trade with; and pay dividends of 24 cents at the end of each of 15 rounds, each lasting a few minutes. (Sometimes the 24 cents is a flat amount; more often there’s an equal chance of getting 0, 8, 28, or 60 cents, which averages out to 24 cents.) All participants are given the same information, but they can’t talk to one another and they interact only through their trading screens. Then the researchers watch what happens, repeating the same experiment with different small groups to get a larger picture.
The great thing about a laboratory experiment is that you can control the environment. Wall Street securities carry uncertainties—more, lately, than many people expected—but this experimental security is a sure thing. “The fundamental value is unambiguously defined,” says the economist Charles Noussair, a professor at Tilburg University, in the Netherlands, who has run many of these experiments. “It’s the expected value of the future dividend stream at any given time”: 15 times 24 cents, or $3.60 at the end of the first round; 14 times 24 cents, or $3.36 at the end of the second; $3.12 at the end of the third; and so on down to zero. Participants don’t even have to do the math. They can see the total expected dividends on their computer screens.
Here, finally, is a security with security—no doubt about its true value, no hidden risks, no crazy ups and downs, no bubbles and panics. The trading price should stick close to the expected value.
At least that’s what economists would have thought before Vernon Smith, who won a 2002 Nobel Prize for developing experimental economics, first ran the test in the mid-1980s. But that’s not what happens. Again and again, in experiment after experiment, the trading price runs up way above fundamental value. Then, as the 15th round nears, it crashes. The problem doesn’t seem to be that participants are bored and fooling around. The difference between a good trading performance and a bad one is about $80 for a three-hour session, enough to motivate cash-strapped students to do their best. Besides, Noussair emphasizes, “you don’t just get random noise. You get bubbles and crashes.” Ninety percent of the time.
Bubbles, in other words, do not need an external cause other than our silly human instincts.
How to prevent bubbles is the $2 trillion question. In the experiments, bubbles stopped forming once the participants had played the game a few times. The participants learned that a bubble was inevitable so they tried to get out of the market earlier; eventually, no one would pay more than the security's fundamental value for fear of getting stuck when the bubble popped. But as soon as the rules and stakes were altered, the participants went back to creating bubbles.
The government could tax bubble profits. That would kill Ponzi schemes before they started. But how does the government identify a bubble? It's easy to identify one when a security's fundamental value is a matter of simple arithmetic. It's harder to identify one in the real world. For example, last spring's stratospheric oil prices might have been the result of a bubble. But perhaps they weren't. Perhaps oil was just scarce and the high prices were needed to ration the limited supply. I'm not sure how the government is supposed to tell the difference.
