Professor Mitchel Abolafia asks "Can Speculative Bubbles Be Managed?"
“Bubbles generally are perceptible only after the fact. To spot a bubble in advance requires a judgment that hundreds of thousands of informed investors have it all wrong. Betting against markets is usually precarious at best.”
- Alan Greenspan (June 1999) i
“Those of us who have looked to the self-interest of lending institutions to protect shareholder’s equity (myself especially) are in a state of shocked disbelief.”
- Alan Greenspan (October 2008) ii
These two quotes may be seen as bookends to the bubble economy of the last decade or so. They suggest an unquestioning faith in the judgment of the market. This kind of faith is a poor prescription for policymaking. Effective policymaking is practical, skeptical, and open to continuous learning. I will argue that this faith in the judgment of the market underlies the Federal Reserve’s role in inflating the bubble economy and its reluctance to restrain it. My goal is to explore how such a faith was adopted, and the confluence of ideas, interests, and events that explain its adoption.
This essay is organized around three questions: What do we know about speculative bubbles? Why do they still occur? Can they be managed? Before proceeding to explore the latter two questions, however, I will introduce two analytic perspectives that have been used to explain speculative bubbles. For our purposes, bubbles will be defined simply as a condition in which “prices are high . . . only because investors believe that the selling price will be high tomorrow -- when ‘fundamental’ factors do not seem to justify such a price.” I will argue in the following section that the unquestioning faith displayed above obscures what we know from historical experience and alternative models.
Where Do Bubbles Come From?
Market Fundamentalism. The most influential approach to understanding asset markets today may be referred to as market fundamentalism. As stated above, it is an exaggerated faith in the ability of the market to achieve socially optimal outcomes. It is not one idea, but a system of interrelated ideas that offer predictions, diagnoses, and solutions. This faith is seen in its strongest form regarding financial markets. Block identifies three basic assumptions underlying what he calls “the conventional wisdom.” First, financial markets are excellent at pricing assets. Second, money will flow to markets with the highest return within and across countries as long as they are tightly linked. Third, the regulation of financial markets should be kept to a minimum to avoid interference with the market mechanism.
In the strong form of market fundamentalism, it is assumed that asset prices always reflect the asset’s true value, leaving no room for the existence of bubbles. Any major price swing is explained as a response to events outside the market, such as a war, or the weather (referred to as an exogenous shock). In its weak form, market fundamentalism, as seen in Alan Greenspan’s quotes above, generally accepts that bubbles may occur in rare instances. In these instances, values are distorted by some exogenous shock to the market. But as Greenspan explains, you can’t tell that it was a bubble until after it’s popped and it’s better to trust the judgment of investors and bankers than to act to inhibit exuberance or manic investor behavior. The three major weaknesses in this kind of thinking are 1) its reliance on exogenous shocks obscures the endogenous weaknesses in the market, 2) its assumption of equilibrium leads to a false sense of financial stability, and 3) its focus on crowd psychology conceals the role of institutions in speculative bubbles. The next theory speaks to these weaknesses.
Bubble Construction Perspective. In this perspective, social actors define the market and condition its stability. Thus, it is the market professionals pushing innovations and insider speculators who create the bubble, rather than the irrational herd of manic victims. In the same vein, it is state sponsorship of easy credit and lax regulation that fosters instability. In other words, markets work because of the structure of formal and informal constraints constructed to tame them. Without this social infrastructure, markets are self-immolating.
The bubble construction perspective emphasizes the structural conditions that facilitate bubble construction by market professionals and insider speculators. Comparative historical research suggests that speculative bubbles have three recurrent features. The first is the creation of financial innovations whose risks are poorly understood and whose complexities can be exploited fraudulently. In recent years, these have included securitization and off-balance sheet accounting. The second feature is lax regulation and low penalties. These failures of the state signal to market professionals that they are free to test the limits of opportunism. The final necessary feature is easy money. Bubbles occur under conditions of easily available credit. In the current bubble economy, this has meant prolonged periods of low interest rates. Both Federal Reserve policy and the glut of Chinese investment have contributed to this.
Why Do Bubbles Still Occur?
I have no illusions that the Bubble Construction Perspective is going to be adopted by our economic policymakers. The Bubble Construction Perspective is adequate to manage speculative bubbles by providing guidance for policymakers to inhibit speculative excess. Even if this idea remains outside the dominant paradigm, policymakers still have economic history and institutional memory to remind them of the legacy of past bubbles and their consequences. But history is notoriously ignored and institutional memory is undependable as older members leave the organization. Although policymakers were fixated on not repeating 1929 during the postwar years, by 1980 it was the Great Inflation rather than the Great Depression that was foremost in their minds. It was at this historical moment that market fundamentalism came to be the dominant ideology. In the following section, I will discuss how market fundamentalism came to pervade American economic policymaking. This is an argument about ideas and policymaking. But, I will not claim that ideas alone determine policy. Rather, I will show that ideas are in a constant interplay with interests and events. Ideas, as Weber indicated, can often embody the interests and events of the moment, creating a new image of the world and switching the direction of history. The institutional approach used here identifies three factors influencing the adoption of ideas. These factors reflect the power of organized actors, e.g., professions, political parties, and technocrats, to create institutional pressures on national economic policy. In this essay, I focus on policymaking at one organization, the US Federal Reserve. During the recent bubble economy, the Fed has been responsible for controlling the money supply and regulating the largest bank holding companies. It is central to understanding the enactment and management of bubbles.
The Role of Professional Economics. The consensus on Keynesianism had dissolved in the 1970s and competing versions of market fundamentalism had risen to fill the vacuum. Heilbroner and Milberg identify four analytical weaknesses in Keynesianism that led to its unraveling within the academic field of economics. First, was its inability to offer a theory of inflation. Second, was its failure to predict or explain the stagflation that plagued the United States in the 1970s. Third, was the relatively limited efficacy accorded monetary policy at the time. Finally, Keynesian behavioral assumptions about the macro-economy are at odds with previous and current rational maximizing assumptions of microeconomics. All these weaknesses opened the door to an assault on Keynesianism, an effort by policymakers to “unlearn” it, and a return to the market rather than the state as the solution to problems.
The Nature of National Political Discourse
Starting in the mid-1970s, during the Carter administration, the nature of political discourse began to shift toward de-regulation of the economy and market-centered policymaking. This discourse was a response to the steep recession of 1974-1975 and the stagflation mentioned above. There emerged a congruence between ideas and circumstances. Under President Reagan, a master communicator, these ideas had a skilled interpreter. The deregulation movement escalated into frenzied opposition to state intervention, or anti-statism. The discourse of anti-statism held sway for nearly thirty years. At the Fed, policymakers adopted a form of monetarist policy to bring down inflation. The policy had newfound legitimacy because it presumably reduced the discretion of policymakers and trusted the rationality of the market. Later, under Greenspan, the Fed loosened regulation of the banking sector and took a laissez-faire attitude toward irrational exuberance as described in the quote at the beginning of the essay. Greenspan was a master of framing, explaining soaring value of stocks in the dot.com bubble as reflective of increases in productivity. National political discourse became resolutely market fundamentalist and skeptics were marginalized.
Receptiveness of State Structures
With the Keynesian unraveling, particularly the discrediting of the Phillips curve, the technical experts at the Fed fell back on the standard operating model of central banking. At the same time, the discrediting of fiscal policy seemed to leave the Fed in charge of the economy. The critique of Keynesian demand management was congruent with the Fed’s capacity for managing the money supply. This unintentionally concentrated more authority in the Fed and put it center stage. By 1999, the passage of the Financial Services Modernization Act and the chairmanship of Alan Greenspan, a market fundamentalist by inclination, insured that banks would enjoy lax regulation and bubbles would not be spotted in advance. The Fed became increasingly reluctant to follow former Chairman Martin’s dictum that its job was to “take away the punchbowl just when the party gets going.”
This failure of the Fed to do its job brings us back to the original question, “Can speculative bubbles be managed?” My answer is yes and no. “Yes,” because we have the knowledge needed to inhibit the worst excesses of a speculative binge. We know that extremes of lax regulations with low penalties, information asymmetries in financial innovations, and easy money are the conditions making economies susceptible to bubbles. Indicators of trading volume, proliferation of new instruments, leverage levels, and market participation by newcomers can all be monitored. Strengthening regulatory agencies and practicing more vigorous, countercyclical monetary policy are well within current organizational capabilities.
But, in the end, I will favor “no” because it seems likely that the institutional factors identified here will be a repeating motif in capitalism. The discourse of market fundamentalism may be repressed, as it was in the Keynesian revolution, but it is likely to reemerge and be championed by institutional entrepreneurs like Ronald Reagan and Margaret Thatcher, backed by political and economic interests. The resonance of this discourse may be seen in the current political difficulties of the Obama administration. Institutional factors, as we know, don’t change easily. Major changes in economic policy call for shifts in academic economics and regulatory practice supported by an institutional entrepreneur with consummate rhetorical skill and impeccable timing. At this point, significant institutional change does not seem probable.
i This quote is taken from Greenspan’s appearance before the Joint Economic Committee of Congress in June of 1999. (Cited in Zandi 2009:70).
ii Testimony of Alan Greenspan, Committee on Government Oversight and Reform, US House of Representatives. October 23, 2008.