Valuation controversies at Bernanke’s “bubble laboratory”
May 19, 2008
A fascinating article came out in last Friday’s Wall Street Journal. Research on bubbles, the Journal argues, has become essential to economics. Much of it is now taking place in Princeton’s economics department — which the newspaper describes as “Bernanke’s lab” to acknowledge the role that the current Fed Chairman had in putting it together. Interestingly enough, the work resembles existing work in the social studies of finance:
How and why do bubbles form? Economists traditionally haven’t offered much insight. From World War II till the mid-1990s, there weren’t many U.S. investing manias for them to look at.
Now, the study of financial bubbles is hot. Its hub is Princeton, 40 miles south of Wall Street, home to a band of young scholars hired by former professor Ben Bernanke, now the nation’s chief bubble watcher as Federal Reserve chairman. The group includes Mr. Hong, a Vietnam native raised in Silicon Valley; a Chinese wunderkind who started as a physicist; and a German who’d been groomed to take over the family carpentry business.
Of the three Princeton economists, Harrison Hong, Wei Xiong and Markus Brunnermeier, Hong’s research comes closest to the social studies of finance. As science scholars have done in the past, and as I did in my work with Raghu Garud on securities analysts, Hong eschews the notion of rational or irrational valuation, viewing it instead as a set of controversies over value.
Mr. Hong, 37, argues that big innovations lead to big differences of opinion between bullish and bearish investors. But the deck is stacked in favor of the optimists. One who believes a stock is too high can short it, borrowing shares and selling them in hopes of replacing them when they’re cheaper. But this can be costly, both in the fees and in the risk of huge losses if the stock keeps rising. Many big investors rarely short stocks. When differences between bullish investors and bearish ones are extreme, many of the bears simply move to the sidelines. Then, with only optimists playing, prices go higher and higher.
The insights of bearish investors “are more likely to be flushed out through the trading process when the market is falling, as opposed to when it’s rising,” Mr. Hong and Harvard’s Jeremy Stein write. They say this explains why prices fall more rapidly than they go up. Over 60 years, nine of the 10 biggest one-day percentage moves in the S&P 500 were down.
One very interesting implication is that research on bubbles may eventually lead to a sharp policy reversal at the Fed:
As a result of all that and more, the Princeton squad argues that the Fed can and should try to restrain bubbles, rather than following former Chairman Alan Greenspan’s approach: watchful waiting while prices rise and then cleaning up the mess after a bubble bursts.
The article, in short, celebrates the work of the Princeton economists, and the genius of Bernanke for hiring them. Scholars in SSF should also celebrate — that these ideas are being showcased. Viewing bubbles as controversies is one of the most promising research agendas for the SSF that I can think of.