Friday, January 17, 2014

Why stopping the next financial crash is an impossible dream

Trying to pop a perceived bubble in 1929 actually sparked the Great Depression. 

Robert Shiller, who shared 2013’s Nobel Prize for Economics, is worried about the financial system, and wants to see measures taken to prevent future crashes:
Just as most people are more interested in stories about fires than they are in the chemistry of fire retardants, they are more interested in stories about financial crashes than they are in the measures needed to prevent them. That is not a recipe for a happy ending. [Project Syndicate]
But are financial crashes really preventable? I don’t think so. The world is just too unpredictable.
First off, changes to the price of assets are very hard to foresee — their value is not just based on what people think they are worth today, but what people believe other people will think they are worth in the future. It's as messy as it sounds.

Second, there are all kinds of uncontrollable and unpredictable events — like wars, terrorism, droughts, hurricanes, pandemics, technological and scientific discoveries — that can completely change investors' perceptions and precipitate a financial crash or a financial boom. Preventing every financial crash or burst asset bubble would mean preventing all of these kinds of shocks.

Beyond that, investors don’t all interpret events in the same way. If inflation rises, many investors today would interpret that as an exciting sign that the economy is recovering. Other investors might interpret it as a dangerous sign that central banks’ unconventional monetary policies are starting to harm the economy.

But, surely, some crashes are preventable? After all, lots of economists and financial pundits — including Robert Shiller — successfully predicted the housing bubble last decade. If Congress and the Federal Reserve had been listening to Shiller and others who warned of a housing bubble, could they have prevented the financial crisis by deflating the housing bubble?

Well, there is no certain way to determine whether prices are really in a bubble or not until the bubble bursts. Sometimes a price rise — like the rising value of land in cities like New York, Chicago or London, or shares in Apple, Microsoft and Google — will hold for a very long time. Sometimes a price rise — like dutch tulip bulbs, shares in Enron, or Beanie Babies — will collapse quickly and disastrously. And many of the pundits who correctly identified the housing bubble whiffed the aftermath. Pundits
like Peter Schiff and Marc Faber got the call right on the housing bubble, but have since warned about bubbles in the stock market, in treasury bonds, and in the dollar itself. Identifying bubbles is hard, if not impossible to do consistently.

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