The Price of Everything - Eduardo Porter [110]
Some eighty years ago the great British economist John Maynard Keynes provided a subtle explanation of how investors can take prices badly astray. In his book The General Theory of Employment, Interest and Money, Keynes compared picking stocks to a reverse beauty contest in which investors didn’t have to choose the most beautiful face but the face that was most popular among other investors. “It is not a case of choosing those [faces] which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest,” Keynes wrote. “We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.” It wouldn’t be smart, Keynes observed, to simply buy shares of the company the investor believed to be a good investment. Regardless of the company’s merits, its stock wouldn’t rise if other investors didn’t share his belief.
In the late 1990s, every investor was a sheep looking for the herd—paying top dollar for dubious Internet stocks in the belief that the next investor along would pay a higher price, regardless of the underlying companies’ profitability. It made little sense for an investor to bet against the flock. When there were enough fools who believed eToys would become the largest toy store in the United States and should be worth eighty dollars per share, it made perfect sense for the most hardheaded dot-com skeptic to buy the shares for fifty dollars even though he or she believed the company was around the corner from bankruptcy.
So it was during the housing bubble. I doubt that at any point in the cycle of euphoria there was a banker who didn’t suspect home prices would eventually stop rising. Still, the dynamics driving investment into the sector depended on prices going up forever. To be able to keep paying the mortgage bill, the financially shaky subprime homeowners needed house prices to keep rising. That way they could either sell and plow the profit into a new property, or refinance at a higher price and pull “equity” from their home to make ends meet. Yet even those who knew that the music would eventually stop couldn’t drop out of this game of financial musical chairs.
In the summer of 2007, as mortgage default rates were rising and the “subprime” mortgage market was starting to falter, the chief executive of Citigroup, Charles Prince, argued that “as long as the music is playing, you got to get up and dance. We’re still dancing.” Months later, Prince was ejected from his post. But he wasn’t wrong. He was referring to a long-acknowledged feature of finance: even if an investor were to correctly call a bubble, it could be expensive to bet against it. If other investors were still carried away by their enthusiasm, the bubble could stay inflated longer than the contrarian investor could remain solvent.
SHOULD WE POP THEM?
Bubbles leave no end of hardship in their wake: banking crises, recessions, and unemployment spikes, as well as more subtle consequences. One study found that the geographic mobility of people whose houses are underwater—worth less than the value of their mortgages—is about half that of homeowners in better financial condition. University students who graduate during a recession earn less throughout much of their careers. A study of Canadian graduates in the 1980s and 1990s found that those entering the labor market during a recession suffered lower earnings for up to ten years.
Some social scientists have predicted the current crisis could favor extreme right-wing politics in Europe and the United States in coming years, as lower growth leads to hostility toward governments and taxes—spawning movements like the populist Tea Party in the United States. A study of the impact of economic shocks on politics between 1970 and 2002 concluded that a one-percentage-point decline