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Bubbles

January 13th, 2004

Here’s part of my next AFR piece, which will focus on the claim that long-term interest rates, particularly in the US, are bound to rise. Comments much appreciated.

The idea of bubbles in asset prices is a troublesome one for economists. To say that there is a bubble in the price of some asset is to claim that the relevant financial market is not doing its job properly. In the atmosphere of uncritical reverence for ‘the markets’ that prevailing during most of the 1980s and 1990s, such a claim was unthinkable for all but a handful of heretics (Will rational bubbles fall on the infallible markets ?, AFR, 24 Jun , 1994.)
Even now that a more measured view has been restored, the suggestion that market prices for assets are unsustainable raises what American economist Deirdre McCloskey has called ‘the American question’ – ‘if you’re so smart, why aren’t you rich?’. To make the point more explicitly, if asset prices are out of line with economic fundamentals, why don’t economists and others who can see this back their judgement in the markets and make large speculative profits. This argument is the cornerstone of the famous ‘efficient markets hypothesis’.
The now-standard response is usually attributed to the great economist and successful speculator, John Maynard Keynes (though there is no evidence that he actually said it) and states ‘‘the market can stay irrational longer than you can stay solvent’. This point is illustrated by the experience of the greatest speculator of all, George Soros, who bet heavily, in 1998 and 1999, that the NASDAQ stock market was overvalued.
Soros was right, but the market kept on rising, and he was forced to liquidate his short positions. By the time the market turned down in April 2000, Soros had lost billions of dollars. As one of the many economists who shared Soros’ view of the dotcom mania (Don’t overrate E-commerce, AFR,,8 April 1999), I was glad to have stayed on the sidelines, although I did switch my superannuation strategy away from overvalued US shares.
The same issues arose in relation to the US dollar bubble that ended about a year ago. Although any competent economist could see that the US dollar was grossly overvalued (US dollar needs a pasting,AFR, 29 March 2001.), the currency was supported by the stated ‘strong dollar’ policy of the Clinton and Bush administrations, and the evident market belief that this policy meant something. Once again, a lot of money was lost by those who were prematurely right in their belief that the US dollar must depreciate.

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  1. January 13th, 2004 at 08:20 | #1

    clearly, as ever, the issue is timing.

    in what sense are they right that the dollar is overvalued. its only overvalued until the next bubble.

    although i guess the point is that certain assets bubble and then burst, and then dont ever achieve the same value ever again (tulip bulbs) so for these it can truly be said it was a bubble.

    soros wasnt ‘right’ in shorting the biggest boom (bubble) in history. thats why he lost millions.

    but i like the keynes quote.

  2. Ric Simes
    January 13th, 2004 at 09:31 | #2

    John

    I assume based on your discussion that you agree that there is a bit of a bubble in US treasuries. I do.

    The question this raises is what’s the (long-run) neutral rate? I’d be interested in your view on this.

    Although the empirical basis for it can be weak, growth theory can provide a starting point. To the extent that US potential growth rates have been increased by tech etc, this, however, should have raised real rates – a point that Greenspan has made in the past. So this suggests the bubble may be more pronounced than a simple comparison with past rates.

  3. dsquared
    January 13th, 2004 at 19:41 | #3

    My response to the implicit question in the article is “Why not wait until tomorrow and short it when it’s more overvalued?” I’ve begun to trick this intution up into an informal model, suggesting that it might be strictly irrational to carry out this sort of stabilising speculation.

  4. January 13th, 2004 at 20:19 | #4

    In the short term (sometimes measured in years), the market can often be wrong. In the medium or long-term it’s usually right. Dot-com prices did eventually fall.

    Didn’t Benjamin Graham say in the short-term the market’s a voting machine but in the long-term it’s a weighing machine?

    I think it’s pretty clear efficient market hypothesis is wrong over short periods. I’m not convinced the case is made over longer periods.

    Criticism of the free market leads to the question: have you got a better model? Government intervention just means you think public servants are better at reading the market than those betting their money.

  5. dsquared
    January 14th, 2004 at 00:53 | #5

    I think it’s pretty clear efficient market hypothesis is wrong over short periods. I’m not convinced the case is made over longer periods.

    But it couldn’t be possibly made because as the period gets longer, it becomes an unfalsifiable assertion because the underlying values aren’t stable.

    Government intervention just means you think public servants are better at reading the market than those betting their money.

    Sometimes they are …

  6. January 15th, 2004 at 08:32 | #6

    good point dsquared: as PK puts it, it sounds very persuasive but it depends how you put it:

    imagine a scenario where you give $1000 of your own money to one of two groups:

    group a) is ten people from the local pub.

    group b) is a mathematician

    they take your money and are locked in the pokie room for 1 day and are told “do whatever you think best with the money”

    who would you give your money to?

  7. Tyler
    January 15th, 2004 at 16:08 | #7

    Speaking of bubbles, the Dow is still running at over 100% of GDP against its historical average of 50% and its peak in 1929 and 1987 of 80%.

    But maybe we’ve entered a new paradigm.

  8. Tyler
    January 15th, 2004 at 17:11 | #8

    The total valuation of the US share market, rather, not just the few shares that make up the Dow

  9. PK
    January 16th, 2004 at 18:52 | #9

    c8to – What’s your mathematician vs pub example got to do with reality? If you don’t mind me asking.

    dsquared – Since you think public servants are better market readers, may I recommend you give your money to one to invest? Perhaps the gurus who made investment decisions in the ex-USSR could help you out?

    If you can come up with a better model for creating widespread wealth than the present one, I’m sure the world would love to hear about it.

  10. dsquared
    January 17th, 2004 at 02:06 | #10

    PK: are you trying to suggest that the current economy of Australia is not based on substantial government investment?

  11. PK
    January 17th, 2004 at 16:26 | #11

    I don’t get your point dsquared. If we got nothing at all in return for the billions in taxes we pay, that would be pretty surprising. What’s that got to do with financial markets? Or good investment for that matter?

    Since you seem to be suggesting that there’s a better alternative to substantially free financial markets, could you provide me with an example? If public servants are better qualified to decide on the flows of money and investment than the private sector, this should be quite an easy task.

  12. January 18th, 2004 at 00:10 | #12

    the point is, people betting with their own money doesnt imply rationality…

    also, because we have bad public servants, doesnt mean the idea of public servants having a role in the economy is bad…

    i believe in free markets for labour, commodities and consumer goods, but probably less so for other things like health, and water pipes…

  13. PK
    January 18th, 2004 at 11:29 | #13

    Not much for me to argue with the c8to. There are some things the government is clearly more suited to providing than private industry. Not so sure about health though…

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