Bubbles Are A Feature

Virginia Postrel takes a look at economic experiments that show that economic bubbles are inevitable.

For more than two decades, economists have been running versions of the same experiment. They take a bunch of volunteers, usually undergraduates but sometimes businesspeople or graduate students; divide them into experimental groups of roughly a dozen; give each person money and shares to trade with; and pay dividends of 24 cents at the end of each of 15 rounds, each lasting a few minutes. (Sometimes the 24 cents is a flat amount; more often there’s an equal chance of getting 0, 8, 28, or 60 cents, which averages out to 24 cents.) All participants are given the same information, but they can’t talk to one another and they interact only through their trading screens. Then the researchers watch what happens, repeating the same experiment with different small groups to get a larger picture.

The great thing about a laboratory experiment is that you can control the environment. Wall Street securities carry uncertainties—more, lately, than many people expected—but this experimental security is a sure thing. “The fundamental value is unambiguously defined,” says the economist Charles Noussair, a professor at Tilburg University, in the Netherlands, who has run many of these experiments. “It’s the expected value of the future dividend stream at any given time”: 15 times 24 cents, or $3.60 at the end of the first round; 14 times 24 cents, or $3.36 at the end of the second; $3.12 at the end of the third; and so on down to zero. Participants don’t even have to do the math. They can see the total expected dividends on their computer screens.

Here, finally, is a security with security—no doubt about its true value, no hidden risks, no crazy ups and downs, no bubbles and panics. The trading price should stick close to the expected value.

At least that’s what economists would have thought before Vernon Smith, who won a 2002 Nobel Prize for developing experimental economics, first ran the test in the mid-1980s. But that’s not what happens. Again and again, in experiment after experiment, the trading price runs up way above fundamental value. Then, as the 15th round nears, it crashes. The problem doesn’t seem to be that participants are bored and fooling around. The difference between a good trading performance and a bad one is about $80 for a three-hour session, enough to motivate cash-strapped students to do their best. Besides, Noussair emphasizes, “you don’t just get random noise. You get bubbles and crashes.” Ninety percent of the time.

Long before the housing market crashed nearly every one knew that housing prices were unsustainable. And yet despite that knowledge prices kept rising and investments in the housing stock kept rising. And not just in America where Fannie and Freddie were pouring gasoline on the fire. It was happening in Europe (worse than America) and China too. And while the housing bubble was in full swing we had an oil bubble at the same time fueled by peak oil scares - you know - buy now because we are running out and what is left can only get more valuable. I guess the Peak Oil folks peaked a little too soon.

My prediction for the next bubble? Alternative energy which is for sure going to be he Next Big Thing. Money has been pouring in to that sector and I'd say now was the time to get in. Then sell when your money has doubled. It may go higher but why get caught holding the bag when the crash comes?

H/T Instapundit

Cross Posted at Classical Values