What Is Scott Sumner Thinking Here?

"A modern example of this conundrum [of thinking that one can outguess financial markets] occurred when many pundits blamed the Fed for missing a housing bubble that was also missed by the financial markets." -- The Midas Paradox, p. 12

Let's consider a single market, say, for tulips. Obviously it is either a nonsense claim, or a tautological claim that there are no bubbles, to say that if there is a bubble in the tulip market, the tulip market ought to have spotted it. For the tulip market participants themselves to detect a bubble would be for the tulip market participants to prevent said bubble!

We can divide bubble theories into three broad categories: collective irrationality theories, partial information theories, and prisoner's dilemma theories. In collective irrationality theories, a "mania" gets going in some market, and market participants buy because they are carried away by their "animal spirits." Per these theories, someone outside the market might be able to spot the bubbliciousness precisely because they are not swayed by the emotions influencing market participants.

In partial information theories, a bubble can occur when a random price movement is mistakenly taken by market participants who lack perfect knowledge as a sign  that someone else knows more than they do, and so they follow this random jiggle, leading others to follow it as well. Theoretically at least, if we have a bubble of this sort, an agency like the Fed might have better information at its disposal than market participants, and so be able to spot the bubble.

Finally, in the prisoner's dilemma theories, market participants may be well aware that a bubble is inflating, but their best strategy is to try to profit from the bubble as long as it is bubbling. Since these theories typically posit that a "big player" (e.g., the Fed) is actually causing the bubble, the Fed is also clearly capable of ceasing to cause it at any point in time.

Perhaps what Sumner is thinking is that, although the housing market may have been bubbling, the market for, say, mortgage-backed securities ought to have been acting on this fact, if it was detectable at all. But it is hard to see how such action in the MBS market wouldn't have prevented the housing bubble itself, since cutting off the flow of mortgage funding would seem likely to have done so.

So, perhaps Sumner just meant, "Bubbles can't exist, because markets won't allow them." But if so, he phrased this oddly.

PS: The three types of bubble theories I describe are not mutually exclusive: all three factors could be at play in a particular bubble!


  1. What do you mean by "bubble"? If one simply means asset market prices can be unstable, no one claims that they cannot be. If one means that prices rose and fell dramatically, then the question arises whether this was reliably knowable in advance. If a price turning point was reliably knowable in advance, then people would not buy at a price where it was understood said assets would shortly be worth significantly less. Which means (1) bubbles occur due to unknown turning point points and (2) they can only be reliably discerned after the fact. This makes them a fairly useless concept.

    What makes asset prices unstable? is an interesting question. Almost anything about "bubbles", not so much.

    1. Lorenzo, I gave no less than THREE theories of how bubbles might occur, and how each would relate to potential bubble spotters, and you just ignored all three, and gave an tautological definition that bubbles can't exist... which tautological definition I already noted in my post!

    2. At no stage did I claim that they didn't exist, I said they are only "obvious" in retrospect, which is not very helpful.


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