De­flat­ing a bub­ble be­fore it busts would be a stren­u­ous busi­ness

Muscat Daily - - BUSINESS - By Noah Smith

Economists may be fi­nally clos­ing in on the rea­son for as­set bub­bles. How to pop them be­fore they grow too large, how­ever, is a much harder prob­lem.

The study of bub­bles has steadily gath­ered ur­gency dur­ing the past four decades as crashes be­came more spec­tac­u­lar and more dam­ag­ing. The stock crash of 1987 was a wake-up call for those who had as­sumed that mar­kets func­tion ef­fi­ciently; there was no ob­vi­ous rea­son why ra­tio­nal in­vestors would sud­denly con­clude that US com­pa­nies were worth 23 per cent less than the day be­fore. The tech bub­ble was even more trou­bling be­cause many ob­servers had warned of a bub­ble for years be­fore the crash, to no avail. The same thing hap­pened with the housing bub­ble, only when that one burst it took the real econ­omy with it - as tends to hap­pen when rapid as­set-price de­clines are com­bined with high lev­els of debt.

Re­searchers have de­vel­oped a large and di­verse ar­ray of the­o­ries about why as­set prices sud­denly rise and crash. The dif­fi­culty in iden­ti­fy­ing the cause of bub­bles has made it hard to de­sign poli­cies to pre­vent them. But re­cently, a grow­ing num­ber of economists are ze­ro­ing in on the idea of what they call ex­trap­ola­tive ex­pec­ta­tions. For what­ever rea­son, it seems, in­vestors some­times de­cide that a re­cent run of good re­turns rep­re­sents some sort of deep struc­tural trend.

A new paper by Zhenyu Gao, Michael Sockin and Wei Xiong sup­ports this idea. Look­ing at housing prices dur­ing the bub­ble, they com­pared states based on how much they changed their cap­i­tal gains tax rates. The states that raised taxes more saw less of a bub­ble and crash.

But even more tellingly, the au­thors found that in states with lower cap­i­tal gains taxes, pur­chases of in­vest­ment prop­er­ties that the own­ers didn’t plan to live in tend to in­crease more in re­sponse to re­cent price gains. The sim­plest ex­pla­na­tion for this pat­tern is that when prices go up and there aren’t tax hikes to make peo­ple ex­pect a re­ver­sal, they start to think that the trend will con­tinue for the fore­see­able fu­ture. And they buy ac­cord­ingly.

A re­cent study by re­searchers at the Bank of Canada pro­vided dif­fer­ent ev­i­dence that pointed in the same di­rec­tion. In sur­veys, they found, most peo­ple ex­pect that house prices will rise and fall dur­ing a five-year pe­riod. But when the re­searchers show peo­ple data on re­cent prices, they start to be­lieve that cur­rent trends will con­tinue for the next five years.

Other papers found the same pat­tern. Economists Theresa Kuch­ler and Ba­sit Za­far found that in ar­eas where lo­cal housing prices in­creased more, peo­ple tend to ex­pect that prices will go up more na­tion­wide in the years to come. And re­searchers Zhi Da, Xing Huang and Lawrence Jin found that ex­trap­ola­tive ex­pec­ta­tions are in full ef­fect on crowd­sourc­ing web­sites.

Ob­vi­ously, in­vestors don’t al­ways ex­pect re­cent trends to con­tinue for­ever. So what makes them start to ex­trap­o­late? It may be that when a price trend gets big enough for peo­ple to no­tice, hu­man psy­chol­ogy tends to as­sume that this is the new nor­mal. If house prices in your neigh­bour­hood nor­mally go up and down, but then they sud­denly start go­ing up by big amounts each year for sev­eral years, you might as­sume that the game has sim­ply changed. In that case, the ob­vi­ous thing to do is to buy, buy, buy.

De­fend­ers of the idea of ef­fi­cient mar­kets might re­tort that if this hap­pens, savvier in­vestors would sim­ply bet against the trend-fol­low­ers and bring things back into line. But eco­nomic the­o­rists have long un­der­stood that be­cause ra­tio­nal in­vestors have limited fire­power to short a bub­ble, they of­ten find it more worth­while to ride the ris­ing prices for a while. That just makes the bub­ble worse.

So economists are start­ing to get a pic­ture of why bub­bles hap­pen. Some event - maybe an in­creased sup­ply of credit to home buy­ers - in­creases de­mand for houses or stocks and pushes up prices for a few years. Spec­u­la­tors see that and de­cide that prices just go up now, so they buy in, in­creas­ing prices even more. Ra­tio­nal in­vestors know there’s a bub­ble, but de­cide to buy in for a while and try to sell at the top. The crash only hap­pens when spec­u­la­tors run out of money to keep buy­ing.

If this uni­fied the­ory of bub­bles turns out to be right, the next ques­tion be­comes: How can gov­ern­ments nip the process in the bud? Gao and his col­leagues sug­gest that tax hikes could be an an­swer. If economists can fig­ure out how many years of ris­ing prices - say, three or five - is needed to cre­ate the im­pres­sion of a per­ma­nent trend in spec­u­la­tors’ minds, then pol­icy mak­ers could adopt a rule where cap­i­tal gains taxes tem­po­rar­ily go up when­ever prices rise for that many years in a row.

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