Wednesday, 3 July 2013

Lessons Worth Remembering: Who Predicted the Bubble? Who Predicted the Crash?

Mark Thornton some 10 years back wrote an article titled "Who Predicted the Bubble? Who Predicted the Crash?" where he discusses who predicted the 2000/2001 bubble and crash.

On pages 22 to 24 he writes the following which is worth noting given the current lofty price of the S&P 500 (even though it has fallen a bit during the last month) and the Fed's expansion of the monetary base and keeping interest rates low:
In general there were two categories of correct predictions. The first group was based on analysis of valuation. Using standard measures of stock market value such as the price-to-earnings ratio (P/E), economists such as Robert Shiller and a number of market analysts who were bearish in 1999 felt that the stock market was extremely overvalued and that therefore the stock market was experiencing bubble-like conditions and fated to steep decline.
Unfortunately, most of these forecasters did not provide detailed economic analysis of their predictions. The use of valuation measures is indeed a useful guide, but is essentially a tool of historical analysis—comparing ratios and percentages from one time period to another or against historical averages. The majority bulls always found some way to adjust the valuation measures to account for modern conditions and to make the stock market look undervalued.
The second group of correct predictions came from outside the mainstream of the economics profession. Most of these predictions came from the Austrian school of economics, including academic economists, financial economists, and fellow travelers of the school. These predictions begin in 1996 and continue until after the downturn in the stock market began, but most of the prediction occurred close to the peak in the stock markets. Given that the Austrian school is both small in number and marginalized in the profession, their dominance in making correct predictions seems like an elephant in the soup bowl. It is a particularly interesting finding given the Austrians’ general disdain for forecasting and the mainstream’s requirement for prediction.
It is especially noteworthy that the Austrian predictions all provided an economic explanation of the bubble and that their explanations were relatively consistent across the group. To generalize, they saw the Federal Reserve as following a loose money policy that kept interest rates below the rates that would have existed in the absence of inflationary monetary policy. Individual writers emphasized the willingness of the Federal Reserve to consistently bail out and rescue investors during the 1990s, thereby desensitizing investors to risk. As a result, a period of “exuberance” and wild speculation took place building into the hysteria of a stock market bubble. If the Austrian analysis is correct, this would suggest that the Federal Reserve is a significant source of financial and economic instability. It also suggests that the general bias to keep rates as low as possible can cause significant losses in the economy and that a better policy might be to let interest rates be determined by market forces, without the intervention of the Federal Reserve.
Those who discovered the “boom” in the economy, the “bubble” in the stock market, and predicted either a “bust” in the economy, or a crash in the stock market work within a tradition of analysis dating back to Richard Cantillon, whose book An Essay on the Nature of Commerce in General was published in 1755. The Cantillon tradition was carried forward and extended in the works of Turgot, Say, Bastiat, Menger, Wicksell, Bohm-Bawerk, von Mises, Ropke, and Hayek, and is now home in the modern Austrian school of economics, with which many of the successful predictors identify themselves.
The hallmark of this mode of analysis is an emphasis on entrepreneurship and the causes for prices to rise and fall, encompassing wages, rents, profits, interest, and the purchasing power of money. With respect to the business cycle, the Cantillon tradition shows that disturbances in the supply of money and credit, especially when a monetary authority expands the supply of paper money, changes relative prices in the economy. Artificial reductions in interest rates encourage investment and increase the valuation of capital assets. The resulting alternations in the structure of production (buildings, technology, and the pattern of industrial organization) are called Cantillon effects. This is the boom—a phase when resources are misallocated, both to malinvestments and misdirected labor. As relative prices correct themselves in the bust, resources are reallocated via such mechanisms such as bankruptcy and unemployment.
You can read the paper here

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