Popping Sumner’s Bubble
[UPDATE below.]
I’m telling you guys, “Scott Sumner” is a computer program from another planet, sent to destroy the dollar and soften up Earth for the invasion. Today he writes:
I am constantly amazed that so many highly intelligent economists and finance-types seem incapable of understanding something as simple as an asset price bubble. There seems to be a common perception that bubbles are inconsistent with the EMH, and that you identify a bubble by noticing when an asset price has risen sharply, and then fallen. But suppose that asset prices never fell back after large advances? Suppose that at worst they leveled-off. In that case investors would have a surefire way of making money. Buy assets that were soaring in value. In that case only one of two outcomes could occur:
1. No price change.
2. Further increases in price.
A no lose proposition. That means that if bubbles are big price advances followed by substantial declines, then a world without bubbles would violate the EMH. Which means asset price bubbles do not violate the EMH.
OK, I am virtually certain that Sumner has written that the very term “bubble” is operationally meaningless, unless we throw the EMH out the window. But, I have a high opportunity cost for researching this.
So here’s my offer. For the first person to post evidence in the comments here, I will PayPal you:
(A) $10 if you find an example of what I’m talking about.
(B) $20 if we catch Sumner quite literally contradicting himself. For example, he might try to squirm out of it and say he is distinguishing between bubbles existing versus recognizing that we’re in one, in real-time. Or, he will say, “Ah, but notice in this recent post I said ‘if bubbles are big price advances followed by declines.’ In my earlier post, when I said bubbles were inconsistent with the EMH, I was using a different definition of bubble.”
I will be the final and sole arbiter of which category a Sumner post falls into.
You have your orders. Good luck, everyone.
UPDATE: Thanks to the sleuthing of Dan, we are able to produce the following work of beauty:
(A) “I’m a believer in the EMH and hence skeptical of the idea of bubbles, a least as the term is usually interpreted. But I’m in the minority, the vast majority of people think bubbles exist.” — Scott Sumner, 9/7/2011.
(B) “Next we have to discuss what we mean by ‘bubble.’ Most people mean a sharp rise in prices, followed by a big decline. I agree with most people.” — Scott Sumner, 1/12/2012
(C) “I am constantly amazed that so many highly intelligent economists and finance-types seem incapable of understanding something as simple as an asset price bubble…[My argument] means that if bubbles are big price advances followed by substantial declines, then a world without bubbles would violate the EMH. Which means asset price bubbles do not violate the EMH.” — Scott Sumner, 8/9/2012
I submit that there are only two ways to reconcile (A) through (C):
Door #1: Sumner claims that not just his definition, but the definition of “bubble” used by most people, has changed during the last 11 months.
Door #2: Sumner claims that a “sharp rise in price, followed by a big decline” is quite a different thing from “big price advances followed by substantial declines.”
My work is done here.
http://www.themoneyillusion.com/?p=8063
This might be what you’re looking for.
Dan that one is definitely a bastard son of the one I had in mind, but I think there was an earlier one where he was more adamant about bubbles not existing.
http://www.themoneyillusion.com/?p=12580
In this one he says, “Next we have to discuss what we mean by ‘bubble.’ Most people mean a sharp rise in prices, followed by a big decline. I agree with most people. More sophisticated people define ‘bubbles’ in terms of market inefficiency, deviation from the EMH. Since I believe markets are efficient, that’s obviously not my definition, or else I’d have to argue that bubbles don’t exist. So let’s stick with the conventional definition.”
> we have to discuss what we mean by ‘bubble.’ Most people mean a sharp rise in prices, followed by a big decline. I agree with most people. More sophisticated people define ‘bubbles’ in terms of market inefficiency, deviation from the EMH. Since I believe markets are efficient, that’s obviously not my definition, or else I’d have to argue that bubbles don’t exist. So let’s stick with the conventional definition.”
Argh, this is such a facile explanation of bubble phenomena. On the one hand, you have the post hoc realization of the “big decline”. On the other, you have this blind application of EMH to pretend that there’s no other interpretation. It’s kind of sickening, really.
Yeah but Rick Hull it seals his doom. Now we’ve pinned down exactly what he means by “bubble” in both places, so he can’t say he switched definitions. (He pulled this trick with “inflation” I think. In a series of posts he said the term was meaningless, yet he himself uses the term all the time.)
Also, FWIW, I’ve tried twice to post to his recent post, and it won’t work. The computer has detected a threat and is acting to minimize it, until the Martians show up and deal with me permanently.
Those damned Martians. I’ve dealt with them in the past. They’re pushovers, but are intent on domination.
They covet your rack.
So, you know exactly what I’m talking about!
http://www.themoneyillusion.com/?p=10679
“I’m a believer in the EMH and hence skeptical of the idea of bubbles, a least as the term is usually interpreted. But I’m in the minority, the vast majority of people think bubbles exist.”
Boom that’s at least $10. Tomorrow when I have time I’ll determine if you get a chicken dinner.
I spent like ten minutes on this. Keep the money and the dinner. I’m cool with just reading you rip apart Sumner. His philosophy annoys me.
Well dang, if I knew you would say that, I would’ve offered $100.
I don’t want to speak for him personally but the extra $90 could easily effect one’s willingness to be so humble.
Murphy’s a cheap date, but likes to live large.
Why not donate it to a good cause like Bob’s debate challenge to Krugman?
😉
Really? Because Sumnewr goes on to say “But most people think bubbles are identifiable–indeed that’s a sine qua non for the existence of bubbles.” I think it is fairly clear Sumner makes a distinction between ‘identifiable bubbles’ and fast rises followed by drops. he discusses that in your long blockquote. So this does not look like a contradiction to me.
Another analogy. Since I don’t believe in god I don’t believe in sin as a transgression against god. But I do use the word the way many commonly do — as a trangression agaisnt commonly accepted standards. So it’s not a contradiction for me to say that there is no sin the way Callahan conceives it, but still call things sins.
Don’t mean to burst any bubbles (har har), but I’m not sure if that quote snippet is a slam dunk.
“Skeptical of the idea of bubbles” – So Sumner can argue that he really just meant he is very cautious when it comes to identifying bubbles.
“But I’m in the minority, the vast majority of people think bubbles exist”
Now this strongly strongly implies that he does not believe bubble exist. But not literally. Consider:
“But I’m in the minority [of people who are skeptical about bubbles], the vast majority of people think bubbles exist [and have no uncertainty].
:/
I don’t even see what his point is? It seems analogous to saying that “if we assume there’s no gravity, then we could all fly,” etc…
Also couldn’t the supposed inconsistency be cleared up by accounting for time? For example the “perfect information” during T1 could cause the asset’s price to rise, and then the “perfect information” gathered at T2 could cause a sell-off? Any clarification on this would be appreciated.
Anyways I’m too tired to dig through Sumner’s archives right now but I’ll see what I can come up with mañana
For anyone wondering how a “bubble” is defined by neoclassical finance people.
1) We do not need to assume ahead of time efficient markets. We do assume market participants are always looking for arbitrage opportunities so we can use arbitrage arguments to develop our pricing tool.
2) The price of the stock today is the sum of: the present value of a future price (p(T)) and the present value of dividends paid until some future date (d(t)). Since stocks theoretically have no maturity date, we can say the stock can be held until infinity so that its value today is the present value of dividends paid from now until infinity.
Note: dividends are often measured by proxy through Free Cash Flow to Equity – the amount available to remit to stockholders.
3) Mathematically, our model is: p(t) = V(t,T)p(T) + integral from t to T of: V(t,u)d(u) du
The first part is the present value in expectation of the future price (V is a discount/expectation operator) and the second part is the dividends. So as T approaches infinity, the first part drops off. Now, the way we can write down a model for a model is: p(t)=pf(t) + B(t) where pf is the price based on fundamentals (dividends stream) and B is the bubble part. Bubbles can be positive or negative, and simply must satisfy B(t) = V(t,T)B(T). So the valuation function is the same for bubbles as it is for future prices.
Thus a bubble is a price effect unrelated to changes in the fundamentals of the firm, but is related to the expectations and discount rates people use to value the firm. The empirically very difficult (if not impossible) part is determining the amount of the price that is given by fundamentals, which allows the remainder to be the bubble. We have to apply a valuation model to the dividends (of the proxy) and the valuation model could be wrong (in fact, it is wrong by definition; we merely try to minimize the error).
The best way to try to find a bubble is to remove the fundamentals. Many have tried, all have failed.
N.B. Bubbles need not be irrational! In fact, in finance, we’re mostly interested in rational bubbles. Jose Scheinkmann (very difficult to read except for math majors) has done a lot of work showing bubbles can be entirely rational.
4) What does this have to do with EMH? Well, absence of arbitrage is something that results in efficient markets. Most finance people don’t think of EMH as a binary category (efficient v. not efficient) but as a spectrum. In other words, the more people are looking for arbitrage opportunities the more competition there is in markets, so the more likely prices are to reflect fundamentals. Whatever interferes with the arbitrage search will reduce efficiency.
A world without bubbles does not violate EMH, just as a world with bubbles does not violate EMH.
The whole issue kind of seems like another one of Sumner’s straw men to me. Sumner is always arguing against “criticisms of NGDP targeting” that I have never, ever heard of before.
So when I comment on his blog in light of what little I may know about a particular issue and make a strong case for what I’m saying, Sumner says something to the effect of, “You might be right, but I’m talking about people who make the specific claim in my blog post.”
It’s a subtle form of trolling. His entire blog consists of answering “criticisms” that no one ever made. Therefore, he always wins the debate, since he is deliberately constructing the opposition out of thin air in such a way that he can defeat the argument easily.
This bubble thing is a perfect case in point. He says, “Assuming bubble prices never decrease. Then, bubble prices need not decrease.” What does that prove?
For these reasons, the point alone is pretty weak. But he doesn’t really even do a good job of making his case, because in a world in which asset prices stay the same, but NGDP rises constantly, the asset prices are effectively decreasing by Sumner’s preferred factor of 4%.
I hate it when Sumner does stuff like this.
I think Sumner lives in a bubble.
If all you mean by a bubble is a big increase in asset prices followed by a big decrease, then of course there are bubbles. But in that sense of the term the existence of bubbles isn’t inconsistent with the EMH. To be inconsistent with the EMH, you would have to restrict the term to apply only to cases where you can reliably predict the asset price fall in advance. In that sense, you couldn’t say that there was a bubble in Japan prior to Fukashima even if the stock market declined afterwards.
Lots of people use the term “bubble” in both senses, and often times they seem to switch back and forth without even realizing it. Scott believes in bubbles in the former sense, but is skeptical that there are bubbles in the second sense. I’m sure you can find posts where he uses the term in the broad sense and posts where he uses the term in the narrower sense. If you interpret him as using the same sense in both posts, then it will appear he is contradicting himself. But that’s an error in interpretation, not an actual contradiction.
+1
So basically this is the same thing as Sumner claiming he is allowed to use the word “inflation”, but denying that anyone else can use the word “inflation.”
Remember that Murphy?
One of the main problems with Sumner is that he tends to engage in philosophical rhetoric and hermeneutics. It’s a remnant of influence from Richard Rorty.
Sumner has before said that bubbles don’t exist, without caveats. Now he is using the word bubble as if it exists.
This isn’t an error of interpretation, it is an error in term usage.
It seems difficult to discuss if you use words that way, doesn’t it?
And, thinking about it, I haven’t heard anyone claim that there was a bubble in Japan before the earthquake.
In your blockquote from Sumner I do not see Sumner saying bubbles exist. He is arguing that if you define and identify a sharp rise in an asset price followed by a fall as a bubble, if that’s what you mean by bubble, then the EMH is consistent with bubbles.
Here’s an analogy. Bob argues that if by ‘unfair’ you mean some action whose justification we cannot understand, if you think unfair can be recognized by bad things happening to good people for reasons we do not know, then it is not inconsistent with Christianity to call God unfair. But one cannot conclude Bob thinks God is unfair.