Wednesday, September 11, 2013

News Flash: Bubbles Exist

It is news when a central banker admits that bubbles exist.

But it happened earlier this week, when John Williams, who heads the the San Francisco branch of the Federal Reserve System, gave a very good speech. An excerpt:
The lesson from history is clear: asset price bubbles and crashes are here to stay. They appear to be a consequence of human nature. And the events of the past decade demonstrate the enormous human costs of asset price bubbles and crashes. 
To understand the past and avoid a recurrence of the devastating events we lived through so recently, we need to acknowledge that investors and financial markets do not behave the way rational asset price theory implies. We need to incorporate these channels into the models we use for forecasting, risk analysis, and policy evaluation. This opens up a world where actions, including regulatory and monetary policy measures, may have unintended consequences—such as excessive optimism, risk taking, and the formation of bubbles—that are assumed away in standard rational models.
If everyone acted rationally, independently, and with perfect information, then, yes, bubbles would be impossible. But guess what? They don't.