Global Agenda: Bubbles and blame

It is hardly surprising that the new fashion is to seek bubbles under every nook and cranny.

We live in the immediate aftermath of the bursting of two of the biggest financial bubbles in history (if not the biggest), namely the housing bubble and the credit bubble. Barely nine years ago, the greatest stock market bubble in history - the Internet/ mania - climaxed. There have been other, more localized bubbles, too, in China a couple of years ago and in Japan 20 years ago. This is, in many ways, a bubbly age.

It is therefore hardly surprising that the new fashion is to seek bubbles under every nook and cranny. Headlines in the international media regularly hail something or other as "the next bubble." In Israel, this very week, an equity analyst at one of the large local investment houses made headlines by accusing the Bank of Israel of creating a bubble in the local housing market, by holding interest rates very low.

This, it is now often claimed, is the very crime that the erstwhile hero and demigod, Alan Greenspan, committed as chairman of the Federal Reserve Board when he cut interest rates from 6 percent to 1% and held them at what was then considered an amazingly low rate for a long time - thereby flooding the financial system with vast amounts of cheap money, which inflated the housing and credit bubbles.

Israel has seen its bubbles, too - and was an enthusiastic and leading participant in the mania, although it missed out completely on the housing/credit bubbles. But there is only a remote chance that this country will experience a bubble in housing, or in anything else, any time soon.

Housing prices are indeed rising, but not every price rise, or even full-scale boom, is a bubble. And when there is a bubble, don't expect economists, equity analysts, or anyone else who uses spreadsheets and models as their main tools, to identify it for you. On the contrary, expect them to explain patronizingly why "this time, things are different," and why, according to some new methodology, the patently insane prices are, in fact, perfectly justified - and likely to go much higher.

The basic fact about bubbles is that they are not economic or financial phenomena but rather stem from processes belonging to the fields of sociology and mass psychology. All bubbles require that a large population, often an entire country, or even, as in the credit bubble, an entire civilization, loses its collective rationality, detaches itself from accepted behavioral norms and willingly suspends its natural disbelief in absurd concepts.

In short, bubbles play out in la-la-land - and nowhere else. True, the mechanics of financial bubbles require the ready availability of a huge supply of cheap money, so that the financial part of the bubble is an essential condition, but nevertheless quite insufficient in itself. Right now there is a huge amount of cheap money available around the world, but no bubble exists that encompasses a large population.

As for the indictment against Greenspan, he is indeed guilty of many things, including failing in his primary task of the conduct of monetary policy. But whereas an entire generation of economists and financiers has grown up with the belief that the financial system is the arbiter of the fate of individuals and nations, and that the central bank is the linchpin of the financial system, there are still a few professional economists who have the intellectual ability and honesty to know and accept the limitations of their profession and its tools.

One such economist is Robert Shiller, whose objective analysis of the US housing market led him to identify the problems and warn (in vain) against the impending disaster years in advance. Yet he has sufficient humility to admit that mainstream economic analysis, grounded as it is in assumptions of rational behavior, cannot handle bubbles and that the new field of "behavioral economics" is essential to understand these phenomena. And he has adjusted his thinking and work accordingly.

Shiller also punctures the simplistic "Greenspan is the villain" argument by pointing out that the housing markets in the US and the UK followed remarkably similar paths in the decade prior to the crash. Yet the monetary policies pursued in the two countries were quite different. In other words, very cheap money is not THE cause of the bubble and the central bank is not the primary guilty party. Rather, it is the entire society, leaders and led, professionals and laymen, that is to blame for taking leave of its senses and attempting financial suicide.

Not surprisingly, that's not a popular approach, because the average guy wants to hear that he was a victim, not a willing accomplice. But, unpalatable as it may be, it's the truth - about all bubbles, including both the recent ones and future ones.