Why Are Traders the Last To Know When a Bubble Is Bursting?


Former reason Editor in Chief Virginia Postrel has a fascinating column up at The Atlantic about how experimental economics helps to clarify why bubbles and crashes happen in the stock market. She concludes with two bits of sage advice as we look forward to a thousand years of bad returns:

For those of us who invest our money outside the lab, this research carries two implications.

First, beware of markets with too much cash chasing too few good deals. When the Federal Reserve cuts interest rates, it effectively frees up more cash to buy financial instruments. When lenders lower down-payment requirements, they do the same for the housing market. All that cash encourages investment mistakes.

Second, big changes can turn even experienced traders into ignorant novices. Those changes could be the rise of new industries like the dot-coms of the 1990s or new derivative securities created by slicing up and repackaging mortgages. I asked the Caltech economist Charles Plott, one of the pioneers of experimental economics, whether the recent financial crisis might have come from this kind of inexperience. "I think that's a good thesis," he said. With so many new instruments, "it could be that the inexperienced heads are not people but the organizations themselves. The organizations haven't learned how to deal with the risk or identify the risk or understand the risk."

More here.

Back in 2002, reason interviewed Vernon Smith, who won a Nobel Prize in economics for helping to create the field of experimental economics. Read all about it here.