Deflating a bubble before it gets too big
PROACTIVE: ECONOMISTS ARE COMING UP WITH TOOLS THAT JUST MIGHT DO THE JOB
The difficulty in identifying the cause of bubbles has made it hard to design policies to prevent them.
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.
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.
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.
Defenders of the idea of efficient markets might retort that if this happens, savvier investors – who think carefully about whether a price trend is justified by underlying fundamentals – 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.
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 policymakers could adopt a rule where capital gains taxes temporarily go up whenever prices rise for that many years in a row.
This policy has very little downside. If there’s a sound fundamental reason prices are rising then the higher capital gains taxes would skim off some of the windfall. And if it really is the start of a bubble, the sudden tax increase would damp speculators’ expectation for eternally rising prices.
If this kind of automated tax system prevents bubbles from getting out of hand, it would be a huge victory for behavioural finance. – Bloomberg
BUBBLES. The chase tends to make matters worse.