The Price of Everything - Eduardo Porter [113]
TO THE EFFICIENT-MARKETS crowd, the financial zigzags that often look like crazy booms and busts are the natural outcomes of the actions of rational investors who face an uncertain future and have to constantly update their expectations in response to new information about the potential profitability of investments. In this land the dot-com bubble was only a bubble in hindsight. In 1999 it might have made sense to put all one’s money into the online grocer Web-van. It did go bankrupt two years later. But in 1999 one could believe it might evolve into the next Microsoft. As the economy reeled following the collapse of the housing bubble, the leading lights of Chicago stuck to their guns. “Economists are arrogant people. And because they can’t explain something, it becomes irrational,” said Eugene Fama, one of the leading economists of this school. “The word ‘bubble’ drives me nuts.”
Yet in the wake of the disaster sparked by the frenzied lurch of housing prices, the assumption of rational investors relentlessly driving prices to their true value looks either wrong or irrelevant.
A Cambridge don and Bloomsbury habitué, a British representative to the peace talks in Versailles, where he argued that imposing tough reparation payments on Germany after World War I would impoverish Germans and lead them to extremism, Keynes was also a savvy investor who made a lot of money in the market. His experience in finance informed his perception that most of the time investors don’t know what they are doing. Investment decisions, he thought, are the result of “animal spirits—of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.”
Robert Shiller, an economist at Yale, has proposed a model based on Keynes’s insight. In it, rationality takes a hike: a plausible new economic opportunity—say the Internet or new trade routes across the Atlantic—leads early investors to make a lot of money. This generates enthusiasm. The prices of the hot new asset—dot-com stocks, shares in shipping companies, whatever—are bid up as investors rush to partake of the profits. This leads to euphoria. Eventually the investments overrun the underlying logic. Investors see the price of stocks go up and assume they will continue to do so. They construct a narrative about how the new economic opportunity changes the conventional rules of the game, justifying stratospheric valuations. They borrow to double up on their investments.
Unfortunately, pessimism inevitably sets in when it turns out that the world was not really transformed by the new investment opportunity but operates in the same way it used to. Then the bubble bursts. Prices fall, begetting more pessimism and further price declines. Investors are forced to liquidate their depreciating portfolios to cover their debts, so asset prices fall further. It ends badly. As I watched estimates for my old Los Angeles condo soar above $900,000, two and a half times what I paid for it, I couldn’t help thinking that home buyers and the banks that financed them were insane. But they could all justify their strategies by pointing to what other investors were doing. And their justification made some sense at the time. It doesn’t make any sense now.
ECONOMICS FOR A NEW WORLD
The financial disaster spawned in the American housing market is changing economics. Forced to reassess, many economists have suddenly acknowledged that we’ve known for a long time that the proposition of unerring reason has limitations. We know that sometimes people’s preferences do not increase their welfare. Preferences can change unpredictably in response to events. And our belief about what set of choices will lead to our preferred outcomes is also a moving target. Add to that our limited ability to process information