Paul Samuelson has died.  The godfather of so many current economists (literally so in one case – he was related to Larry Summers- but metaphorically through being the author of a book that must have brought economics to thousands of current professors), I bet I am not alone in wishing I had time to read his great books this Christmas.

Paul Krugman’s thoughts on Samuelson mention how ‘his discussions of speculation and monetary policy are particularly striking: they run quite contrary to much of what was being taught just a few years ago, but they ring completely true in the current crisis.’

This sounds both likely, and contrary to some prevailing theories about how conventional economics has no clue whatsoever about how to deal with bubbles, or about how dangerous they are.   This has always struck me as overblown, and in the hands of some, annoying nonsense at that.  My last course on my MBA in 2003 was all about Financial Crashes and Economic Theory, and the standard dilemmas about what to target monetary policy at were well-worn by then. Economists did not sit around, dumbstruck, by the notion of a bubble collapsing and causing such mayhem.

Which is why I think Paul de Grauwe is shutting the door on a long-departed horse when he calls for a new science of macroeconomics.  Many professionals will have reacted to that article in the FT with “we knew it was not like that in the models.  And here are 100 obscure papers to prove it”.  Fact is, bubbles acquire political momentum, quite regardless of what the average economist thinks about them.

In fact, such problems were were well-worn even when Samuelson was a young man.  My excellent bedtime reading, Lords of Finance, describes brilliantly the dilemmas for the 1920s Fed, which was struggling to balance the international consequences of the gold shortage in Britain, and its own problems with massive speculation.   Many observers realised that there was a tremendous bubble in US stocks from 1928.  But most of the solutions would not work.  Regulate broker loans? Money can come from elsewhere, including overseas.  Raise rates? It’s using a sledgehammer to perform fine surgery.

The parallels are eerie in places – in particular France as an accumulator of foreign exchange and gold, causing difficulties elsewhere after its earlier currency traumas had scared it into holding down a fixed exchange rate.

There are no easy answers to how to manage a speculative bubble – and few new questions.  The ‘modern’ notion that bubbles are harmless, or non-existent because of market efficiency, has never been particularly influential in the actual markets.  What has really changed since the 1920s is how we now expect the Fed and its international buddies to have learned from 1930-1939, and actually deal with the aftermath in a less cack-handed way.  This is why people did not intervene in 2005 or 2003 or whenever to prick the bubble.

And as the author of Lords of Finance points out, there were plenty of calls to prick the 1920s bubble that would have been ludicrously early, and have done nothing but damaged the real economy, which was enjoying none of the highlife demonstrated by a few individuals in finance. The same would have been the case if Mervyn King or Bernanke had tried sticking rates up to 7% to kill off housing.  All that would have happened is that they would have been blamed for the carnage that followed.


6 thoughts on “Paul Samuelson, Lords of Finance and controlling speculation

  1. Surely however the point is that King and Bernanke really didn’t know that the housing bubble was as bad as it was, or at least that its effects would have been as terrible, not that they simply didn’t have the guts to bite the bullet earlier (which, had they had such information, would have been a smaller than the inevitable upcoming bullet they would have prevented).

  2. I am not sure we can play counterfactual monetary policy that easily. Yes, burst earlier would have been better. But people started shouting “Bubble!” in 2003, just as they wanted (incorrectly) to cool the Dow in the mid 1920s. An already high pound would have rocketed; Middle England would have revolted; manufacturing would have crunched; and it is quite possible that, international capital markets being what they are, the money would still have gone into a market characterised by low supply and high demand.

    A basic housing-rental yields equation could have determined that the housing bubble was ‘bad’. What was invisible to policy makers was the liquidity and capital issues that less well functioning markets might cause when the bubble started turning around. IMHO, anyway ..

  3. Wasn’t Greenspan’s argument not that bubbles were harmless but that they were too difficult to a) identify and/or b) deflate in advance, so monetary policy should essentially follow with a bucket and mop up the mess afterwards by slashing interest rates?

    My personal opinion is that it should be perfectly possible to detect bubbles in the housing market, if not necessarily in the stockmarket. After all, there are a number of market-based solutions like looking at rental yields (always assuming the rental market is free, which it is in Britain but not in Sweden, for example) or housing affordability indices. As you say, any fairly thoughtful person crunching the numbers in late-noughties Britain could see that house prices were far above the levels implied by demand for rental housing, suggesting that people were buying on a “sell to a greater fool” basis.

    I agree with you that deflating a bubble might be politically difficult – though that says a lot about the capture of government minds by the figure of the homeowner, even though there are plenty of people in other forms of housing. Raising interest rates might be a blunt instrument, but what about raising capital requirements for mortgages, or having a sliding scale of rising capital requirements for higher LTV ratios? I think such an intervention would have been justified (and would be in the future) because of the pivotal importance of real property as security on lending – if the value of the security falls banks suddenly have to find more capital, starting a vicious circle of tightened credit causing further price falls. On the other hand, a stockmarket bubble would not endanger the banking system in itself because banks lend very little on the security of shares (for good reason!).

    That’s my loose change anyway…

  4. Hi Niklas

    The problem was that the machine automatically thought that comments with links might be spam. That was very rude of it – but I always read through and check that spam is spam, or not, so I am glad yours has survived!

    Your suggestions seem quite sensible. I would go back one step further, however: we need more supply of housing in this country, IMHO. That would address the problem, though not entirely (look at Spain).

  5. If housing supply was elastic, any bubbles would be relatively small and short-lived, since we would know that house prices would soon return to “normal” levels.

    Given that houses prices are pretty much back up to where they were, and given that there is a recession, and given that lending is relatively limited, I struggle to see any evidence of a bubble in UK housing. What I see is a shortage of supply relative to demand forcing prices up. That is not a bubble.

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