In a discussion about bubbles my friend pointed this out…
(my bold)
The argument is essentially that we are irrational, however as I have highlighted, he seems to accept my point - that bubbles are caused by too much money chasing too few goods. Are there any other refutations?
The problem with the animal spirits theory is that it doesn’t explain where the animals get the money to bid up assets. Normally increased demand for bubble goods would result in lower demand for other goods.
Bad speculators will lose their money, weeding out the inefficient and putting money for speculative purposes into the hands of the most efficient predictors. He’s offered no proof of this “animal spirits” doctrine, which outside the confines of neoclassical economics, probably makes little sense, like 99.9% of all “paradoxes” in neoclassical econ. All speculation does is speed up the path to equilibrium. It takes credit expansion to make it dangerous.
-Jon
If you’re irrational you either:
a. Lose your money and are therefore out of the market.
b. Lose your money, wise up, and enter the market again as a better investor.
Bubbles just cannot form in a market economy. If you accept the fact that markets clear, you have to accept that bubbles cannot form in a free market. What causes the so-called “irrational exuberance” is credit expansion creating a rising demand for a certain set of products. For example, easy credit in the late 90s allowed the dot-com bubble to form since businesses were using the credit to purchase new technology and the people working in those businesses used their money to purchase new technology, etc. That, in turn, blew up the telecom bubble as new dot-coms were taking out loans to pay for groundwork needed for their businesses.
Enterpreneurs most certainly can invest in unprofitable investments simultaneously. A bubble, if you want.
The problem being that it is theoretically impossible for a pure market economy to have a large portion of market actors who make unprofitable investments. Again, standard theory and experience dictate that people who make unprofitable investments will either go bankrupt or wise up. The fact that we’ve had bubbles for hundreds of years now shows that some force outside of the market (government) is causing them to happen with bailouts and easy credit policy.
I have thought a lot about this. I think a key point that I feel most people miss is that money is a speculative investment, just as any other form of saving.
A commodity, by being increasingly used as a medium of exchange rather than a medium of consumption, gathers a much higher demand, and its price rises. Bubbles seem to mirror this increase in speculative demand. They appear as a better form of saving than money, money substitutes and loans to banks.
Markets seem to choose a money commodity that has a relatively stable supply. This in combination with its demand consisting of the entire economy’s output of goods and services leads it to be relatively free from changes in its market value. The speculation in money is not in making a large return, but it’s safety. Also, money appears to make a small return as economic output grows.
Enter government (dum dee dum dum).
Legal tender law (de facto when the government accepts X as payment taxes) increases the speculative demand for X. If X is already used as money, this may not change much in the way the economy operates. However, when government subsequently debases the money, it will maintain an artificially high demand for X.
Government deposit insurance is another artificial means of increasing speculative demand for money substitutes. Central banking does the same for all credit to banks. It removes risk, while maintaining promises of reward. And although it isn’t explicit for some things, government is obviously insuring against risk in a variety of additional investments, including money market accounts, government debt, and even the stocks and bonds of many big businesses.
It makes no sense to speculate in cash, when there are other investments with higher returns with the same risk.
By increasing the supply of money, money will lose relative value. It will diminish or even negate gains normally caused by economic growth. If done on a large enough scale, it can lose its status as money; however, the above government distortions will keep its demand as money higher than otherwise. In this manner, inflation is essentially a tax on money-denominated savings/investments. At the same time, because the money supply increase takes place through the banking system, interest rates will decline, offering depositors and bank creditors less and less return.
In this environment, speculative activities will appear to be more and more profitable, especially relative to cash, money substitutes, and other bank credit. And as people have more money units to invest, they will engage more and more in the speculation du jour, particularly ones that have their risk limited by government backing.
The housing bubble should have been obvious by the amount of government intervention that lessened the risk and broadened the reward of home ownership and mortgage securities. There’s the '97 capital gains tax exclusion. There’s the implicit government guarantee of Fannie and Freddie. There’s the CRA, which implicated the government would rescue lenders facing default. There are the publicly accredited rating agencies. Finally, there is previous bailout of the S&L’s. This was the setup. The inflation and negative real interest rates caused by the FED made it happen. People bought on credit.
The housing bust simply came as a reversal of the trend. Money supply tightened and interest rates rose. Saving in money or money-like items regained a better risk/reward profile than houses or mortgage securities, and a sell-off occurred. Subsequently, the prices stopped rising and reversed. This caused a drop off in investment demand and greater sell-offs. This will continue to occur until housing sees demand from housing consumers rather than speculators to meet this massive supply.
The end result is always the same - as money supply tightens, interest rates rise, and price inflation lessens, money and similar instrments become better speculative assets relative to the ones that replaced them. This causes a sell-off and a drop in investment demand, which forces prices to crash quickly.
The same thing would happen to a currency if we had a free market monetary and banking system, and one bank decided to pursue a reckless policy of credit expansion. Its currency’s speculative demand would decline and its price would drop like a rock, as it became less and less usable as money (due to better substitute currencies). Its sole value would be in repaying that bank’s debt. If the bank went bankrupt, its notes would be worth next to nothing.