De­flat­ing a bub­ble be­fore it gets too big


The Citizen (KZN) - - Business -

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

Pic­ture: Shuttersto­ck

BUB­BLES. The chase tends to make mat­ters worse.

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