Will There Always Be Bubbles?

Yale Economist Robert Shiller recently wrote an op-ed piece for Project Syndicate titled Bubbles Without Markets. His basic argument is that there will always be economic bubbles and that, at least in a market economy, these bubbles are far more mild than non-economic bubbles. But, just what are non-economic bubbles and what is the average person to do to protect themselves if economic bubbles are inevitable?

Shiller starts out the article with a nice definition of bubbles:

A speculative bubble is a social epidemic whose contagion is mediated by price movements. News of price increase enriches the early investors, creating word-of-mouth stories about their successes, which stir envy and interest. The excitement then lures more and more people into the market, which causes prices to increase further, attracting yet more people and fueling “new era” stories, and so on, in successive feedback loops as the bubble grows. After the bubble bursts, the same contagion fuels a precipitous collapse, as falling prices cause more and more people to exit the market, and to magnify negative stories about the economy.
Read more at http://www.project-syndicate.org/commentary/bubbles-without-markets#4luigKezyXrskezB.99 

The important points are the idea of positive feedback and contagion, two processes that create both the inflation and the deflation period in bubble formation.

Shiller looks at bubble formation as a general social process that describes not only market activity (the Mississippi Bubble 1719-20, the South Sea Company Bubble 1711-20 and the Tulip Mania of the 1630) but also non-market social epidemics (belief in alchemy, prophets of Judgement Day, fortune telling, astrology, magnet and crystal therapy, witch hunters and the Crusades). Some of these social epidemics, such as the Crusades, had much worse consequences for society than did the Subprime Mortgage Crisis (see Charles MacKay’s 1841 best seller Memoirs of Extraordinary Popular Delusions and the Madness of Crowds).

Shiller concludes that:

The recent and ongoing world financial crisis pales in comparison with these events. And it is important to appreciate why. Modern economies have free markets, along with business analysts with their recommendations, ratings agencies with their classifications of securities, and accountants with their balance sheets and income statements. And then, too, there are auditors, lawyers and regulators.

All of these groups have their respective professional associations, which hold regular meetings and establish certification standards that keep the information up-to-date and the practitioners ethical in their work. The full development of these institutions renders really serious economic catastrophes – the kind that dwarf the 2008 crisis – virtually impossible.

Read more at http://www.project-syndicate.org/commentary/bubbles-without-markets#4luigKezyXrskezB.99 

Shiller doesn't say this in the article but in other places (here) he has argued that the expansion of insurance to cover a whole range of events (to include impacts from economic bubbles) would allow the average person to weather these catastrophes without further intrusion of the government in the market economy. Insurance would be great and might eventually happen in the distant future, but it would require a number of things to fall in place that seem unlikely: insurance companies would have to offer such vehicles and pay up during a general economic downturn, people with enough financial knowledge and foresight would have to buy such vehicles (rather than spending their money on immediate consumption) and people would have to have enough disposable income to devote a lot of it to all the possible things they might need insurance against (think about getting health insurance on the private market). In the end (just as with health insurance), the answer is still government intervention. The US does have unemployment insurance, food stamps and welfare assistance, as long as the Right-Wing does not destroy these New Deal achievements. Eventually, the US will probably end up with Single Payer health insurance. And, some of the financial abuses during the Subprime Mortgage Crisis certainly should be controlled with government regulation.

This still leaves open the question of whether economic bubbles can be controlled by some sort of government action such as monetary policy. The first problem on the way to controlling bubbles is to be able to identify them as they develop (the topic of this blog). Even if the government cannot do anything to prevent economic bubbles, it would be useful information to anyone interested in protecting themselves against catastrophes.