Thursday, July 17, 2008

Life is a series of bubbles

This article from The Onion (thanks to pointer from G. Mankiw) should be taken more seriously by academics:
WASHINGTON—A panel of top business leaders testified before Congress about the worsening recession Monday, demanding the government provide Americans with a new irresponsible and largely illusory economic bubble in which to invest.
"What America needs right now is not more talk and long-term strategy, but a concrete way to create more imaginary wealth in the very immediate future," said Thomas Jenkins, CFO of the Boston-area Jenkins Financial Group, a bubble-based investment firm. "We are in a crisis, and that crisis demands an unviable short-term solution."

The current economic woes, brought on by the collapse of the so-called "housing bubble," are considered the worst to hit investors since the equally untenable dot-com bubble burst in 2001. According to investment experts, now that the option of making millions of dollars in a short time with imaginary profits from bad real-estate deals has disappeared, the need for another spontaneous make-believe source of wealth has never been more urgent.
How about a model where the economy is always on the cusp of some bubble and in some cases bubbles form and in others it doesn't? Or perhaps bubbles seem to be more frequent now because the Fed has been using interest rates (or lowering interest rates too often) to stimulate output? (This is Jeff Frankel's view as far as commodity prices are concerned.) So, isn't the recent rise in commodities prices a bubble that we can all invest in?

Here is George Soros' view on bubbles:
"As I explain in my new book The New Paradigm for Financial Markets, the regulators and the market participants were acting on a false interpretation of how financial markets operate. They worked on the assumption that markets tend towards equilibrium and deviations are random. That false perception about financial markets led to the construction of the structured products, and it made this crisis much bigger than it would have been if it was merely a US housing bubble. Some people didn’t understand this. Ben Bernanke [the Fed chairman], for instance, said that it was a specific problem of the sub-prime loans, which is wrong. Others, like Paul Volcker [a former Fed chairman], did understand it. Asset bubbles are endemic. There are self-reinforcing processes that operate where investors’ initial misconceptions then reinforce a trend, and that leads to a bubble."
And here are some more of my more contrarian views:
1. Free trade is NOT a natural or stable equilibrium so the Edgeworth Box where gains from trade arise naturally is not the correct way of thinking.
2. Competitive markets are NOT a natural equilibrium. Successful firms tend to become big and gain some kind of monopolistic power so promoting "market economies" by privatization or sale of GSE's in general is not sufficient to claim that a sector has become more efficient. It's the process of competition with new entrants that results in efficiencies. Likewise, a hands off approach will lead to agglomeration. Subsidies should be used to target and encourage new entrants.

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