Danny ChaiMy theory on the cause of financial bubbles. Boring.
As you know, the Bay Area is currently suffering from significantly overpriced housing, a housing bubble. I’m not even going to argue this point. Just read the series the Merc ran all last week, or the Economist, or what Greenspan’s been saying the past couple months, or what even the head of Freddie Mac has been saying about the coming downturn. But whatever.
What I find strange is how this bubble has come right on the heels of the stock market bubble of the late 90s. You’d think people would learn their lesson – when prices completely disconnect from fundamentals, chaos eventually ensues. You remember what they said during the stock bubble. It’s a new economy. No one even cared about profitability, which makes zero sense whatsoever. The market was in a new era of constant high returns.
Same thing’s happening with housing in the Bay Area. Complete disconnect from fundamentals. SN. Some people say fundamentals actually explain the rise in prices. Population growth and low interest rates. Unfortunately, that’s completely wrong in the Bay Area. In the past 5 years, the population has actually declined, as have the number of jobs. Salaries, constant. And housing prices have doubled? Makes no sense. Can’t be attributable to interest rates, either, since the majority of buyers are using interest only loans, or option ARMs, or other weirdo stuff. You would not need those exotic loans if low interest rates were acting as an enabler. But yeah, it’s the same mentality. Ignoring fundamentals. Believing we’re in an era of a permanently new high prices.
Anyway, I have a theory as to what causes these bubbles: information. Information is generally a good thing. Freakonomics mentioned something that happened in the life insurance industry a few years ago, where rates dropped virtually overnight. The cause was the Internet. Now people could search and compare different offerings, and it forced everyone to lower their rates in order to compete. When lots of people have access to information that used to be in the hands of just a few, the consumer generally wins.
But I do think there’s a downside to the immediate availability of information: a speculative, herd mentality that leads to bubbles. I’m sure I’ve mentioned this before, but there was this fascinating study done where they had people play this game that mimicked a market like the stock market. That is, they could trade shares of pretend commodities, and at the end of a time period, they received a reward based on the values of those commodities and how many shares of them they owned.
The fascinating thing about this experiment was, the information was perfect. Meaning, everyone knew exactly how much the commodities would be worth at the end, something like that, so there should be zero fluctuation in the share prices. Despite this, bubbles still developed. Shares started trading above their known value, and as they continued to go up, people continued to bid up the price to get in on the momentum. When asked afterwards why they did this, when they knew with certainty that the shares were overpriced, people who got burned all said the same thing, that they thought they could get out before it started to go bad.
This totally fascinated me. A system where everyone has perfect information, and bubbles still formed. Anyway, I think that’s what’s been happening now. Starting a few years ago, people were able to track and trade stocks essentially in real time. Everyone knew at any moment what was happening in the market. The more information they had, the more momentum the saw, the more they wanted to get in. With housing, it’s a relatively recent phenomenon of e.g. newspapers posting specific sale prices and median values in different areas. Before, people only had a vague idea how much their house was worth. Now, with the immediate availability of information, they know exactly how much their neighbor’s house went for. The more people see how much prices are going up, the more they want to get in before it’s “too late”.
Anyway, that’s my theory. People have unprecedented access to information, and aren’t necessarily rational or knowledgeable about what they do about it. So whenever there’s upward momentum in anything, people immediately know about it, and a herd mentality kicks in, where they want to get in on it while they still can, fundamentals be darned. So in my opinion, we’re entering an age where we’re going to see repeated bubbles all over the place. And that’s my theory.