A curious idea is knocking around the gilded ghettos of Wall Street -- that speculative bubbles are natural. Not only are such spasms unpredictable, the theory goes, but there's not a damn thing we can do about them. Former top Morgan Stanley (MS) analyst Kenneth Posner recently made the argument in the ideologically friendly confines of the Harvard Business Review:
It would be nice if we could predict bubbles; even nicer if we could prevent them. Unfortunately, this would violate the laws of nature: asset bubbles occur because of the limits of our ability to process information and coordinate activity in a market setting, where no-one is in charge, and no-one has a complete view of the big picture.Big word, "nature." Sneaky, too, since technically people are part of it. (That means you should feel free to curse the cosmos the next time the Chinese takeout joint forgets your side order of hollow vegetables.) JPMorgan Chase (JPM) CEO Jamie Dimon echoed this theme of inevitability earlier this year in claiming that major financial crises occur "every five or ten years," just like a class reunion.
It would be nice if such debates were academic. They're not. To belabor the obvious, understanding why bubbles periodically soak the U.S. economy informs the current debate on financial reform, and whatever public policy that emerges from it.
The notion that bubbles are unpredictable is odd for several reasons. First, a minor point of logic. How can a phenomenon be so ingrained in the natural order of things, so recurrent, and yet still be so impossible to foresee? We may not know exactly when the earthquake is going to hit, but lots of people know it's coming.
Really, it's a moot point. By now it almost goes without saying that many folks -- from economic seers such as Joe Stiglitz, Dean Baker, and the late, great Wynne Godley to investors such as Marc Faber, John Paulson and Peter Schiff -- correctly predicted we were going over the falls in the years leading up to the financial crisis.
Second, in financial circles it was once a point of Milton Friedmanesque dogma that asset bubbles didn't -- indeed, couldn't -- exist. Under this thinking, speculators have no capacity to destabilize markets, which are inherently efficient. Quite the opposite, in fact; they provide equilibrium, buying undervalued assets as prices fall and selling overvalued assets when prices rise.
Today, of course, such ideas seem ludicrous. That's because they are. Recent history has seen to that. Still, it's interesting to see Wall Streeters so abruptly turn once hallowed beliefs on their head, like sun-worshippers suddenly bowing down to the moon. Once, bubbles were impossible -- now they're inevitable.
But the biggest reason why it's strange to argue that bubbles are unpredictable is that it's so manifestly wrong. For every historical outbreak of speculative fervor, there were people predicting it, and sometimes profiting when things finally blew. For instance, rich merchants in 17th century Amsterdam escaped the "tulip mania" crash largely unscathed. Instead of pouring their guilders into flowers, they chose to stay in things like real estate and stock.
In other words, the Dutch upper class saw the bubble filling up and stayed well clear. It was the plebes, supremely credulous and unhip to risk (sound familiar?), who got burned.
Or take sovereign debt crises of the kind we're seeing now in Europe. We know they're coming. How? Because such meltdowns happen over and over again. Between the 1550s and 1790s, France defaulted on its external debt eight times. Spain went bust six times during that period. A glance back at the 20th century will show well over 100 such defaults around the world. Same shit, different day.
Posner and Dimon are no closer to the truth in throwing their hands up in air and characterizing financial crises as inexorable. Because while it's true that pilot error may predispose us to repeatedly splatter the mountainside, it's also true that bubbles are rooted in the structure of financial systems. You know, things like monetary and tax policy, or, say, the sudden confluence of investment and commercial banking.
In other words, the Fed could have tightened the spigot on all that easy money pouring into the U.S. during the housing boom. Lawmakers could've preserved the Glass-Steagall wall between commercial and investment banking. Regulators could've done their job. Executives at Fannie Mae (FNM) and Freddie Mac (FRE), and the federal officials who licensed them, had a choice about whether to plunge deeper into the subprime pit.
That none of this happened owes less to human fallibility -- oops! -- than to tectonic shifts in our politics and our economy.
At heart, guys like Posner want people to believe that financial crises are simply an extension of the business cycle. Mere symptoms that must be coped with, oh, maybe every five or ten years. They nod toward shining a light on finance, but accept that it must by definition operate in the dark. It's unnatural.
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