Is It Possible to Spot a Bubble?

On the one hand, it seems obvious; didn’t we all know there was a housing bubble back in 2006? On the other hand, if it’s that easy, why aren’t we all as rich as John Paulson?

A while back I suggested that the Fed could spot a housing bubble by treating housing prices the same way if treats the prices that make up the CPI. If there is high inflation in the core CPI, you don’t stop and ask if there is a fundamental reason for higher inflation; you tighten monetary policy (raise interest rates). The Fed could do the same thing for housing prices, since housing is an asset that people need to consume. But that’s probably a simplistic view.

Leigh Caldwell thinks that behavioral approaches may be able to separate out irrational overvaluation from changes in fundamental values. I believe his argument is that you can measure the degree of irrational overvaluation for certain types of assets, and you can extrapolate from there to see if there is a bubble:

Outside of the laboratory, precise knowledge of the returns of some assets does become available at times, and it would be possible to measure investors’ behaviour with regard to those assets. If investors, in aggregate, become overconfident about returns it will be possible to spot this from certain types of price change.

This makes logical sense to me, but it’s pretty vague. Caldwell’s VoxEU post goes a bit further:

I propose that regulators develop a small set of measures of irrationality that can be calculated and published at least monthly. These might include measures related to expected personal income, job security and asset values; measures of expectations about the performance of the economy as a whole; and measures of hyperbolic discount rates and other specific observable cognitive biases.

In essence, I think, the idea is that instead of trying to figure out whether a given financial asset is overvalued, we create an index of consumer expectations and cognitive biases and use that to tell us if we are in a bubble. If people are wildly optimistic, as reflected both in what they say and in how they act, then asset prices are probably also irrationally high.

There may be something here, but I worry that you still have to have something to compare your expectations index to. We already have indexes of consumer confidence – which, granted, are not quite what Caldwell is talking about – and I don’t think they have been much good as bubble-spotting devices. Maybe if you graphed consumer confidence against average economic forecasters you might see something – but most likely those forecasters are just as prone to irrational exuberance as the ordinary person. Really what we want is a reliable indicator of irrational exuberance that will be the same in every bubble; but how you would find such a thing, and how you would be sure that it would work in the next bubble, is beyond me.

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About James Kwak 133 Articles

James Kwak is a former McKinsey consultant, a co-founder of Guidewire Software, and currently a student at the Yale Law School. He is a co-founder of The Baseline Scenario.

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