My Response to David R. Henderson’s Proposed Bet on the Stock Market
Over at EconLog, in response to my recent post here, David writes (with my minor formatting changes):
I propose to Bob the following bet:
==> “I bet that by May 27, 2020, the S&P 500, adjusted for inflation measured by the CPI, will not be more than 10% lower than it was on May 27, 2015. Even odds with a bet of $500.” <==
Of course, you could argue that Bob and I have already made much bigger bets than that. I haven’t checked exactly, but about 45% or more of my net worth is in stock funds, both U.S. and international. I’m guessing that, given his views, well under 25% of his net worth is in stock funds.
So why bet with each other? The main reason is that it’s fun. The other reason is that we save all the transactions costs that would be involved with buying, and renewing, puts and calls.
So, Bob, do we have a deal?
Here was the answer I gave David on Facebook:
In terms of the actual bet, it’s not appealing to me at all. For example, suppose in May 2008 I said, “I think the stock market is in a bubble and could crash at any time.” David says, “Oh yeah? Bob I bet you in May 2013, the S&P is up 20% compared to now.” He would be right. (I’m not adjusting for CPI.) And yet, in our scenario, surely I could claim, “I told you so!” when the market fell in half (from that point) by March 2009.
To put it in other words: The stock market could crash in the next two years (say), and then the Fed might come in and blow up another bubble, poising it for still a fourth big crash even further down the road. That outcome is consistent with David’s proposed bet. (Also, it’s hardly a vote of confidence for “buy and hold” to know that over the next five years, you probably won’t lose more than 10 percent in real terms. Stocks are more volatile than bonds and “cash,” so I’m surprised that David put such a low bar for equities into his proposed bet.)
However, I don’t mean to suggest that if David and I went back and forth a few times, we might come up with a suitable wager. The fundamental problem here–as we learned last time–is that this is foolish in terms of the broader blogospheric discussion of economic policy. Last time, David (who has written a policy study for Mercatus pushing for “fiscal austerity” through spending cuts and using the Canadian example as a model) bet me that CPI inflation would be modest, while Krugman predicted accelerating deflation, and then when David won Krugman & Co. ran around saying it proved the success of the Keynesian model. (Furthermore, I often see people referring to my failed predictions on “hyperinflation.”)
The famous Julian Simon / Paul Ehrlich wager made sense, because they were on opposite sides of the ideological spectrum. But in this environment, I have learned it’s not wise to make public wagers with your friends. No matter which of us won, our opponents could claim, “Ha ha, the free market guy just botched another prediction, this story is getting old at this point.”
Wouldn’t the appropriate bet to check for a bubble be something more like “Sometime within the next two years, the S&P will be at 60% or lower than its current value?
You aren’t claiming that you know WHEN the bubble is going to burst, just in the relatively near-term. And surely a burst bubble would eliminate AT LEAST 40% of value, right?
When a bubble is burst, all value is lost. Do you really think a bubble boy whose bubble bursts will survive? Just watch Seinfeld if you want to know the truth. There is a George Costanza in all of us, waiting for the moment to destroy someone’s bubble.
“And surely a burst bubble would eliminate AT LEAST 40% of value, right?”
The essense of a bubble consists of the same *kind* of mistake that all businessmen can make.
What we know of as a “bubble” is when a bunch of businessmen are making those mistakes at the same time.
The Austrians say that the coordinated nature of the mistakes can be accounted for by their exposure to artificial credit.
They each (those that have actually done so) have taken advantage of varying amounts and rates of this credit, and so they each have made malinvestments of varying severity.
Those who have taken the least advantage of the cheap credit will have made a less number of, or less severe, malinvestments.
Not all businesses that have been mislead into making malinvestments will lose a lot, and cheap credit tends to effect businesses engaged in longer term investments (such as capital-intensive ones) more than those which sell finished goods.
To the extent that other businesses rely on an exposed business, their increased income is also a bubble.
Technically, only exposed to the cheap credit – either directly, or indirectly – will experience a bust (ceteris paribus).
So, not everyone will lose in a bust, and not an equal amount. And since a bust is really just a long-overdue correction, some businesses will happen to be better situated for sustainable income as the economy is restructured to conform to consumer preferences, which is how it’s supposed to be.
… UNLESS the government tries to prop up the failing businesses with bailouts and price controls – which they always do. Then failing businesses are being propped up with other people’s money, and capital is being destroyed/wasted, and everyone gets poorer except those who get to use printed money earlier than others.
Rothbard basically said that if one person makes a mistake that’s perfectly normal, but if a large number of people make the same mistake all at the same time in a coordinated manner, then we can automatically deduce that some manipulating factor must have been causal in this (I’m paraphrasing to make it brief).
I personally think that a belief in self-organizing systems must, by consistency, imply a belief in self-organizing mistakes as well… that is to say the same marketplace that assists everyone in coordinating their activities can in principle have the effect of coordinating their failures as well. This of course does not rule out the possibility of nefarious manipulation. People being what they are, if nefarious manipulation was possible in any way, someone would give it a try, and if it worked there would be incentive for quite a lot of people to get into it.
Maybe it helps to say that, to the extent that we are justified in thinking of the economy as a system (which is not to a great extent), what we would mean by “self-organizing” is that a free market would tend toward prosperity from the perspective of each individual, without violating the rights of any.
In a free market, people would almost exclusively use a commodity as money, so, when payments are due, the creditor either gets paid in something for which consumers have signalled that there’s a use-value …
(and that there’s a good chance it will be liquid for about the same amount and kind of goods – or better – in the future as it is expected to be at the time of the transaction) …
… or he does not get paid, and he has the information he needs to halt any plans he had for the money he’s owed (and therefore does not malinvest his resources), until he can get paid.
That’s unlike today, where we get paid in paper that does not communicate the correct information about consumer preferences for goods and services, and we end up thinking we have more purchasing power than we do.
Or, we get the money first and don’t realize that we’re the beneficiaries of government theft of the purchasing power of later users of the new money.
So, absent the artificial credit, price signals would be much clearer such that there couldn’t be a coordinated failure.
-Depressing, but true. Paul Krugman doesn’t make bets on the future of the Euro or on RGDP in times of sharply rising taxes and base money.
“I’m surprised that David put such a low bar for equities into his proposed bet.”
Maybe he’s out of the betting business and just looking to pad his retirement fund?
I predict that posting comments on the internet is like the state having free consultants and advisors feeding it information.
This does kind of open the question of what the S&P 500 actually measures in real terms (with or without CPI adjustment).
Bob, you wrote “But in this environment, I have learned it’s not wise to make public wagers with your friends. No matter which of us won, our opponents could claim, “Ha ha, the free market guy just botched another prediction, this story is getting old at this point.””
Good thinking Bob, your actions should be fundamentally determined by what your opponents will claim. If you’re saying your decisions about what to do with your friends is impacted by what your opponents will say, then Krugman and Co. have already won.
The terrorists have already won. Wise words and even wiser letters.
Heads up:
Zerohedge is right …:
“The Fed Has Been Horribly Wrong” Deutsche Bank Admits, Dares To Ask If Yellen Is Planning A Housing Market Crash
http://www.zerohedge.com/news/2015-05-31/fed-has-been-horribly-wrong-deutsche-bank-admits-dares-ask-if-yellen-planning-housin
“The reason why Zero Hedge has been steadfast over the past 6 years in its accusation that the Fed is making a mockery of, and destroying not only the very fabric of capital markets …”
… But for the wrong reasons:
“Companies have to meet a given demand say but choose to use cheap labor rather than invest for productivity. Productivity may be weaker for longer. … Since it takes a while for wages to pick up (need to be nearer full employment), demand doesn’t really strengthen much. Global issues may depress pricing, so this is an additional constraint for the investment outlook.”
There’s just one piece missing from your analysis, Bob: Krugman will say you’re both wrong whether you place public wagers with each other or not.