Thursday, July 30, 2009

Predicting Asset Bubbles: The Queen And The Answer; The Fed And Bubble Popping

Three pages to answer a simple question

Recently, economists at the British Academy sent a 3-page letter to the Queen of England in response to a question she asked about the financial crisis during her visit to the London School of Economics. Last November, the Queen of England discussed the financial crisis with Luis Garicano, a professor at the school and she asked him why did nobody notice the makings of the credit and financial crisis earlier? In summary, the economists' letter response said:
So in summary, Your Majesty, the failure to foresee the timing, extent and severity of the crisis and to head it off, while it had many causes, was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole.
Read the entire letter here. Also, see Washington Examiner article here.

Can the Fed see and burst bubbles

William C. Dudley, the president of the New York Federal Reserve, thinks the Fed should be responsible for identifying and preventing asset-price bubbles. Dudley believes asset bubbles, especially large bubbles, may be easy to identify and control. See July 29, 2009, Wall Street Journal Opinion piece by Donald Luskin, "Can the Fed Identify Bubbles Before They Happen?"

Will the Brits and Americans prevent the next bubble and crisis?

With hindsight,one can always find a few economists and others who, prior to the crisis, claim there is a bubble and a coming financial crisis. Usually, the predictors cannot say when the crisis will happen or accurately predict its severity. If they do predict a date, or severity, they are usually substantially off the mark.

Likewise, it is easy to see the indicators of the coming crisis after the fact when all the noisiness of the information prior to the crisis has dissipated. Additionally, many have predicted crises that have never occurred.

When smart, trained and well-intentioned people cannot, in a timely manner, see and prevent a coming crisis, then it must be extremely difficult, if not impossible, to see a coming financial crisis.

While attempts will be made to do better forecasting of asset bubbles and a coming credit and financial crisis, the attempts will not succeed with the current knowledge and tools available. Our failures in the past are not for want of trying or for lack of available tools.

Randomness obscures the future

Asset prices and the economy randomly move around their trend lines. They exhibit randomness. Randomness is predictable in the long term, but not in the short term. It is like tossing a coin and trying to determine if the coin is unfair and biased.

The law of large numbers says that on average for a very large number of flips of a fair coin, heads will come up half the time. Randomness says that a fair coin can have a very long run of heads or tails. One can theoretically flip a coin 12 times and get heads each time. There is no "head flip" bubble that is occurring and the coin does not need fixing, because the law of large numbers says that as one keeps flipping the coin the average number of heads will be 50 percent.

The same is true for the economy and asset prices. Asset prices can exhibit several years of exceptional growth. Eventually, the law of large numbers says that there will be declines in the rate of growth, even possible negative price growth, but the average expected rate of growth will be true for a very large number of years. It just does not say when a run of exceptionally good growth will end, nor does it say how long before the average will revert to its mean level.

Behavior under randomness

Unfortunately, as psychologists know, people who are in random situations tend to develop superstitions and other behavior as attempts to control outcomes over which, due to their randomness, they have no control over. The same is true of asset prices and economic growth.

We will spend a lot trying to prevent the next financial and asset price bubble crisis, but to no avail. The next crisis and bubble will occur anyway. It will be due to a random streak of good or bad luck. It is just a matter of time and it will occur despite our best efforts. Unfortunately, we will not know until we are in the next crisis, when it will happen.

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