How to Start a Bubble

by: Modeled Behavior

By Adam Ozimek

Paul Krugman has linked approvingly to Karl’s post on Fannie and Freddie, and I want to use this renewed attention to his piece as an opportunity to disagree with it. Well, maybe not disagree, but at the very least I want to present an alternative story of Fannie, Freddie, and the bubble that is inconsistent with his, and which I have yet to see a strong argument against.

Whether or not you agree that a bubble had actually started by 2002, it’s clear that fundamentals had become divorced enough from historical levels to begin convincing some people, notably Dean Baker, that a bubble was present. To me this divergence and the subsequent uncertainty around it was a key driver of the huge and indisputable bubble that followed the debatable 2002 and 2003 semi-bubble.

Once fundamentals were potentially outside historical levels, it became unclear to market participants and economists what the fundamentals were anymore. Thus, a signal which traditionally could be used to hold prices in check was gone, and the only signal market participants were left with was prices themselves. It’s as if someone turned out street lights and the only way drivers could navigate is by looking at each others headlights. It’s easy to see how this could lead everyone collectively far from the roads despite behaving rationally individually given the information available to them. This uncertainty and unanchoring of fundamentals set off the herd behavior that drove prices even higher, this lured private companies in who eventually crowd Fannie and Freddie out of the market.

Now herd behavior of market participants is also causal here, but that doesn’t mean that the initial divergence of fundamentals that set the herd off was not causal as well. However, this story does make Fannie, Freddie, and their enablers less negligent than typical stories that assign causality to them. This is because few could have foreseen that causing fundamentals to somewhat diverge from historical levels would set off such extreme herding behavior. This unforseeableness of the consequences means you can’t exactly call their policies reckless. In contrast, had they been the primary force continually driving the prices higher and higher to manic levels, as some narratives of the bubble hold, then one might call them reckless.

So that’s one story of Fannie, Freddie, and the bubble. Maybe it’s not the right one, and maybe Karl’s is, but I’ve yet to hear a convincing case for why it’s wrong.