Sorry, stopping the next crash is impossible

The boom-and-bust cycle is here to stay, and there is no certain way to determine whether prices are really in a bubble or not until the bubble bursts.

By The Week Jan 16, 2014 3:39PM

Stock market crash © Kyu Oh/Photodisc/Getty ImagesBy John Aziz, The Week

Robert Shiller, who shared 2013's Nobel Prize for Economics, is worried about the financial system and wants to see measures taken to prevent future crashes:

"Just as most people are more interested in stories about fires than they are in the chemistry of fire retardants, they are more interested in stories about financial crashes than they are in the measures needed to prevent them. That is not a recipe for a happy ending." [Project Syndicate]

But are financial crashes really preventable? I don't think so. The world is just too unpredictable.


First off, changes to the price of assets are very hard to foresee -- their value is not just based on what people think they are worth today, but what people believe other people will think they are worth in the future. It's as messy as it sounds.


Second, there are all kinds of uncontrollable and unpredictable events -- like wars, terrorism, droughts, hurricanes, pandemics, technological and scientific discoveries -- that can completely change investors' perceptions and precipitate a financial crash or a financial boom. Preventing every financial crash or burst asset bubble would mean preventing all of these kinds of shocks.


Beyond that, investors don't all interpret events in the same way. If inflation rises, many investors today would interpret that as an exciting sign that the economy is recovering. Other investors might interpret it as a dangerous sign that central banks' unconventional monetary policies are starting to harm the economy.


But, surely, some crashes are preventable? After all, lots of economists and financial pundits -- including Robert Shiller -- successfully predicted the housing bubble last decade. If Congress and the Federal Reserve had been listening to Shiller and others who warned of a housing bubble, could they have prevented the financial crisis by deflating the housing bubble?

Well, there is no certain way to determine whether prices are really in a bubble or not until the bubble bursts. Sometimes a price rise -- like the rising value of land in cities like New York, Chicago or London, or shares in Apple (AAPL), Microsoft (MSFT) and Google (GOOG) -- will hold for a very long time.

Sometimes a price rise -- like dutch tulip bulbs, shares in Enron, or Beanie Babies -- will collapse quickly and disastrously. And many of the pundits who correctly identified the housing bubble whiffed the aftermath. Pundits like Peter Schiff and Marc Faber got the call right on the housing bubble, but have since warned about bubbles in the stock market, in treasury bonds, and in the dollar itself. Identifying bubbles is hard, if not impossible to do consistently.


And on a practical note, who in the government would be in charge of making the call?


Should it be the Fed? The last time the Federal Reserve tried to tighten to deflate a perceived bubble, it actually sparked a financial crash. This was in 1929, the year of the great Wall Street Crash that led to the Great Depression.


What about Congress? Given how it's acted in the past, I am dubious that it would make the difficult decisions necessary to prevent a crash, even if it could. While many blame Congress for inflating the housing bubble last decade, the laws that Congress made that led to the risky government-backed subprime lending didn’t emerge from nowhere. They were in response to massive lobbying by the financial industry, which was looking for easy profit, and constituents who wanted help to become homeowners. If politicians don't make the laws people want, they get voted out. So it’s hard to expect lawmakers to not make laws that are widely demanded by lots of different groups of people just because of the future possibility of an economic bubble and financial crash.


But these examples are pretty moot: Even if the Fed had acted correctly in the lead up to 2008 or if Congress had not backed subprime lending, there's no guarantee there wouldn’t have been a similar bubble and a financial crash. Why?


As the mid-20th century economist Hyman Minsky put it, stability is destabilizing. The American economy experienced a period of relative stability from the end of stagflation in the early 1980s until the 2008 financial crash. Ben Bernanke called this period The Great Moderation. But how do people react to a stable world? Very often, they become more tolerant of risky behavior.


During the Great Moderation, the financial industry began to make riskier loans at higher leverage ratios, with lower deposits, and even to individuals with no income and no job or assets (NINJAs). And risk-takers began hiding the risks by selling the future income from these risky loans on as asset-backed securities. Financial regulations like Glass-Steagall that separated publicly-guaranteed depository banks from investment banks -- and which may have been partially responsible for the relative financial stability between the Great Depression and the 2008 recession -- were repealed. Politicians were convinced by the financial industry, and by the long period of relative stability that such curbs on risk-taking were no longer necessary. The long period of stability destabilized the system by making politicians and the financial world more risk-tolerant. Successful regulations became victims of their own success. Stability is destabilizing.


Ultimately, I think we need to move beyond the impossible dream of preventing financial crises before they occur. Laws to prevent theft, fraud, intentionally misleading investors, and gambling with other people’s money or with an implicit guarantee (like Glass-Steagall) are prudent regulations. But they do not eliminate booms and busts. Booms and busts are normal behavior in markets, because the future is so hard to predict and people are so unpredictable.


In the long run, I think policy must focus on being more responsive to the booms and busts of the market by minimizing real world damage as problems occur. This means more firefighting -- to prevent damagingly excessive unemployment or a deflationary spiral following a financial crisis. That may not be as clean and satisfying as making the problem go away altogether. But if the problem of financial crashes is inherent to financial markets -- which it certainly appears to be -- making it go away altogether is not an option.

More from The Week

Jan 16, 2014 7:00PM
Funny I don't remember anyone telling me in 2006 "Damn, this housing bubble sucks. It is killing me. Bush needs to do something about it!" But I do remember what seemed like every Tom, Dick, and Harry taking out home equity loans and buying boats and harley's and BMW's. And boasting about it. Americans loved every minute of it. Now the honeymoon is over. But they would love to do it all over again.
Jan 16, 2014 9:54PM

I think this article is off the mark.  Describing the period 1980 - 2008 as a period of great stability which caused banks and people to take mroe and more risky behavior is way off the mark.  During that period there were 2 legislative episodes of financial deregulation which helped fuel the massive risk taking and bad lending.  The first was the Reagan-led de-regulation of the Savings & Loan industry which collapsed that banking sector, required a big bailout and led up to the Recession of 1989-92.  The 2nd was the Clinton-led de-regulation which eliminated the Glass-Steagall act and allowed big banks to gamble recklessly with depositors' money, causing a huge bailout, the massive Crash of 2008 ---- (we are still in it in many ways as jobs have yet to recover). 


The period of Stability that actually promoted growth and prosperity that we should be celebrating and emulating is the post-war period 1948 - 79.  During that period, Depression-era regulations on banks remained in place. Savings & Loans made modest car and home loans.  Glass-Steagall kept big investment banks in check, wage income was more evenly distributed - promoting a stronger middle class, and the economy grew .... until it hit the stag-flation of the mid-1970s (partly caused by the Vietnam War).  Paul Volcker cured stag-flation with Fed actions.  But Reaganomics launched Congress into a de-regulatory frenzy that Clinton echoed and that got us into the mess we are in today.  Dems and Repubs both responsible.

Jan 16, 2014 4:30PM
Seeing how we never fixed the problem that caused the last one, you think? Greed is the number one reason we continually have Booms and Bust.
Jan 16, 2014 6:20PM
Greed is not the #1 reason we have bubbles.  The Federal Reserve is the #1 reason we do.  The lower interest rates to entice all money to be invested into risky assets.  They do this on purpose to boost the economy, well this creates bubbles.  You can say people invest in these risky assets because of greed, but it is because the fed lowers rates so that you get .1% interest in a savings account. bubble was fed induced, savings and loans fed induced, real estate fed induced.  Today we are in yet another fed induced bubble, only this time it is impossible to lower rates any more once the bubble pops
Jan 16, 2014 4:02PM
Our gov who is control of the financial markets will not allow a crash to occur because nobody wants that on their "watch".  The majority of the American public when surveyed all feel the market is manipulated by our gov, big banks, big corporations etc. and yet we are powerless to make the necessary changes to the system to restore fiscal accountability.  Laws are passed not protect the taxpayers but rather to benefit big corporations and wealthy individuals and that folks will not change.  The old saying "He who has the gold..makes the rules" and that is the way it is. 
Jan 16, 2014 10:10PM
Wait wait wait!  What do you mean next "crash"?  The President said the economy is recovering!!  You don't think he lying do you?
Jan 16, 2014 7:04PM
Bubbles happen when stock prices are high relative to earnings. Stocks that have no earnings and a high price are the first to go. Just look at Tesla, they sell 1/1000 the number of vehicles that Ford does and their stock is very high with very little earnings. Ford has good earnings and pays a dividend , so who do you think will fail in the next crash. Buy quality with earnings and not fads.
Jan 17, 2014 12:19PM

six years of Obama and all we talk about is the next crash - how accurate!!!

All he has done is bad for America -

1. multimillion dollar vacations.

2. further divided race relations

3. obamacare

4. has further grid-locked Congress

5. Bengazi

6. NSA

7. National debt is now approaching $20 Trillion

8. gross increase in food stamps, WIC, etc.

9. transparent administration - you MUST be kidding!!

Obama = the worst president in American history.

Jan 16, 2014 9:01PM
When BitCoins are now considered Real Currency by so many folks, you know things are going to Hades. Global Debt is soaring yet interest rates are falling. Eventually things have to equalize.
Jan 16, 2014 6:42PM
Oh, what a bunch of crap. This article was written by the same people who wrote "DOW 30,000," the same people who have priced everything into the market. Crash? Priced in. End of QE? Priced in. Greed? Priced in. Terrorism? Who do you think the terrorists are? Priced in, baby. Climate Change? Priced in by the same people that say Climate Change doesn't exist. This is a fully rigged, manipulated, centrally controlled, globalized, financial system in a closed and closing society. These people predict all this stuff, the internet bubble and crash; the housing bubble and crash, but do they ever try to stop something they have predicted? No. Not once.
Jan 16, 2014 9:41PM

   To regulate or not to regulate, that is the question.

For many years I bought into the Greenspan philosophy that big government regulations were holding the market and economy back from it's full potential. This ideology made sense and Rush Limbaugh confirmed my beliefs daily. So one by one we deregulated the banks and the markets, sub prime loans gave banks more flexibility in lending decisions, the repeal of Glass steagle would make American Banks more competitive on the world markets and deregulation of derivatives would healthy and fuel foreign investment in America. Greenspan believed that banks would self regulate and not give loans that weren't in their self interest.

   Well we were wrong, the failure of deregulation is an axiom, greed is more powerful than common sense, trillions were made by giving out bad loans, foreign investors fueled the madness by buying every Mortgage Backed Security in site and banks showed no regard for the end game because they were now to big to fail.

   The next time someone says deregulation is the way to go, you know what to tell them.

Jan 16, 2014 10:57PM

You said "And on a practical note, who in the government would be in charge of making the call"  then you asked "Should it be the Fed?"

So my question to you is, do you realize that the Federal Reserve has absolutely nothing to do with the government of the USA - it is a group of private bankers, trusted and supported by all financial organizations.  In fact it is trusted so much that the currency it prints is legal tender everywhere in the USA.  The Federal Reserve is controlling the economy, and the government has very little influence.

Jan 16, 2014 3:48PM
So why not write an article about how to prevent greedy behavior? That's what creates bubbles!
Jan 16, 2014 7:24PM
This morning went down to the Walmart to get a few things as it is close as live out in the country a bit. Speedy line was not so "speedy" as a Mexican lady had a full cart...curiously enough our cashier was Mexican. This line was for 10 or less items.  She proceeded to pull out 3 qwest cards and all were individually rung up per card.  They only talked Spanish or some derivative thereof.  I speak Spanish and could follow it all.  You might wonder the point of this...give it some thought.  This is just one of a multitude problems that will never get fixed, now. There is a cure but it will come from without as will this "correction".  I have always had a curiosity about these "vacant" cities that China has all over.  Waxing philosophical.  Our country is in deep and not talking just financially.  Have a nice weekend coming, all. 
Jan 16, 2014 9:29PM
Bubbles may be impossible to prevent entirely, but central banks have been instrumental in inflating bubbles well beyond where they would be otherwise. Central banks should act to offset unwise policies coming from the legislative branch, but instead they often make things worse. 
Jan 16, 2014 6:24PM
Jan 16, 2014 6:17PM
And of course by the same logic, the next bull run is just as inevitable. What a waste of space to try to justify a histrionic headline.  Same old MSN B.S. Yes, I got sucked into reading this drivel.....but I refuse to patronize any advertisers who appear on this site. Are you listening, Fidelity Investments?
Jan 16, 2014 6:16PM

Busts don't worry me... It's a bust that causes our deficit to spiral out of control.  All this "slapping on a band-aid" every month isn't stopping the leak.  Even if our economy survives and we go back to business as usual, that isn't going to magically erase our debt which is roughly 28k per infant child adult in this country.  That correlates to about  85k per family.  Imagine adding 85k in credit card debt to each family in America.  Any Tom Dick or Sally can understand that it's not a pretty picture. Especially when we aren't cutting that price, only raising it.   The interest on that alone is frightening.  The stock market right now is so over bloated with Fed QE's, each of us are wondering constantly... Stay in it and make more? or Pull out now while I'm ahead??  Anyone notice how gold bottomed out about 5 months ago, yet stocks have surged since then?? Gold should have kept sinking, but didn't.  So what to do now....? That's the big question.  The fed is continuing to pump 75 Bill a mo into the economy for a while.  Is that enough anymore??? Maybe, maybe not

Jan 17, 2014 10:14AM

How can the next crash not come?  Housing prices are back to pre-recession levels while unemployment is still over 6.5%  How in the world did prices increase as fast as they did?  Stocks are at all time highs despite a lot of companies not making record profits.  In fact the Christmas shopping season was a huge bust considerably below analyst expectations which tells me people either aren't spending money or they don't have money to spend.  Seeing how we aren't seeing a huge rise in savings account deposits I would say there just isn't the money out there we are led to believe there is.  So the market is due for a correction (a real correction this time about 25 - 30% drop) and the housing market needs another correction as well. 


Just because Apple or Google posts a hefty profit doesn't mean every company with publicly traded stock needs to increase its value 2% that day.  But that's how investing in the market today works.

Jan 17, 2014 12:28PM

The liberals will always over spend.

We have a false economy fueled by our out of control president.

Congress isn"t allowed to solve anything because of lobbiest.

Obuma loves this because it divides our nation.

If it isn"t stopped he can then declare martial law and be the dictator.

We need real jobs and less Gov"t regulations.

We need leadership.

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