Asset Bubbles and Transparency
I would like to clear up a common mistake: transparency does not prevent asset bubbles from occurring. What transparency does do is it makes cleaning up the financial system after these bubbles occur easier.
How?
All investors understand transparency involves a trade-off. In exchange for disclosure so the investors can know what they own, investors are held responsible for all losses on their investments. Investors understand they will not be bailed out and therefore should limit their exposure to what they can afford to lose.
It is the adjustment of the investors’ investment exposure as the risk of the underlying investment changes that we call market discipline. As the risk of an investment goes up, investors reduce their exposure. This selling tends to reduce the price of the investment. This sends a message to the sponsors/operators of the investment to reduce its risk.
With investors, and this includes banks, limiting their exposures to what they can afford to lose, it is easy to clean up the financial system after bubbles occur. The investors recognize their losses and transparency allows everyone in the market to confirm this has occurred.
As I said earlier, transparency does not prevent asset bubbles. This was shown by Vernon Smith in a behavioral economics experiment.
He set up a lab experiment in which participants traded a perishable commodity of use. He found—as expected—that the lab trading quickly converged on the “efficient” market price.
Almost three decades passed when in the 1980s he decided to conduct a similar experiment in which the object traded would be a financial asset (Gjerstad and Smith 2014). He expected a similar efficient market outcome. The financial asset was as transparent as you could get: a series of cash payments that amounted to a fully advertised determinant sum by the end of the trading period. Smith expected that the lab participants would trade this asset quickly at its known fundamental value.
But they did not. To his great surprise, in every experiment, after brief oscillations around fundamental value, the participants bid the asset price above that value higher and higher. Of course, since the determinant cash value of the asset would be received by the end of the trading session, at some point the traded price crashed to its fundamental value.
Vernon Smith was surprised. Everyone was surprised. The experiment has been repeated well over 400 times. It has been repeated with students, with butchers, bakers, and candlestick makers, with captains of industry and captains of finance. They all bid the price well above known fundamental value. This excess in the price above fundamental value known with certainty Smith terms a “bubble.”
Smith concludes that this can only happen if people instinctively have adaptive short-term expectations, which he calls “myopic rational expectations” (Gjerstad and Smith 2014). To this he adds a natural propensity to “herd.” Once prices start to rise above a known fundamental value, market participants chase the rising trend on the assumption that the other guy will do so for long enough to sell to him at a profit. Such a revelation about real-world behavior proves the general equilibrium postulate of rationality is an academic economist’s plaything and nothing more.
There is one last important discovery from Vernon Smith. After the bubble in the first lab experiment crashed, Smith replayed the trading game with the same participants a second time. Once again a bubble emerged, but with only part of the amplitude and duration of the original one. When the trading experiment was run a third time there was no bubble behavior whatsoever. Smith concludes after repeated crashes there is “learning” that bubbles burst (Gjerstad and Smith 2014), and the propensity to play the bubble game is extinguished. It is fascinating that Edward Chancellor (2009) has looked at 12 of history’s real-world bubbles and has found that the same pattern of bubble/echo bubble/no bubble has emerged in every case.
About Post Author
