Wednesday, July 29, 2009

Blowing Bubbles

. Wednesday, July 29, 2009

Alex Tabarrok has a very good post on "bubbles", or investment markets that get over-blown and then collapse. He discusses all the major points, namely the difficulty in identifying bubbles, the difficulty in diffusing them, and the resilience of bubbles against education (but not wisdom gained through experience!). There are repercussions for monetary policy, rational choice theory, regulatory policy, and portfolio theory.

Most of the post simply summarizes the high points in the academic literature on bubbles and investor sentiment, but these arguments are worth reiterating (and note that Daniel Gross has argued that bubbles are a net positive force, although I don't see anyone mentioning his argument these days). Please read the whole post, and if you're feeling ambitious read the cited articles as well (esp. the Vernon Smith). I have criticized Tabarrok before, but I can't see a flaw in this post.

Some smart people have argued that the Fed, or another national regulator, should be in the business of identifying and deflating bubbles in an attempt to prevent the shocks that occur when a bubble pops. Other smart people have argued that this is impossible. Still other smart people have argued that even if it is possible for investors to identify bubbles and bet against them, "the market can stay irrational longer than you can stay solvent".

So this leads me to a challenge: Predict the next investment bubble to catastrophically explode. I'm not asking for any money to be put on the line; just a wild-haired guess. There's nothing on the line, because by the time it happens this post will be long forgotten. This is only in fun. I insist that all of my fellow IPE@UNC authors participate in the comments or their own posts (and yes, that includes SBD), but I'd also love to see some predictions from readers and other bloggers.

Here's mine: The easy bet is on Eastern Europe, but I think that's for suckers. Those markets have already inflated and deflated several times in the past two decades, and I think investors will have learned some lessons. So my bet is on China. So far, the PRC has been careful to monitor and regulate portfolio investment inflows, but if China is going to fully integrate into the global economy that will have to change. There are already signals that China has over-reported its growth rates and may be not be quite as prepared to emerge as a global economic power as commonly believed. Add to the mix a reliance on exchange-rate stability and a strongly export-biased growth model and China seems ripe for some over-reach in the coming decade. I still remember the 1990s, and as strong as China looks now, Japan looked even stronger in 1994.

I don't actually expect to be right about this, and I'm certainly not prepared to wage real money on it, but that's the fun. So let's hear it.


Blowing Bubbles
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