This Time is Not Different!

The most recent book on economic bubbles was written by Carmen Reinhart and  Kenneth Rogoff titled This Time Is Different: Eight Centuries of Financial Folly. The title comes from the type of reasoning that seems prevalent at the start of the economic bubbles surveyed. Some argument is always offered why financial sanity is no longer necessary.  For example, in the late-2000s Subprime Mortgage  Crisis in the US, it was argued that new financial instruments such as Mortgage Backed Securities (MBS, the last two letters of the acronym should have been warning enough) spread risk so widely that the stability of the financial system would actually be increased. As the Financial Crisis of 2007-2008 proved, that idea was folly.

In the video above, Prof. Rogoff explains the book's premises and findings. Although the book is quantitative, it does not offer formal economic models. It's not that Prof. Rogoff is incapable of developing a formal model. He was the developer of the influential GEM (Global Economy Model) macroeconomic model currently being used by the IMF (Prof. Rogoff was the director of research for the IMF from 1982-1983 and was at the University of Wisconsin from 1985-1988--see his cv here).

I will argue in this blog that there are good reasons why macroeconomic models have not been used to study economic bubbles. The models are designed to predict economic data from year-to-year, quarter-to-quarter or month-to-month. If a model stops predicting well during a bubble, the model is revised to follow the data more closely, that is, to follow the bubble more closely. As a result, the models don't see the bubble coming.

Although there are many problems with current economic models (problems I discuss in another blog here), their lack of usefulness for studying bubbles comes from how the models are used in practice and the myopic focus on accurate forecasting. Before offering solutions, however, I need to review the current thinking on bubbles and the existing historical examples.