The Joe Walker Podcast - Housing Bubble Week: A Philosophy Of Bubbles - Timo Henckel

Episode Date: May 19, 2019

Bubbles are everywhere today — or so we're told. But what are they really? I speak with behavioural...See omnystudio.com/listener for privacy information.

Hello there, ladies and gentlemen, boys and girls, swagmen and swagettes. Welcome to episode five of Housing Bubble Week, my seven-part series on housing bubbles generally and the Australian one specifically. I'm your host, Joe Walker, and this is the Jolly Swagman Podcast. Bubbles are everywhere today, or so we're told. A cursory Google search reveals there is a new hyper bubble in US real estate, an MBA bubble, a higher education bubble, and a FANG bubble. Not to mention lawyer, indices, tech 2.0, hedge fund, exchange traded fund, China credit, corporate bond, sharing economy, and restaurant bubbles. In 2014, New York Times economics journalist Neil Irwin darkly suggested the entire world may be in an everything bubble.

How many of these are actually bubbles? Only time will tell. It certainly feels as though whenever somebody claims something is hyper-bubbly, it's more likely to be hyperbole. Indeed, to follow the modern finance media is to be in a bubble bath. A dominant reason for the apparent proliferation of bubbles is simply, I believe, our collective confusion about what they really are. In a 2010 article for the Rolling Stone magazine, journalist Matt Taibbi denounced Goldman Sachs as the great American Bubble Machine. It had orchestrated and profited from precisely six bubbles, in his estimation, including not just the Great Depression, tech stocks, the housing craze and commodities, but also carbon credits and top government bailouts. In Taibbi's eyes, it would seem anything financially exorbitant or unsustainable can be branded with the B word. He's in distinguished company here.

Some economists frequently refer to credit or debt bubbles, not in reference to any particular asset class, but as if the pileup of debt itself is a bubble. Others have offered definitions broader still. In 2012, Yale economist and Nobel Prize winner Robert Shiller wondered aloud about bubbles without markets, such as China's Great Leap Forward. In fairness to Shiller, who, as by now should be clear, is one of my intellectual heroes, he uses the term bubble in this broader sense as distinct from a speculative bubble, the type we're concerned with, which he defines as a quote-unquote social epidemic whose contagion is mediated by price movements. But since most people use the terms bubble and speculative bubble interchangeably,

it only adds to the confusion. Indeed, Schiller himself treated the terms as synonyms in the preface to the third edition of his classic Irrational Exuberance, published in 2014. The same year, Peter Thiel waxed in his bestseller, Zero to One, that, quote, conventional beliefs only ever come to appear arbitrary and wrong in retrospect. Whenever one collapses, we call the old belief a bubble. End quote. Like the surface area of a soap bubble, the definition of a financial bubble appears to have expanded unsustainably. So what is a bubble? I titled this episode A Philosophy of Bubbles, but that's a vague catch-all title. Our guest is charming behavioral macroeconomist

Dr. Timo Henkel from the Australian National University. Timo and I talk about how to define bubbles, the psychology of bubbles, why they are not so much born in the absence but with the help of good economic fundamentals, and how the informational cascades that inform invested decisions can create price movements with trends that can't be described as random walks. We don't necessarily offer a complete definition of bubbles, but we do paint a compelling portrait. By the way, the middle of the conversation is thick with theory. If you're into that, you'll love it, but if you're not, push through because we don't talk about theory for the whole podcast.

So without much further ado, please enjoy my chat with Timo Henkel. Timo Henkel, thank you for joining me. Thank you. Pleasure to be here. It's great to meet you. And maybe we could begin by having you tell us when you first arrived in Australia about 14 years ago. Correct. What your perception of the housing market and the broader economy was. Do you remember a moment or how did it strike you at the time? Because it was in bubble territory even when you arrived. Some would say. Some would say. I would say so too. And I said so back then. I had just moved to Canberra from London and I thought London is an expensive place, well known for its expensive real estate. I moved to Canberra with my young family and had considered buying, albeit not straight away, because it seemed to make sense to get a feel for the market first and to also be sure that we really wanted to be there for a while.

When we first looked for rental property, we had agreed on a maximum weekly rent that we were going to pay. And we went out on the hustings and decided to start looking for a house and realized very quickly that our estimation of what we could afford per week was just way out of line with reality. So we had to adjust our rent, our willingness to pay as weekly rent. We had to adjust that up very quickly. And a year, perhaps two years later, after we decided that we're going to stay in Australia for longer, we looked into buying property. But as you said, it already seemed overvalued. about the turn of the millennium, house prices in Australia overall, but particularly in Canberra, had been rising at rates that I didn't even see in London. That seemed unrealistic to me. It didn't seem like the right time to buy. And so we refrained from buying. Little did I know,

15 years later, that this trend was going to continue. So I saw a bubble back then and I still see a bubble. And there's some sour grapes coming through here because I'm still not a homeowner. We're going to come back to the nasty B word, as Eugene Farmer calls it, and give it a little more shape and definition. But before that, before we started recording, we were just talking about the interesting cultural differences between how Australians and other Westerners think about houses versus how Germans, you're originally from Germany, think about them. Can you tell us a little bit more about that? Yeah, it starts with the difference in, for example, tenants' rights. In Germany, it is perfectly acceptable that you

make your rental property a home, a long-term home. It is not just something temporary. My parents moved into their apartment, the one that I grew up in, in Berlin, in 1969. They rented that place for more than 40 years. And that is not unusual at all. That's possible because tenants have many more rights. The owners cannot request a biannual inspection, for example. As a tenant, you can choose to hammer any nail in the wall as you please. You can even tear down the occasional wall without having to worry about it. Most tenants install their own kitchen. That's, again, pretty normal. There are restrictions, of course, on how you have to leave the place if you do choose to move out. You pretty much have to leave it in the state that you found it in. But in between, while you're occupying the property, it is your home. And that's how most Germans feel it should be.

I recently had to leave my property, my rental property in Canberra, because the owner decided to sell the house, and they had been given advice by the real estate agent that it would be better to sell it vacant rather than occupied. I obviously wasn't too pleased about that because I had to move house. And I was curious what that would look like in Germany, whether that was possible or not. And true enough, in Germany, that would not be possible. If you own a property that is rented out and you want to sell it, you cannot expel the tenants. You have to sell it with the tenants in the property. And if the new owner wants to, however, live in the

property, because that's the reason why they're purchasing the property, then they have to wait at least three years before they can give you notice to vacate the property. So it's just a very, very different environment. Now, you may well argue that tenants have far too many rights in Germany. That is fine. And my point is that there is a huge cultural difference. Moreover, there's a lot of outrage at the moment amongst many Germans about the steep increases in real estate prices that Germany has experienced, mostly in the major cities, Berlin, Munich, Cologne, Hamburg. That kind of outrage is just something I haven't seen in Australia. There is this understanding that housing is a fundamental right and houses should not be an object of speculation. If you want to speculate, do it in the casino, possibly in the stock market, but don't do it with real estate. I think that's what the majority of Germans probably feel.

Interesting. And I guess it's also noteworthy that Germany was one of the few Western nations that didn't experience a house prices bubble in the 2000s. That's correct, yes. Unlike many other countries, sadly. Well, but they're arguably doing now. Yeah. They're doing some catch-up.

Yeah. So let's define what a bubble is. And there are two kind of approaches. So, I mean, we all know colloquially a bubble is when the market price significantly or sufficiently departs from intrinsic value. That seems to be like a very core part of what people understand to be bubbles. But there are a few different approaches to measuring what that intrinsic value is. One of them is what's called the quote unquote fundamentals approach.

Can you just give us an overview? What are fundamentals and what do they look like in the context of a housing market? Fundamentals are those variables that economists presume to be important to determine the valuation of any good. So if you think about a standard supply and demand framework for a good, what determines demand? Well, it's ultimately going to be preferences of some sort. If you think about Econ 101, if a supply is limited for a good but demand is high because many people have strong preferences in favor of that good, then that would tend to drive the price up.

If demand is weak, then that would tend to drive the price down. What determines those preferences? That's not really in the purview of economists to determine, because we typically as economists assume that human beings are endowed with preferences. They're somehow given to us in birth. It's in our DNA. So unlike other social scientists or, let's say, marketing experts, we don't really, in our models, in our thinking, allow for preferences to be influenced much by the people around us or by society at large, which I think is a very problematic assumption in economics. So those fundamentals are ultimately all those factors that are going to affect the demand and supply of a good. They can be obviously visible ones, you can measure how many houses are actually on the market, how many new ones are being built, for example. They might be something like the interest rates,

which is going to determine how affordable a mortgage is for a possible home buyer. It could relate to population growth, because it says something about how many new people are coming into the market and given the supply that's there, how the demand is likely to shift in response to that population growth. But there may be other factors that are not measurable and very hard to put your finger on. Why, for example, housing as a speculative asset might suddenly become more attractive relative to other assets such as stock or equity or bonds, that's not always so obvious. Why certain areas, real estate is all about location, why certain areas, for example, become more attractive than others. It's very hard for us, certainly as economists, to dictate. But ultimately, if we had that kind of information, we consider them fundamentals

in the sense that if we had that information, we would be able to say what a reasonable price would be. That price which clears the market where supply is equal to demand. When we start talking about bubbles, I don't know if you wanted to ask me that question or if I can lead into it myself. observed on the market is in some ways divorced or departing from this benchmark price that would be in place if it were just determined by fundamentals. But of course, this is where it becomes very fuzzy and very difficult and why there's so much disagreement. Ultimately, it comes down mostly to psychology. The underlying force normally for the existence of a bubble or the assumption of the existence of a bubble is the speculative behavior by home buyers, namely that they buy a property because they expect to sell it for capital gain.

It is the, the reason for buying it is because they anticipate a price increase and therefore an increase in their wealth. This is, and therefore an increase in their wealth. This has profound implications because in terms of economics, it gives you an upward sloping demand curve as opposed to a downward sloping demand curve. So it really turns Econ 101 on its head in many ways. Because as we know in Econ 101, the intuition behind the downward sloping demand curve is that if the price goes up, people want to demand less of it because not everyone will have

as high a valuation at the margin for that good. And so a few potential buyers will drop out of the market and so demand will go down. For speculative assets, for assets which people speculate on, or for speculative goods, it's exactly the opposite. If an increase in price actually confirms the view that it's worthwhile betting on that consumption good or on that asset, then that's a signal to increase demand for it. And therefore, it becomes self-fulfilling. Without putting too fine a point on it, why are the quote-unquote fundamentals uh to use your word fuzzy

well because you have to you have to think about all those possible factors that make any one person or a whole collective of people decide on on what they like and what they don't like, what their preferences are. That requires a degree of psychological knowledge, I think, that we don't have. So we have, obviously, some idea. We know certain factors that affect people's behavior. But it's too complex to get a good grip on,

let alone to have an exhaustive list of what, for example, all those fundamental factors ought to be. Still thinking about this fundamentals approach to measuring intrinsic value, but moving from theory to practice now, what strikes me is one of the very pernicious things about bubbles is that many people think that bubbles occur in the absence of strong fundamentals, but on the contrary, they're usually midwifed into existence by good fundamentals. Ray Dalio, the hedge fund

billionaire and founder of Bridgewater says that that bubbles are over-extrapolations of justified bull markets. Jeremy Grantham, the legendary investor, has a very parsimonious definition of a bubble. He just calls it excellent fundamentals euphorically extrapolated. George Soros has a similar quote, pretty much to the same effect. Exactly. And the problem therefore is that, you know, in any bubble, there are very good underlying fundamentals and the bubble itself is sort of an overlay. But what that means is that people can always torture the fundamentals to lie for the bubble. And we've seen this, you know, in the 2000. Economists were arguing very intelligently and persuasively that there was no bubble, for example, in the US housing market because things like interest rates and incomes could explain 100% of the price increases. I can link to some papers that made that argument, a couple by the New York Fed in 2004, for example.

Is there a better way of gauging intrinsic value that doesn't rely on fundamentals? Well, that's the million or trillion dollar question. If we believe in bubbles, if we accept the theoretical concept of bubbles which we'll come back to which we'll come back to

then at the very least what we can do is to take a very long term view of the asset market right because bubbles by their very nature are ultimately going to correct themselves in one way or the other so if we have whatever benchmark that may be it might be the it might be an estimate of a fundamental value based on some kind of structural model which is going to be highly imperfect but so are all the other measures

or whether it's going to be some kind of average value some historical benchmark etc etc there comes a point when a bubble when it's a really when when a bubble becomes obvious, and that's where it probably is a few standard deviations outside some kind of norm. to identify this and it may be perhaps even too late to do something about it, to engage in any kind of policy about it because it might be just before it's going to pop anyway. But I think there comes a point

when prices are so elevated that probably the majority of people would accept that this cannot continue, right? At least in terms of changes, the growth rates just aren't sustainable. The primary reason being that the only way you can sustain these continuous growth rates of asset prices is that they are eventually fueled by debt people take on additional debt in order to afford these higher assets whether it's housing or stocks or whatever and that's a ponzi game that has to end at some stage. So I think ex post, I think we ought to be able

as economists anyway to go out on a limb and declare something a bubble. In real time, of course, that's a lot more difficult and it raises important questions about whether we should devise policies to try to keep uh bubbles in check i love what you've just said because

some people say well should we be able to draw a line in the sand and say this is a bubble this isn't a bubble you know it's a binary house prices increase 50% or more in three years, then that's a bubble. But then that leaves the obvious problem of, well, what do we do if they increase 49%? You know, is that not a bubble? Should I invest in a property? So, should we just settle for, you know, Justice Stewart's dictum that like hardcore pornography, bubbles are a question of I'll know it when I see it. But I think without, you know, verbaling you, what you're proposing is that we should think about bubbles probabilistically before the fact.

Correct, yeah. And so a larger run-up in prices is more likely to be a bubble. And that's actually a very defensible approach to take to bubbles because statistically if you look back over the course of history if you look at the empirical data larger price run-ups have a they do have a higher probability of crashes in both stock markets and housing markets so just looking back at the most recent example of a bubble which if you look at the graph looks like the mother of all bubbles and that is for bitcoin yes i was i have coffee about once a week with a colleague of mine who

is also a trader and i did some futures trading for a couple of years in between myself a while ago and we were dead certain that in fact we would have bet a lot, but we didn't have anything to bet. But we would have bet a lot that this was a bubble. It ticked all the boxes of a definition of a bubble. Perhaps the only difference being that we don't know how much debt actually went into it. But that's because it wasn't a very big market in the first place. And there were probably enough players out there who had enough capital to play with and to speculate on it. But there were also stories of, I remember reading in the newspaper, there was, I think,

a Dutch father who sold up his entire house and moved into a caravan with his wife and one or two children, thinking that, well, he's going to be a millionaire in a couple of years and they're going to live in a big mansion.

His great-great-great-great-great-grandfather probably did the same with a tulip. With a Dutch tulip. So, I don't know when he bought, but if he had bought at the peak, when Bitcoin was worth about $20,000, he would have lost by now 80% of his capital, right? That kind of dramatic run-up, it cannot be explained by anything fundamental to me because the the there was no significantly new in significant new information for example that's that appeared there was no new revelation about the blockchain technology that underlies bitcoin there was nothing really to suggest that this was actually a new invention that

is going to change the world and thus justify its value. It doesn't leave anything else but a speculation game. People seeing that the price goes up and getting in on the game. So, obviously, all of this begs the question, you know, if we can see bubbles coming, should central banks and policymakers do something about them preemptively i think we might save that for a little bit later and do what to many people might sound like a bit of a backtrack but i think is actually a very interesting discussion point which makes sense to talk about now and that is this a prior, can bubbles exist? That depends on how you're going to define a bubble. And I think that's probably going to be informed in many ways by your economic training and your paradigm.

Which paradigm? Yeah, so I'm thinking aloud a little bit here. Go for it. But if, in economics, when you solve, and since we do most of our work in equations, when you solve a difference or a differential equation, which is an equation that describes, for example, how an asset's price changes over time. The solution to that equation is going to consist

of two parts. The one part is the part that can be explained by other exogenous variables, whatever they may be, whatever you want to put into the model. And then there's going to be another part, the second component, which is tacked on, which is the component based entirely on expectations of future changes in the prices. So the first bit is what the economists call the fundamental component, and the second bit is what they call the bubble component. Now the bubble component, in principle, when you just calculate the solution to this kind of difference or differential equation, there are no constraints.

It can go on forever. But the real world, of of course does face constraints and you cannot have people forever playing a ponzi game for example because at some stage at least one of the constraints is going to bite you cannot continue issuing debt forever for example or with the old good old chain letter for, there's going to come a point where you've exhausted all the possible people who are going to contribute and pay up to make the initiators of the chain letter rich and perhaps a few more participants

later down in the chain. So economists who often think that people are rational and understand well how the world works, they would argue that this second bubble component must be ruled out. Because you understand that in the real world there are these constraints. And then just thinking backwards, unraveling this game, it would never make sense for you to speculate on a good, because you might actually be the last one, the sucker who ends up buying at the peak and then sells later on and making a capital loss.

So this second component of the solution to this difference or differential equation describing the price movement of an asset is very often in economics ruled out. And there are variations to that and it comes up in various guises in economics, but it's often referred to, for example, as a no Ponzi condition. Now, that's very technical, I understand that, but the point is that for many economists,

the way they work with these models and trying to put everything into equations, they wouldn't know how to handle a bubble very well if they just look at this solution to a difference or differential equation. And the constraints dictate that the second bubble component cannot really exist. So they rule it out, which means you're only left with the fundamental. But then if the fundamentals don't change much, which they rarely do, fundamentals don't change by a large amount over a short space of time, typically. It's not like Australia suddenly has 5 million new inhabitants overnight, right? Immigration is a steady process, something that you can essentially plan for.

So economists in that kind of world would rule out the existence of a bubble altogether. They would say it doesn't make sense to think about it. And so if the price of housing goes up, well, then it must be because of fundamentals. There are other economists who have different models in their head and who accept that price movements may have considerable psychological components. And so they would entertain the idea that perhaps people aren't so rational

as other economists assume. And they may not understand that this bubble component actually should be ruled out because it can't last forever. Or it's just a case of playing the greater fool, assuming that someone down the chain who's going to be the fool and not yourself.

So I really think it depends on what your view of the world is, how sophisticated you think people are, how well they understand the economy, how well they understand asset markets, how much they buy, for example, into the story that, which in a housing bubble you hear all the time, that house prices never really fall. I mean, look, everyone always needs a house, so surely house prices can't fall or not significantly. Some people are going to be more gullible, Some people are going to be more gullible.

Some people are going to be less gullible. But again, the assumptions that you make about human behavior, how people process information, how their preferences are generated, their imperfection in many ways is going to dictate whether you think that bubbles exist or not. So now on the other hand, what is information asymmetry Infection, in many ways, is going to dictate whether you think that bubbles exist or not. So now, on the other hand, what is information asymmetry, and how does it open up the possibility of bubbles?

Well, we talked about this briefly before the recording started. Informational asymmetry is clearly intrinsic to financial markets. The whole reason why we have so much trade is because people have different sides of the market, the buyers and the sellers, they have either different preferences or very often different expectations about what they think the future holds. So someone may be more bullish, someone may be more bearish, and therefore they engage in a trade. This is one of the interesting features is that we know that there is a lot of transaction volume in financial markets, even on a daily basis. Just think about the foreign exchange market.

The daily transactions now in the foreign exchange market are about $5 trillion US dollars per day. Now, all of this movement, all of this trading that's happening there is not just because there are firms who want to export and import. There's a lot of speculative behavior that drives this turnover. What's the source of this? It's got to be because people readjust their expectations of whether they think currency is going to devalue, appreciate or depreciate, for example. So, informational heterogeneity is a key driving force of what's going on in the financial markets. Now, interestingly, standard economics

doesn't really allow for that informational heterogeneity. Because if you assume that everyone has rational expectations, no one is making systematic mistakes, no one has biased expectations, for example, then there really is no reason to trade at all, because we're all pretty much alike anyway. Can you just define rational expectations? That's a term of art in economics. Yeah, rational expectations. There are different definitions of rational expectations, but

basically, well, there are two ways to think about it. One way is that rational expectations is, as I just said, it's the assumption that people, agents, firms, whoever is forming a view about the future, is using all the available information to them in a sophisticated, optimal way. way meaning that people will not make at least in the medium to long run they will not make consistent biased errors right if you see that prices are continuously going up for an asset you're not going to keep underestimating what that price behavior is going to be at some stage you realize, okay, well, prices are always rising by 4% and not by 2%, so you basically learn. Now, the extreme form of rational expectations is actually that this learning process basically happens instantaneously. In other words, people have learned everything there already is to learn. It's not a dynamic process. A more technical version of this is that for us

economists, when we write down our mathematical models and we assume rational expectations, it really just means that the people in our models, the agents, the households, the consumers, the firms, they have what we call model consistent expectations. In other words, they expect exactly what the model would say they would. Because if they didn't, then their expectations would be inconsistent with the reality. The reality in this case just being of course our model our imagined reality but that's just really another way of saying saying the same thing so coming back to informational asymmetry you were saying that the the whole idea of like a trade in a market presupposes heterogeneous uh informational expectations because assuming we're at the same you know point in our life cycle i'm selling so clearly i think that there's no more upside in

in whatever the asset is you're buying you think there is upside that's a difference of opinion that can't be explained by rational expectations correct me no no that's right i mean it can't you know you can't have differences in opinions i guess in in somewhat more elaborate rational expectations models um ultimately they all wash out though right and so the reality is that most of the economic models, when they assume rational expectations, if at all, allow for only very little heterogeneity in expectations because they don't really know how to handle it. And if you've got a lot of heterogeneity, well, then that opens up a host of issues precisely about how assets are actually priced. So how does heterogeneity lead to bubbles? Can you just join those dots for us? Heterogeneity leads to bubbles.

So there are two aspects here. First of all, going back to your starting point, namely informational asymmetry or incomplete information or imperfect information. As economists, again, we use these terms quite discriminately, but I'll use them less so at the moment. Informational incompleteness in the markets are an intrinsic feature of financial markets. That's why it exists. That was what I stated earlier. That generates a bias, an upward bias in asset prices more generally. For the very simple reason, which is an example I mentioned before,

that John Kay, the UK banker and economist, mentioned in a talk some 10 years ago quite nicely that it's much easier for an owner of a fake Rembrandt to sell it to a buyer who thinks that it's real than it is the other way around for an owner of a real Rembrandt to sell it to a buyer who thinks that it's fake. This leads to a general preponderance of buyers out there who probably overvalue assets and a dearth of buyers who undervalue an asset, right? And that is ultimately a function or a consequence of that informational asymmetry. Now, that's probably true in a dynamic sense as

well, because if we think about how people form expectations about the markets, how they assess how valuable something is, given the uncertainty that's out there, well, they will often look to their neighbors, to the people around them, to expert commentary, and so on, and, of course, also to the data. And if they see that, say, house prices are going up, they re-evaluate their personal valuation of house prices and may adjust that upwards.

And that can, in turn, sort of become self-referential and generate a self-fulfilling prophecy. So another way of describing what you just said is an information cascade correct which is another new piece of jargon for all the listeners who are learning a lot in this conversation tell us what an informational cascade is uh and how it differs from from a random walk uh you might need to define what those what a random walk is as well a random walk is simply a process whereby the next step is just as likely to be up as it is down right

for so so so there's no there's no trend in there. You can build a trend into it, but a basic random walk doesn't have a trend. The image that's often invoked for this is some drunkard walking down the street and staggering down a dark alley, just as likely to take a step to the left as he or she is to the right.

So his movements are independent of each other. The movements are independent, exactly. In particular, each movement is independent of the previous movement. Correct. Information cascades are processes where someone's, you can imagine more generally that someone is trying to value a good or an asset. And they have a personal or private notion of what the value of that asset should be. But they understand that they live in a world with imperfect information.

And so their personal valuation may not be entirely accurate. So they also look to some other source that usually is some kind of aggregate source. It might be just experts, but then experts typically are also assumed to be a consolidation of aggregate opinions or so. And people who try to value a good or an asset then use a combination of their personal valuation and some kind of outside valuation. Over time, depending on the relative weights that you attach to your personal valuation or the outside valuation, you may end up in a situation where, again, it becomes self-referential.

If there's sufficient weight attached on the opinion of outsiders or experts or the public or actual price, for example, and not so much weight on your individual personal valuation, then you have this person's valuation basically take on or more or less adopt the market's valuation and this in turn might then affect someone else who also then relies slightly more on the market's valuation or outsiders opinions valuation as opposed to their private valuation and and so on you you then get a sequence of information that affects everyone else's valuation, such that you may end up with essentially a large amount of consensus. Right. Because no one is thinking about, well, what's the real value here? I don't trust myself, but I'm going to go with what everyone else is saying.

And if everyone says, I'm going to go with what everyone else is saying, then the information is really just the aggregate information and there's no personal information anymore. And this usually happens because it's a dynamic process. This usually happens in the form of a cascade. Across time. Across time, exactly.

Gotcha. Well, across time and also across agents or people yeah because they're because different people attach different weights to their personal information so those who attach a lot of weight to outside information are the first ones who gets infected by by outside information and then you go down the cascade as people attaching less weight to outside information see, however, that, for example, the market price is moving in one direction ever so strongly. Well, then they start doubting their own personal information

and so on. Okay. So an information cascade is sequential. It is sequential, yes sequential yes it sort of makes sense when you think about it i mean a lot of things in life we will we decide you know what we want by consulting the gaze of of other people like renee gerard has this idea of memetic desire which i find really interesting and and you know conformity is well studied in psychological literature the ash conformity experiments really really interesting where they have

one person who's who's the subject and another six or eight people who unbeknownst to the subject are actually confederates with the experimenter. And the experimenter asks a very easy question, holds up sort of a placard with a line on it. Everyone gets to see the length of the line. It's pretty obvious. And then a second placard with three lines. One of them clearly matches the first line. Two of them clearly don't.

And the experimenter asks the group, which line matches the first one i showed you and the subject always answers last and here's the confederates first who give a clearly an obviously wrong answer and i'm trying to remember i think in a third of about a third of the i don't remember what the proportion is but it is about a third the person defied their own common sense exactly and scarily high yeah that's right yeah and they just yield to group consensus yeah and they and they start doubting their own uh intuition or or they don't dare speak up correct crazy but but basically there's a there's a lot of sort of psychological literature and

human nature underpinning what you're saying. Exactly. And, of course, this psychology, this idea that we are social animals, that we are deeply connected in society seems dead obvious. Yeah. Any lay person out there is going to agree with that statement. And yet most economics doesn't acknowledge that yeah most formal academic economics right yeah there are some economists who do try to model this kind of behavior but these are basically niche market niche this is niche research mostly it's not it doesn't form the the core or basis for much of mainstream economics so i was going to say another thing which i i meant to address and i hadn't

hadn't touched on this because you earlier on mentioned that many bubbles do have their origin in in good or sound fundamentals and this this is absolutely true because of course what's required is is a strong narrative that the public buys into or else it would be really hard to see why a bubble would ever emerge in some ways right it's not it's not a total hallucination no no it's not it's not it's not a total hallucination by no means although i found bitcoin was to be about as close to a total hallucination as there ever was one but anyway um clearly with bitcoin people bought into this idea that this blockchain technology applied to money was going to revolutionize the world now i think they misunderstood what blockchain technology can do.

I think they also understood the monetary system more generally. So this is a classic example, I think, of asymmetric information, to be honest. But there were enough buyers, potential buyers, who bought into this story, this narrative, that this is a new invention, this is a new paradigm, this time is different. This means that we are entering a new era where we've got a new technology that is going to change everything and for that

narrative to take hold for that story to take off i think there has to be something fundamental to to trigger it so it's no surprise that there was the dot-com bubble example right it was it was the imagination that that took hold and people's minds of what the internet revolution might might do to to the new millennium the the new millennium and and in the housing market is so it apparently even works with brick and brick and mortar but if you listen to the rhetoric 10 15 years ago in the u.s market there was clearly no one entertained the idea at least publicly that house prices could also go down it was it was a safe bet, as safe as houses, right? Yeah. And people bought into that. So this narrative, I think, is a really crucial part of explaining the emergence and also the sustaining of a bubble. psychiatrist or psychologist David Tuckett at UCL

in London who wrote a book about this I think a year or two after the global financial crisis and he was really emphasizing that point that we need to think more about the psychology of

people and this is closely connected again with the social interactions that we just referenced the psychology of people. And this is closely connected, again, with the social interactions that we just referenced, that we are social animals and we talk to each other, we look to each other, we don't form opinions in a vacuum, but we are heavily influenced by one another. And that's how these stories get a hold. And this is not new, right?

This is perhaps the scary thing, and that's how these stories get a hold and this is not new right this is the this is perhaps the scary thing because whenever there's a big bubble that bursts or there's i'll for a moment not use the bubble term but i'll say when there's a big crash in prices of some asset yeah it it causes some consternation and pain and head scratching and i guess because this narrative of this time is different has an echo and i don't i i'm often surprised by this head-scratching because I think it has been understood for hundreds of years, if not back to the ancient Greek philosophers, that trading and asset valuations is actually a deeply psychological phenomenon. I could show you on my computer i've got um a nice picture from the mid-19th century i i can show it to you sometime but uh if you send it to me we can put it in the show notes yeah okay um can i reference it as we speak is that sure is that right absolutely i'll have to switch on my computer briefly go for it yeah yeah this is a caricature

called the overstone cycle of trade lord overstone was an english banker philosopher politician back then they were everything right and uh i think it's actually the caricature i think is by a frenchman if i'm correct but may be wrong. I have to look it up again. But I think it, in a very nice way, captures many aspects of both the business cycle but also the financial cycle. And that's one of the interesting features of this caricature is that it very clearly weds the financial cycle with the business cycle, which again is something that standard macroeconomics often does not do. There's been a little bit of reconsideration now after the global financial crisis

as to just how important finance is to understand the business cycle and the real economy. But you can see here, if you start up at the top, for example, you've got sort of the prosperity phase. At 12 o'clock. At 12 o'clock, happy family sitting around a dinner table. And then you've got the excitement phase, which is the next one. You can see there's some kind of fantastic flying object there

that clearly doesn't exist. Some kind of pie-in-the-sky stuff or so. And then you've got the South Pole Warming Company, right? Which, of course, is also ridiculous. So this is when everyone thinks things are going great, which invariably leads to convulsion. This here is, you can barely see it, but this is a bank that's exploding um and

and clearly what what fueled the excitement turns out to be or to have been unsustainable leading to stagnation uh people in the poor house there's even someone who hanged himself there um and then slowly that turns into improvement and confidence again. And again, I think it's the marriage of the financial cycle and the business cycle that actually is a pretty good description of what's going on. Along with this unrealistic expectation of what the real world holds some fantastic flying object that's going to change the world and and um give us the riches that we all long for i yeah like i said this is from the mid 19th century i always thought that was quite quite cute so this connects to this idea of narratives exactly that yeah that there's a narrative

that that bubble does usually have its roots in some kind of uh sound fundamental yeah or or shift in fundamental let's put it that way but it's it ultimately becomes an overreaction and that overreaction in itself is sort of a self-perpetuating or yeah has a self-perpetuating element i think the the people to people connections are fascinating and and they're the sinews like the the lifeblood of bubbles there's a couple of really interesting papers u.s economists did can't remember the names off the top of my head send them to you, Timo. I'll link them in the show notes for everyone listening. One paper, they examine geographically utterly disconnected regions in the US where prices start rising in unison and they map these over people's social graphs on Facebook. Oh, fantastic.

What's connecting the areas of friendships. Amazing. Another one is just the idea that when investment properties sell in your neighborhood, you're more likely to become a property investor. That's right. Yeah. So, what you're saying is this psychological dimension of bubbles, you know, and seeking to understand it. We should listen to what people are literally saying to each other. Absolutely. saying to each other absolutely yeah I mean when I when I went to my ex partners barbecues yeah in WA 15 years ago yeah or 10 years ago during the mining boom yeah that was the topic of conversation right people were saying

our discussing their possible second investment property or third investment property, etc., etc. Go to a barbecue now and the conversation will be a different one. And it doesn't sound like a very scientific way of collecting information. But this kind of anecdotal evidence short of having any hard numbers is actually not that inaccurate no i want to come back to the question of of what we do about bubbles whether we should should stave them off if we see them coming and how we do that how aggressively we offset them pre preempt them, policymakers, central banks, governments. Assuming that we can see them coming using maybe some of the tools we've discussed so

far, do you think there is a role for central banks and policymakers to preempt bubbles and stamp them out before they get too big? And if there is, what would that look like? I do think there is a role, but I'm not entirely sure what it's going to look like. I simply do not like this fatalistic view that, for example, former Federal Reserve Chairman Alan Greenspan proposed that we just mop up after the fact, right? Because he considered it too difficult to identify a bubble. He thought you could only ever identify a bubble when it's too late

in other words the identification of the bubble takes place in the downswing as opposed to on its way up because because it could go up for perhaps other reasons now that to me is um like i said i think it's fatalistic and and i think it it comes actually from ultimately a deep suspicion of the assumption about the existence of bubbles in the first place it's it's really someone who comes late late the party and says, I didn't really think there was such a thing as a bubble, but now that astrophyses have collapsed so much, so fast, so quickly, I don't really have any other explanation other than saying that it was a bubble. But on the way up, I had plenty of explanations and justifications for it. I think we need to think more closely in how government, what kind of public policies we can put in place

in order to tackle asset price bubbles. I don't think it's going to be something as simple as having a structural estimate of what, let's say, the price-rent ratio should be for houses, and as soon as it exceeds a certain threshold, then you step in and, I don't know, hit the brakes or the gas pedal. But as we've said before, or you've mentioned it before, it's difficult to identify the difference, for example, between pornography and art, and yet most people think that they know pornography when they see it,

and most people have pretty strong views about whether something should be done about pornography or not um i don't think this is really all that that different just because it's difficult to identify a bubble um doesn't mean that we should abandon any attempt at doing something about it and trying to prevent bubble or at least limit the bubble. And in particular, what we're concerned about is limiting the fallout of a collapsing bubble. What that kind of policy might look like, I don't think we have enough theory in place to readily come up with an optimal measure that we can confidently all agree on and say this is the best measure and we can discard all the other possible measures it'll probably come down to do to some trial and error to be honest what i do believe is that it's not the interest

rate the cash rate of the central bank the rba in australia case, that should do the job. That is a very, very crude instrument to try to tackle an asset price bubble in the economy. Moreover, it compromises the other policy objectives that the RBA or the central bank is pursuing. And there is a famous rule in economic policy called the Tinbergen rule, which you may have heard that says that for each independent policy objective that you're pursuing, you need a separate independent policy instrument. So using the interest rates to, which already is probably not following the Tinbergen rule because the RBA has multiple mandates. But adding another mandate to the RBA

and not giving it an additional instrument is highly problematic. Because there might be trade-offs in their goals, but they've only got one lever. Correct. So that's one lever. Correct. So that's a problem. Correct. And this comes through in the official commentary of the RBA, which is why they were... The RBA was concerned about the housing bubble, has been in the last few years,

but they basically tried to use moral suasion to get people to perhaps back off a little bit from buying houses rather than really putting the money where their mouth is and raising interest rates. There are other institutions, of course, who can do that. That's ultimately what macroprudential policy is for and why we have institutions like APRA unfortunately they were a little bit late to the party they did too little too late in my opinion but at least I think it was the right idea. And taking a bird's eye view, I think it's the general approach is the correct one, not to leave it to the Reserve Bank to pursue that goal, even though I think it's okay for them to talk about it,

but for another agency, a prudential agency, to do this and then lift margin requirements and so on. Because ultimately, the fuel, especially at it so costly when the asset price bubble collapses because you then have lots of households or firms sitting on a lot of debt and and uh and less wealth which i guess means that recessions are inevitable consequences. I dare say inevitable. Nothing is certain in economics. But traditionally housing price bubbles that collapsed have led to recessions yes and those recessions tend to be considerably more protracted and deeper than than other recessions i think kenneth rogoff and carmen reinhardt have some

very good empirical data on that uh they've got a number of papers but also their classic book this time is different looks at how the recessions off the back of housing bubbles are particularly bad that's right and usually attend the bursting of a housing bubble that's right but at the very least this question of bubbles is incredibly important albeit esoteric for us as a society to to think about you know and and to grapple with how we deal with. Absolutely. And as always, it's because people have different personal experiences and different vested interests. There are those who benefit from rising house prices and those who do not.

And that immediately affects people's incentives I think to and affects how they form their opinions and will color their view of the world as I said at the outset I'm a renter so I've been seeing a bubble for the last 15 years yeah yeah Timo it's been great talking with you we've covered a lot of grounds thanks so much for joining me it's been very my pleasure thank you for having me thanks so much for listening I hope you enjoyed that as much as I did. Before you go, I have a quick favor to ask. If you liked this episode, please rate and review the podcast on iTunes.

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