Sumner: Greatly Doubts Bubbles Always Burst

      This is always something of a pet peeve of his. I think part of it is because it implies inefficient markets:

      "I have a visceral dislike of this sort of column:

We haven’t learnt as much as we should have over the past few years. But the one thing that is surely clear to all by now must be this: bubbles always pop. And so it is with this one.

      "It’s possible that bubbles always burst, although I greatly doubt it. But it absurd to argue that we’ve learned that from the last few years. Take the 6 major English-speaking economies (The US, Britain, Canada, Australia, Ireland, New Zealand.) All have experienced bubble-type rises in house prices, and yet only two saw the bubbles burst. The same is true in continental Europe, where there were many bubbles that haven’t burst. And Asia. And there are many major metro areas in the US that experienced sharp real house price gains in earlier decades, which are still holding up (San Francisco, San Jose, Manhattan, etc.)"

      http://www.themoneyillusion.com/?p=15637

      I think the idea that the market can be this inefficient in allocating resources offends him. Then again, there's a sense that he wants to argue that "bubbles don't matter" all that matters is NGDP growth:

    
     "Here’s more sloppy reasoning:

The other thing we have probably learnt is that when housing bubbles pop, economies crumble. Is that happening in China yet?

    "Again, this is simply false. The US economy did fine during January 2006 to April 2008 while the housing bubble collapsed. Only after NGDP collapsed in late 2008 was there a sharp decline in the economy. Unemployment was 4.9% in April 2008."

     I've read things like this from him for awhile. He's been saying it for probably as long as he's been blogging-back in 2009, though I only started reading him last October or so. I have read some of his archives though and he always gives this stat in discussing bubbles.

     It never sounds right to me. I feel on some level there's some casuistry in this claim that everything was alright until late 2008. Ironically, to the extent that he as a Market Monetarist believes in market signals, the market was already prophesying that there was a coming recession in late 2007. Sumner believes in "monetary policy works with long and variable leads" as opposed to Old Monetarism's believe in "long and variable lags."

   Yet, what's clear is that the markets themselves were predicting a recession in late 2007. The market topped in July, 2007, slipped in August, came back to retrace for a double top in October due to Fed easing.

   I can remember the literal day the market the market topped out and predicted a recession-it was the day that Angelo Mozillo at Countrywide Financial had suggested that things wouldn't improve in the housing market until 2009. The market was totally jolted by this and fell 400 points the next day. This was the start of the bear market that lasted until March, 2009.

  So this episode seems to validate the idea that the market is a forward indicator. The bear market in equities preceded the actual recession by over a year-the bear market started on that July day-I'm thinking the 18th though don't quote me on the exact date, it was close to that-when Mozillo spooked the markets.

  So the markets had long forecasted the recession. Yet supposedly it only happened due to Fed actions in late 2008?

  Sumner linked to another post he wrote in 2010 again attacking predictions of bubbles. In this post he linked to an interesting post that Nick Rowe wrote at the same time:

   "Economists' ideas about bubbles aren't very clear. We can define a bubble theoretically, but we can't explain why they sometimes exist, sometimes don't exist, or why they sometimes start and stop existing. And we are not very good at identifying bubbles, even perhaps in hindsight. And even when we do say something is or was a bubble, all we are really saying is that we can't think of any plausible fundamental explanation of the time-path of prices, as Scott Sumner argues. That doesn't mean there wasn't one; just that we don't know what it is. (Scott's been doing more great posts recently than I can hope to keep track of.)"

   "For what it's worth, I do think that bubbles are sometimes real, even though that belief is about as unfalsifiable as a belief that UFO's are real. In fact, we should probably drop the term "bubble" and replace it with "UFP", for "Unexplained Flying Prices".

   "And, for what it's worth, I believe in bubbles because I believe humans tend to follow faddish beliefs in lots of things, and I don't see why their beliefs in asset values should be any different."

   "Bubble" is a metaphor, of course. But there's nothing wrong with using metaphors in science. How useful they are depends on how far you can push them."

   "Real bubbles are unstable; they burst when you prick them. They don't spontaneously revert to their original size. Soap bubbles aren't like tennis balls. If the bubble metaphor means anything, it has to mean that. If asset price bubbles aren't unstable, and don't burst when you prick them, or re-inflate immediately, then the bubble metaphor is useless."

   "How do you know if something was a bubble? If you prick it and it bursts, it probably was a bubble. If you prick it and it goes back to the original size, it probably wasn't."

   "We can (at least in principle) decompose the price of any asset into a fundamental component and a bubble component. The fundamental component evolves over time according to the expected present value of the dividends, rents, or whatever other benefit holding the asset indefinitely would yield the owner. And the bubble component must be expected to grow (or decline, if a negative bubble) exponentially at the rate of interest."

   "The expectations about the fundamental component are expectations about something that has an objective existence apart from beliefs about it. The expectations about the bubble component are expectations about expectations. Like Tinkerbell the fairy, they only exist if we believe in them; otherwise they die. That's what should make bubbles unstable. If others stop believing in them, there is no reason for us to believe in them."

   "If anything should cause a bubble to burst, it should be a fall in the price of the asset, especially a fall that is larger than any fall in the fundamental value of the asset. Because that is ipso facto evidence that others have stopped believing in the bubble."

   "US house prices fell last year, and show no signs of recovery yet. Canadian house prices fell last year, and have now recovered. Bubbles don't re-inflate themselves; they pop. Tennis balls return to their original size after they get hit, or even punctured; but then tennis balls aren't bubbles."

   "Now some might argue that the Bank of Canada's low interest rates have re-inflated the bubble. But if the metaphor "bubble" means anything, it means you can't just re-inflate it after it's burst. It's supposed to be unstable."

    http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/01/dont-bubbles-burst-when-pricked.html

     Nick I think does a better job-or at least I find it more clear-of explaining what a bubble is or isn't. We know it's a bubble if we prick it and it bursts, however, if they return to their original size after they get hit, they aren't bubbles.

     If anything, I find Sumner a lot more agnostic about the very existence of bubbles. He seems to me to be not very sure that they exist at all, but if they do they can't be very important.

    Nick is clear that they do exist. In Sumner I can't tell if he's certain they do or not. It's also clear that even if they do exist, the best thing to do is to just wait for it to pop and fix NGDP afterwards-to be sure he would argue that maintaining a stable NGDP target might protect against bubbles on the way up. But this seems to me tied up with the idea that Scott can't  imagine that a serious misallocation can happen.

    P.S. I agree with Scott obviously, that it's very misleading-and I think wrong-to talk about a housing bubble in China. By Nick's criteria-we know it's a bubble if we prick it and it pops-we can certainly after the fact say that of course the U.S. and U.K. had bubbles. The U.K. in some ways had it much worse than us. Even during the boom it caused hardship as prices got so high that many Britons could not afford to buy a house.