Thursday, April 15, 2010

Leverage as a cause (amv)

Historians of economic thought know that in the aftermath of financial turmoil 'symptoms' are often confused with 'causes'. Just think of the huge literature on the Great Depression before and after Friedman and Schwartz. It is somewhat tedious to see all this Minskyesque work about credit expansion, financial leverage, etc. Here some Fama-Wisdom:

Q: I guess most people would define a bubble as an extended period during which asset prices depart quite significantly from economic fundamentals.

Fama: That’s what I would think it is, but that means that somebody must have made a lot of money betting on that, if you could identify it. It’s easy to say prices went down, it must have been a bubble, after the fact. I think most bubbles are twenty-twenty hindsight. Now after the fact you always find people who said before the fact that prices are too high. People are always saying that prices are too high. When they turn out to be right, we anoint them. When they turn out to be wrong, we ignore them. They are typically right and wrong about half the time.

Q: Are you saying that bubbles can’t exist?

Fama: They have to be predictable phenomena. I don’t think any of this was particularly predictable. [I usually formulate the same thing differently: bubbles are ex post phenomena. All economic theory is based on choice and is thus ex ante. Bubbles have no theoretical underpinning. 'Stuff' without theoretical underpinning is useless; amv]


Q: There were some people out there saying this was an unsustainable bubble…

Fama: Right. For example, (Robert) Shiller was saying that since 1996.

Q: Yes, but he also said in 2004 and 2005 that this was a housing bubble.

Fama: O.K., right. Here’s a question to turn it around. Can you have a bubble in all asset markets at the same time? Does that make any sense at all? Maybe it does in somebody’s view of the world, but I have a real problem with that. Maybe you can convince me there can be bubbles in individual securities. It’s a tougher story to tell me there’s a bubble in a whole sector of the market, if there isn’t something artificial going on. When you start telling me there’s a bubble in all markets, I don’t even know what that means. Now we are talking about saving equals investment. You are basically telling me people are saving too much, and I don’t know what to make of that.

Q: In the past, I think you have been quoted as saying that you don’t even believe in the possibility of bubbles.

Fama: I never said that. I want people to use the term in a consistent way. For example, I didn’t renew my subscription to The Economist because they use the world bubble three times on every page. Any time prices went up and down—I guess that is what they call a bubble. People have become entirely sloppy. People have jumped on the bandwagon of blaming financial markets. I can tell a story very easily in which the financial markets were a casualty of the recession, not a cause of it.

Q: That’s your view, correct?

Fama: Yeah.