[OPE] Bernanke's Bubble Laboratory

From: Gerald Levy (Gerald_A_Levy@msn.com)
Date: Sun May 18 2008 - 13:15:45 EDT

Bernanke's Bubble Laboratory
Princeton Protégés of Fed Chief 
Study the Economics of Manias
May 16, 2008; Page A1

PRINCETON, N.J. -- First came the tech-stock bubble. Then there were 
bubbles in housing and credit. Chinese stocks took off like a rocket. 
Now, as prices soar on every material from oil to corn, some suggest 
there's a bubble in commodities.

But how and why do bubbles form? Economists traditionally haven't 
offered much insight. From World War II till the mid-1990s, there 
weren't many U.S. investing manias for them to look at. The study of 
bubbles was left to economic historians sifting through musty records 
of 17th-century Dutch tulip-bulb prices and the like.

The dot-com boom began to change that. "You were seeing live, in 
action, the unfolding of lots of examples of valuations disconnecting 
from fundamentals," says Princeton economist Harrison Hong. Now, the 
study of financial bubbles is hot.

Its hub is Princeton, 40 miles south of Wall Street, home to a band 
of young scholars hired by former professor Ben Bernanke, now the 
nation's chief bubble watcher as Federal Reserve chairman. The group 
includes Mr. Hong, a Vietnam native raised in Silicon Valley; a 
Chinese wunderkind who started as a physicist; and a German who'd 
been groomed to take over the family carpentry business. Among their 

Bubbles emerge at times when investors profoundly disagree about the 
significance of a big economic development, such as the birth of the 
Internet. Because it's so much harder to bet on prices going down 
than up, the bullish investors dominate.

Once they get going, financial bubbles are marked by huge increases 
in trading, making them easier to identify.

Manias can persist even though many smart people suspect a bubble, 
because no one of them has the firepower to successfully attack it. 
Only when skeptical investors act simultaneously -- a moment 
impossible to predict -- does the bubble pop.


. Lots to Study: Research on financial bubbles is hot in academia 
these days.
. Jersey Boys: The hub is Princeton, where three young economists use 
mathematical methods to study them.
. One Finding: Investment manias can persist even though many 
investors see that a bubble is forming.As a result of all that and 
more, the Princeton squad argues that the Fed can and should try to 
restrain bubbles, rather than following former Chairman Alan 
Greenspan's approach: watchful waiting while prices rise and then 
cleaning up the mess after a bubble bursts.

If the tech-stock collapse didn't make that clear, the damage done by 
the housing and credit bubbles should, argues José Scheinkman, 60 
years old, a theorist Mr. Bernanke recruited in 1999 from the 
University of Chicago. "Advanced economies are very dependent on the 
health of the financial system. What this bubble did was destroy the 
capacity of the financial system to finance the U.S. economy," Mr. 
Scheinkman says.

The Fed is giving the activist approach some thought. In a speech 
scheduled for delivery Thursday night, Fed Governor Frederic Mishkin 
suggested that while it was inappropriate to use the blunt instrument 
of interest-rate increases to prick bubbles, if too-easy credit 
appeared to be fueling a mania, policy makers might craft a 
regulatory response that could "help reduce the magnitude of the 


Yet the very concept of bubbles is at odds with the view of some that 
market prices reflect the collective knowledge of multitudes. There 
are economists who dispute the existence of bubbles -- arguing, for 
instance, that what happened to prices in the dot-com boom was a 
rational response to the possibility that nascent Internet firms 
might turn into Microsofts. But these economists' numbers are 

When Mr. Bernanke became head of Princeton's economics department in 
1996, he saw finance as a fertile field for economic research. 
Princeton was weak in it. Mr. Bernanke raised $10 million from the 
Leon Lowenstein Foundation to create the Bendheim Center for Finance, 
named for the foundation's president, Robert Bendheim, an alumnus.

Mr. Bernanke hired finance experts who had broad interests and were 
eager to work with the university's deepening bench of theorists. He 
lured Dilip Abreu, known for work in game theory, back from Yale, to 
which he had earlier defected. Making a virtue of an institutional 
weakness, the absence of a business school, Princeton assimilated the 
finance scholars into the economics department and freed them to 
pursue research.

They are building on work done by the late Hyman Minsky, whose once-
ignored ideas about investing manias are now in vogue, and the late 
economic historian Charles Kindleberger, whose 1978 "Manias, Panics 
and Crashes" is a classic. But compared with Mr. Minsky or another 
student of bubbles, Yale's Robert Shiller, the Princeton trio focuses 
less on mass psychology than on mathematical models. These they use 
to show how bubbles can be created even in markets that include 
rational, calculating investors.

Hard to Short

Bubbles don't spring from nowhere. They're usually tied to a 
development with far-reaching effects: electricity and autos in the 
1920s, the Internet in the 1990s, the growth of China and India. At 
the outset, a surge in the values of related businesses and goods is 
often justified. But then it detaches from reality.

Mr. Hong, growing up in Sunnyvale, Calif., and teaching at Stanford, 
had a front-row seat to the technology boom. Recognizing a mania, he 
resisted investing in tech stocks himself -- until they were about to 

He recalls his thought process: "My sister's getting rich. My friends 
are getting rich....I think this is all crazy, but I feel so horrible 
about missing out, about being left out of the party." In 2000, "I 
finally caved in," he says. "I put in some money just as a hedge 
against other people getting richer than me and feeling better than 
me." But 2000, of course, was the year the bubble burst.

Mr. Hong, who came to Princeton two years later, and now is 37, 
argues that big innovations lead to big differences of opinion 
between bullish and bearish investors. But the deck is stacked in 
favor of the optimists.

One who believes a stock is too high can short it, borrowing shares 
and selling them in hopes of replacing them when they're cheaper. But 
this can be costly, both in the fees and in the risk of huge losses 
if the stock keeps rising. Many big investors rarely short stocks. 
When differences between bullish investors and bearish ones are 
extreme, many of the bears simply move to the sidelines. Then, with 
only optimists playing, prices go higher and higher.

In housing and the credit markets, the innovation was slicing and 
dicing loans in novel ways. As investors bought the resulting 
mortgage securities, they provided abundant capital for home buyers; 
buoyed by this and falling interest rates, house prices surged.

Betting against house prices is hard; only a few sophisticated 
investors found roundabout ways to do it, in derivatives markets. 
Most skeptics about the housing boom just sat it out; the optimists 
were unchecked.

At some point in a bubble, optimists' enthusiasm runs its course. 
Prices turn down. There's an expectation that at this point, 
investors who were skeptical may see prices as more reasonable and 
start buying. If they don't, that's a signal that prices had gotten 
way too high -- and then they tumble.


The insights of bearish investors "are more likely to be flushed out 
through the trading process when the market is falling, as opposed to 
when it's rising," Mr. Hong and Harvard's Jeremy Stein write. They 
say this explains why prices fall more rapidly than they go up. Over 
60 years, nine of the 10 biggest one-day percentage moves in the S&P 
500 were down.

When a lot of borrowed money is involved -- as it often is in a 
bubble -- once prices peak, the speed of their fall is intensified as 
investors sell urgently to pay down debt. That pattern offers a 
strong argument, in Mr. Hong's view, for government to restrain 
bubbles and the borrowing that fuels them.

The Trading Signal

At the height of the tech bubble, Internet stocks changed hands three 
times as frequently as other shares. "The two most important 
characteristics of a bubble," says Wei Xiong, are: "People pay a 
crazy price and people trade like crazy."

After finishing undergraduate studies in China at age 18, Mr. Xiong 
came to the U.S. intent on becoming a particle physicist. He earned a 
master's from Columbia but decided physics was too mature for him to 
make a mark. He switched to economics and earned a Ph.D. from Duke 
University. He was just 24 when Mr. Bernanke hired him in 2000.

According to a model he developed with Mr. Scheinkman, investors 
dogmatically believe they are right and those who differ are wrong. 
And as one set of investors becomes less optimistic, another takes 
its place. Investors figure they can always sell at a higher price. 
That view leads to even more trading, and, at the extreme, stock 
prices can go beyond any individual investor's fundamental valuation.

China's stock market gave Mr. Xiong, Mr. Scheinkman and New York 
University's Jianping Mei a laboratorylike setting to study. Chinese 
companies issued two classes of shares, representing identical 
stakes. Only Chinese could buy Class A shares, and, until 2001, only 
foreign investors could buy Class B shares.

When other countries have used such setups, the foreign-owned shares 
have traded at higher prices. But in China between 1993 to 2000, the 
economists found, Class A shares averaged more than five times the 
price of Class B shares and were traded five times as frequently -- a 
hint they were infected with bubble virus.

Companies with fewer A shares outstanding tended to see both higher 
trading volume and higher prices. That was consistent with a theory 
Mr. Xiong developed with Messrs. Scheinkman and Hong: In markets with 
lots of disagreement about values, the optimists are better able to 
dominate when there are fewer shares available.

Today, there's disagreement over commodity prices: to what extent do 
they reflect fundamentals like Chinese demand, and to what extent 
investment mania? Trading points toward a bubble: Daily volume on 
crude-oil contracts is running 50% above last year. Yet the initial 
findings of work Mr. Hong has done with Motohiro Yogo of the Wharton 
School -- comparing cash prices and futures prices -- suggest 
that "prices for commodities are expensive," but not a bubble, Mr. 
Hong says.

Mr. Xiong's father-in-law and brother trade stocks in China. At the 
start of 2007, he cautioned his brother to get out, to no avail. But 
Chinese stocks are higher today, despite falling since November. "If 
he actually followed my advice I'm not sure what he would think of 
me," Mr. Xiong says.

Why Bubbles Persist

Bubbles often keep inflating despite cautions such as Mr. Greenspan's 
famous warning of "irrational exuberance." Tech stocks rose for more 
than three years after he said that, in late 1996. Markus 
Brunnermeier, 39, thinks he understands why this happens.

Growing up near Munich, Germany, he expected to become a carpenter 
like his father. A building slump dissuaded him, and after stints in 
a tax office and the army he enrolled at the University of Regensburg.

He had struggled to understand why West Germany, where he lived, was 
so much more prosperous than East Germany. At Regensburg, he came 
across the work of Friedrich Hayek, the Nobel prize-winning Austrian 
economist known for a spirited defense of free-market capitalism. Mr. 
Hayek noted that while East Germany's government set prices, in the 
west the market set them -- and provided information about supply and 
demand that helped the economy adjust.

Inspired by Mr. Hayek's work, Mr. Brunnermeier studied economics. But 
in the 1990s, soaring tech stocks made him skeptical of the quality 
of information that prices convey. As a graduate student at the 
London School of Economics, he wrote a survey of research on bubbles 
and crashes that turned into a book.

Under the Hayek view, bubbles don't make sense. As soon as some group 
of traders irrationally pushes prices way up, more-rational traders 
should take advantage of the mispricing by selling -- bringing prices 
back down. But the tech boom reinforced an oft-quoted warning from 
John Maynard Keynes: "The market can stay irrational longer than you 
can stay solvent."

So investors who spot the bubble attack only if each is confident 
that other skeptics are on board. In work done with Mr. Abreu, Mr. 
Brunnermeier concluded that if all the rational investors could agree 
to bet against the bubble, they could make big profits. But if they 
can't coordinate, it's risky for any one of them to bet against a 
bubble. So it makes sense to ride it up and then get out quickly as 
soon as the bubble's existence becomes common knowledge.

That's what Pequot Capital Management did. The hedge-fund company 
boarded the Internet bandwagon early, investing in America Online in 
1994. It was heavily invested in tech stocks through the late 1990s. 
When they started falling in March 2000, Pequot got hurt. But it was 
agile enough to take bearish positions on the stocks, and its funds 
posted strong performances for the year.

Looking through security filings, Mr. Brunnermeier and Stanford's 
Stefan Nagel found that hedge funds on the whole "skillfully 
anticipated price peaks" in individual tech stocks, cutting back 
before prices collapsed and shifting into other tech stocks that were 
still rising. Hedge funds' overall exposure to tech stocks peaked in 
September 1999, six months before the stocks peaked. They rode the 
bubble higher and got out close to the right time.

Mr. Brunnermeier saw the bubble, too. He thought people were crazy 
for buying tech stocks. But as both the hedge funds' gains and his 
theoretical work suggest, even if you know there's a bubble, it might 
be smart to go along.

"I was always convinced that there was an Internet bubble going on 
and never invested in Internet stocks," he says. "My brother-in-law 
did. My wife always complained that I studied finance and her brother 
was making a lot of money on Internet stocks."

Write to Justin Lahart at justin.lahart@...

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