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Michael F. Martin

"Often, including in the case of the housing and housing-credit bubbles, it is a rational adaptation to uncertainty. It is not efficient behavior in an overall social sense, and so efforts at detection and prevention of bubbles are probably worthwhile."

Academics should have a comparative advantage in detecting bubbles -- at least compared to market actors or government regulators. Their failure in these latest episodes thus seems like an important puzzle to solve.

The rational herd is a useful construct for what it says and doesn't say about the canonical views of the crisis. Behavioral economics has always struck me as more like psychology, attempting to "explain" bubbles by redefining terms rather than specifying mechanisms. On the other hand, the reduction of group behavior to a composite profile of homo economicus is fatally reductionist in understanding markets out of equlibrium. A new set of preferences that spreads contagiously will not be observable in aggregate statistics until is too late for central planners to accommodate.

In other words, the part of rational expectations theory that emphasizes extremization -- i.e., the maximization or minimization -- of resource use is not going anywhere, and there will still be a role for central planners to define the rules of the game for market actors. But the part that relies on the existence of allocative equilibriums, much less their stability or attractiveness -- that part must be relegated to its place on the dusty shelf of obsolete academic theory, for historians to mull over.

Unfortunately, these notions of equilibrium seem to be intertwined with the fundamental tenets through which economics has been operationalized into an empirical discipline. Data about individual behavior was too expensive to be collected in the predigital era. The predictive success of the principle of revealed preference (especially in economic analysis of law), when used to explain coarse-grained aggregate measurements of consumer behavior, led naturally to a monolithic conception of individual preferences. Ironically, the behavioralists are guilty of the same monolithic conception.

Most of the beautiful existence proofs of equilibrium are useless in a world as mutable as ours. But the basic approach of measuring preferences and modeling behavior as consistent with maximization of fit between preferences and available alternatives is sound. Perhaps more granular data on consumer behavior, and models that can accommodate the adaptation of preferences, can rehabilitate the instrumental value of rational expectations theory.

The detailed structure of exchange seems to be one of the biggest blind spots arising from coarse-grained data and the assumptions needed to make models tractable before computers. Judge Posner speaks of the rational herd as an abstract entity in the same way that Holmes spoke of the bad man. In fact, these entities must have a temporal and spatial extent, susceptible to observation and measurement.

The structure of economic organization seems an underappreciated cause of instability and allocative inefficiency. So long as structure is ignored, the allocative efficiency of private institutions can be elevated above public alternatives. For a generation of economists, public literally meant centrally planned. But a lesson of the present financial crisis, at least for me, is that institutions both public and private may fall victim to the information problems that result from central planning. It is not, fundamentally, the governance mechanism that puts leaders into control that determines whether an institution best promotes allocative efficiency, much less welfare.


Since not everyone with asset liquidity participated in the "bubble" and therefore did not lose enough value to change their life style and/or their jobs, it might be more instructive to ask them how they avoided the "herd" rather than asking why the others joined it. Group psychology is far different than individual psychology, the former, in my opinion, to be avoided in most situations as it is much more likely to experience unusual and perhaps extreme swings with unpredicable outcomes. Are there not behavioral economic studies which have made this point?


One question. Why did housing prices stop rising? You explained why they were rising and why they fell rather than leveled off, but you never explained - unless I missed it - why housing stopped rising?

One other point. I thought this would've been a good time to discuss the near-attack at Times Square or the Oil Spill in the Gulf. I hope you will take up these topics in the very near future.

Don the libertarian Democrat

"assumed to impound the best available information about their value, including future value discounted to the present."

I don't see that this view is incompatible with a Bubble Theory. It's possible a theory focused on the future would be useful but unable to predict a Bubble until too late. At that point, a Bubble Theory might be useful to set in place policies to try and limit them in the future. As well, where Rationality is dependent upon assessing an action with certain specific information, it's possible that a decision be rational but not work out.

I think perception also figures into this, which is why Deflation is much more disorienting than Inflation. Many people are worried about retirement, for example. That led many people to try and buy a house who shouldn't have on the theory that this would be their last chance. That's just my view.

In the end, I'm with Burke. What we need to learn is Prudence.



My point exactly. Following the crowd is not prudent in most if not all cases especially is the crowd is being led by individuals of questionable character or motivation.


"So why did the sophisticated finance industry finance a housing bubble whose bursting was bound to hurt the industry? There were plenty of warnings that there was a housing bubble; why did the industry ignore them? I think it was another though somewhat more complex example of rational herd behavior. The major assets of a modern financial institution are short-term capital and talented staff, and both are highly mobile assets that the institution will lose if it is less profitable than its competitors, and it will be less profitable if it refuses to make risky mortgage loans."


This clearly sums up an utterly irrational social contract and a sharp departure from capitalist principles. Those many of us real capitalists engaged in small biz, not only are not rewarded for running our firms into the ground but often lose assets a lifetime in assembling.

This board has supported the outlandish "bonuses" paid on WS as being necessary to retain top talent. But what good is top talent if the underlying scheme pays more than top dollar for utterly reckless behavior and complete disregard of traditional underwriting standards?

You can't have it both ways, either these guys are employees paid a salary for taking prudent positions for their company and due a small year end bonus or they are, as Goldman and others like to claim, partners in the enterprise who should have both upside as well as downside exposure to the gambles they take. "Heads I win, tails you lose" is hardly a model for making risk commensurate with expected reward.

In fact in the "old" Goldman before Paulson and others became very rich as it was taken public the partners were very much partners sharing in the risks and the very typical rewards. Now? Ha! only the stockholders (aside from taxpayers) play the responsible role of gaining in the good times and holding the bag when the "top talent" has recklessly gambled away their company for short term personal gain and then "retires" absconding with the rest of what's not nailed down.

Hopefully, this game is over soon and all this "top talent" will be forced to turn their energies to productive enterprise that might re-employ our people in mfg, export, research, renewable energy and other.


Right on, Jack.


I would also like to see a discussion from the learned professors about why an economy exits. What is its purpose and for whom. Some? All? Are there requirements to participate in an economy and if so what are they. Should a government act proactively to create an economy or simply avoid negative actions like monetary solutions embedded in the Federal Reserve?

Transor Z

Didn't EMH die two years ago? Keep the faith, Chicago!

Wow, this is some real Flat Earth Society stuff. Good luck with these ponderings. I'm sure some radical deregulation will come back into fashion one of these days. Probably not until the BP oil spill gets cleaned up though.


Man is by nature a social and political animal. Prone to all the frugalities and excesses of his character as impacted by the social and political. While things go well, all the rats want on the boat. When the boat appears to be sinking, all the rats abandon ship. Dare we call it "Mass Hysteria"?

As for the Housing Bubble, it also has a lot to do with market saturation on the big ticket items and overpricing across the board on all items. Coupled with the spector and fear of loss of income (i.e. employment)necessary to support prices.

Fidel Davila

The continued rise in housing market pricing after 2006 was due to wide spread and systematic one-house-at-a-time housing market manipulation by realty agents and mortgage brokers. Their idea (meme) spread virally to countless other agents and brokers and also attracted many fraudulent house buyers that compounded the rising prices. Together, they inflated housing prices even more and they all made off as bandits.

In the dust are those who could not afford their houses when they bought them and the banks holding these loans. The middle men and the money changers are left with all their ill gotten gains.

Systematic grassroots market manipulation practices using memes and their 'viral spread' is the cause of the recent housing bubble. It is scarey to see how easily the market can be manipulated this way. Enron, Oil Speculators, etc. have done it recently and others will do it again.


Jim: Joyce Appleby was interviewed on Cspan's Booknotes this W/E. You might find the hour long interview interesting -- they now archive them all for download.

Her book goes back to the beginning. I was cheered that she pointed out "capitalism" being a cultural phenomenon takes on a different cast in each culture. Here......... we've erred over the last half century in letting "the market" be our master as compared to our harnessing the power of capitalism for the general welfare and OUR ends. The specter of our?? financial sector becoming larger than mfg and skimming off 30% of ALL the profits of America while working folks make no gains at all should illustrate that we've the cart before the emaciated and starving horse.

Or? consider oil and energy........ for that same half century we've been led down the road to profitable operation of energy companies when we ("consumers"/working blokes) would have been far better off had we continued down the road of conserving much of what we waste that was all too briefly begun when President Carter and a fairly sensible Congress responded to the mid-70's "oil crisis". But! conservation efforts that save our non-renewables and have the cumulative effect of lowering demand and therefore price doesn't reward the huge corporations that purchase "access" to Congress and the WH.



"Buying a house or other asset because other people are doing so may seem an example of irrational “herd” behavior. But herd behavior is not irrational. If you are an antelope, and you see your fellow antelopes begin to stampede, you are well advised to join them, because they may be fleeing from a lion. We commonly take our cues from people who we believe have desires and aversions similar to our own."

That very same herd may well be running the annual migration across crocodile infested waters. Undoubtedly there will be those that do not make it based on the number of hungry predators awaiting at the waters edge. But many more drown and die as a result of overcrowding of the passage way as a result of herd mentality. Perhaps herd mentality is not always rational.

Tom Rekdal

Judge Posner's posting is disappointing. He asks why the regulators and the economics profession failed to spot a major real estate bubble developing. Yet he himself provides the only plausible explanation.

It is not always irrational to follow the herd (which explains why so many continued to buy houses at escalating prices). Yet it is not possible to identify the few perceptive predictions of disaster from the many signals we had (which is why we missed Pearl Harbor and the economics profession missed the housing bubble).

The problem is inherent in the limitations of human knowledge. Judge Posner asks a silly and unanswerable question.


Part of the "herd mentality" is virtually genetic. A high percentage of folks marry and some 60-70% buy a home. (Though in recent years the number of non-traditional (other than married couple/family) home owners have risen above 50%)

After the great inflation of the 70's and decades of it seeming that money grew from home ownership it's no surprise that folks of all ages would want to "get on board", trade up or buy second homes. Obviously, the underlying flames of "excessive exuberance" were turned into a blast furnace by the reckless underwriting and derivative based Ponzi.

Ha! in the Pearl Harbor example that does shed light, what would most of us do if we suspected or were fairly sure the recent run-up in home prices were soon to fall? Well, some would surely sell or at least unload 2nd or "investment" homes, thus tanking the market, while half or more of us would continue to live in and make payments on the homes of our choice in neighborhoods we enjoy or that are close to our jobs and activities. Ha! everyone has to live somewhere! But it's still something of a "mystery" that we were building 2.5 million homes against a basic demand (population increase/replacement) of less than one third that number.



Thanks for the Appleby reference. I watched it and agree with her completely. You might want to read the letters about the value of a liberal education in today's WSJ and the reprint below from Adler in 1978. Put it all together and one has a pretty good explanation of our economic Tower of Babel. relative to home building I can accept a disconnect because of the time it takes to plan, acquire land, finance, contract and build. Maybe two or three years. And once the process is started, it would be hard to turn the ship.

Oops. Can't paste Adler but what he said was that our loss of liberal education and rise of specialization like farm teams for the professions and business will (and has) lead to the complete destruction of our culture and by implication of our way of life including our economy (whatever it happens to be). What Aristotle described as paideia, the learning of the generalist, which was the saving leaven of western civilization from the Greeks to the end of the nineteenth century, no longer exists.

Mats Björkenfeldt

After reading Benoit Mandelbrot´s & Nassim Nicholas Taleb´s ground-breaking article, ‘Mild vs. Wild Randomness: Focusing on those Risks that Matter’, in 'The Known, the Unknown, and the Unknowable in Financial Risk Management: Measurement and Theory Advancing Practice', Princeton, 2010, I´m not so sure that Eugene Fama was the right winner of 2008 Morgan Stanley-American Finance Association Award, but quite sure that Robert F Engle focused on the wrong risks, before and after (cf Engle, 'How to Forecast a Crises’, The Journal of Portfolio Management SPRING 2010, Vol. 36, No. 3: pp. 1) he got the Nobel-price 2003. Josef E Stiglitz, Freefall, 2010, says at p. xiv, that crises ‘in developing countries have occurred with an alarming regularity – by one count, 124 between 1970 and 2007’. How was (is?) it possible for Fama, Engle et al to be neglectful of that?

Brian Davis, Austin, TX

Bad banking and bad law made the housing bubble. 1998: Citicorp (Citi National Bank + Salomon Bros + Travelers Insurance); Greenspan's Fed gives the OK. 1999: Congress enacts Gramm-Leach-Bliley, effectively validating the "global financial supermarket" that not only enabled but gave cover to shadow banking and loosely-regulated securities trading via affiliates and subs. These were evils that brilliant, unselfish men like Wright Patman and Henry B. Gonzales spent their long careers in Congress to keep under heel. In the meantime, the bankers plied the State legislatures with bundles of political dollars to pass laws and promote constitutional amendments that vitiated the unitary American family's most sacrosanct legal protection, that NO lien shall ever attach to a homestead unless to secure repayment of original purchase money, ad valorem taxes duly assessed, or permanent improvements contracted for in writing by husband (and wife). The rest is history, as they say. The bubble grew itself, as "momentum" markets tend to do. It's a disappointing few Americans who know much of our history any more, the struggles besides the triumphs, the post-Civil War devastation wrought by the Reconstruction, the panics and the Great Depression, a 20th Century shaped by World Wars and Cold Wars.

Chris Graves

I am amazed that Judge Posner does not understand why more governmental officials, businessmen, and economists did not recognize that we were in a bubble as it occurred. The economists and officials were working off the Keynesian model (and that includes Monetarists) that over-aggregates and is oblivious to the importance of inflation in distorting relative prices. So, they had no accurate theoretical means of sorting through the observable data.

What they should have seen was as the Fed artificially lowered interest rates, more credit was injected into the economy. The new money was not evenly distributed throughout the entire economy as it was directed into particular markets that served to drive up the prices of the goods or services offered in those markets. In the most recent cycle of boom and bust, the governmental policy of attempting to increase the number of lower income folks buying houses helped overstimulate the housing market.

As prices were driven up relative to other markets, then more entrepreneurs entered the housing market seeking to make a profit. The dynamics discussed by Judge Posner might have been at work as well, but the main reason for increased activity in the housing market was not some loss of reason by the market players. Rather they were induced to make the mistakes that they did by the distortion of relative prices by the artificial increase in credit that was not evenly felt throughout the economy. When the investment could not be sustained and the effective demand could not continue, the housing market collapsed.

We need a course in Hayek's theory of the business cycle to begin to grasp what transpired. Austrian economists and others who relied on their basic insights did realize that we were in a bubble and accurately predicted the bust.


Jim: Lot's of truth! I think........ though as I get frustrated with the seeming lack of a younger generation I remind myself that Socrates had the same lament. Also, it's easy to forget that what I may know now, I didn't know at 25.

.."the learning of the generalist" A tough assignment these days! But I hear you; engineers who are just sure political problems can be engineered, doctors who seem least able to comprehend the medical delivery problems and some lawyers able to eloquently and convincingly advance poor ideas. But what democratic process is supposed to do is to elicit the best from a wide variety of participants and stakeholders. I've seen the process work at times in Alaska, but overall it seems our democracy is in shambles.

Brian: Yes! And hat's off to the late Henry Gonzales, I remember well his repeated ringing of the bell as the S%L mess grew from a $20 billion mess and NO one doing anything until it was well over a $100 million mess. Shouldn't a single year of review of what took place after the SL "dereg" have been long enough to "discover" they'd figured out how to gamble for their own purse with house money? No one in the wheel house!

Chris! Geez! Once again "the businessmen" were busy playing "heads I win, tails you lose" for their own gain and were certainly NOT going say or do anything to kill the goose until they'd built family fortunes for themselves.

As for Hayek he should come back and deal with this mess! Monday's news was NO inflation, next to NO headway on lowering unemployment. Theory is fine, but people are real and there are real risks to our entire society of there being 30% unemployment among youths and minorities with yet another cohort coming out of HS and college in a couple of weeks. And, you'll recall our "theorists" dismantled much of the safety net that seemed so superfluous during the unprecedentedly low unemployment rates of the Clinton era.

In this mess, you're the practical choices of doing nothing while gangs roam the streets, paying out welfare and unemployment so they don't HAVE to steal, or finding ways to put folks to work doing something so you at least have something to offset the predictably massive deficits.


In a quick look I found only CA numbers:

160,000 college grads to enter the job market, more or less.

376,000 high school grads for 2010. Lets assume that 30% of them will go on to college, so 264,000 go on to the job market. 264,000 + 160,000 college grads= 424,000 people entering the job market in 2010 just in california. Now, lets not forget about the 62% graduation rate, so what about the high school dropouts, some of them must be looking for work as well. Lets make it simple and add 100,000 to the 424,000. So now we have 524,000 people entering the "job market" every year in California.

How many of these young people will join street gangs as they cant find employment? Currently, many are joining the army as they hire anyone. Of course the military can soak up only so many young people from Cal as there are 49 other states that are having similar problems. The future looks bleak for the golden state.


I doubt CA figures are typical for the nation but for a very rough approximation say the nation is ten times CA for 1.6 million college grads and 2.6 million HS grads (that sounds low to me) entering the job market in a few weeks. Any ideas?

Fernando Torres MSc

Bubbles seem to form as a result of slow adjustments system-wide. In a sense, this is a result of TIME; a device, as Keynes said, to keep everything from happening all at once.

Classic Mortgages

I think chicago is the brillient economist of university.Once can imagine factors that would explain a steep rise and a later in the price of housing. They might include a sharp increase in incomes or wealth, or in population, or big changes in construction costs, A bubble is an increase in the price of an assets that can not be explained by changes in conditions of demand or supply that could be expected to alter the value of the assets relative to the value of other goods or services.

Classic Mortgages
Daniel North


I was a bit too negative, above, on grads joining the economy. After all 70% or so will be employed and will become super-consumers, spending not only all of their wages but borrowing for cars, and sopping up some of the excess housing supply, furnishings etc.


Jack, Don't be so hard on yourself. First off, they have to get jobs (along with the rest of us), begin the paydown on Education Loans that can run into the tens of thousands of dollars. Then, they have to build a degree of credit worthiness and finally find a Bank or Financial Institution that is willing to lend (all in a realm where the Banks and Financial Institutions have become all the more tightfisted - tightwads than they have ever been in the past). All due to the Institution's own excess's. And we wonder why we can't get the Economy jumpstarted.

It's really too bad that the Jacksonian Democrats killed off the National Bank Idea and in the end we ended up with the S.E.C., Treasury, Federal Reserve and et al. trying to control a bunch of independent and arrogant S.O.B's.

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