If we buy into Bryan Caplan’s model, then it’s not really a bubble so much as zero-sum arms race. It’s less like tulips, and more like keeping up with the Joneses. Keeping up with the Joneses doesn’t pop; it’s a stable phenomenon.
In the case of education, people who are diligent/smart/conformist get a degree, employers mostly want to hire those people, so then everyone else tries to get a degree in order to keep up, and the diligent/smart/conformist people then have to get more degrees to stand out. That’s a signalling arms race, but it’s stable: nobody gains by doing something else.
We shouldn’t expect to find ways to “short the bubble” for exactly that reason: it’s stable. If there were ways to gain by shorting, then it wouldn’t be stable. Sure, we’d all be better off if we all agreed to less education, but the Nash equilibrium is everyone defecting. Policy position for 2020: ban higher education!
Asset bubbles can be Nash equilibria for a while. This is a really important point. If surrounded by irrational agents, it might be rational to play along with the bubble instead of shorting and waiting. “The market can stay irrational longer than you can stay solvent.”
For most of 2017, you shouldn’t have shorted crypto, even if you knew it would eventually go down. The rising markets and the interest on your short would kill you. It might take big hedge funds with really deep liquidity to ride out the bubble, and even they might not be able to make it if they get in too early. In 2008 none of the investment banks could short things early enough because no one else was doing it.
The difference between genius (shorting at the peak) and really smart (shorting pre-peak) matters a lot in markets. (There’s this scene in the Big Short where some guy covers the cost of his BBB shorts by buying a ton of AAA-rated stuff, assuming that at least those will keep rising.)
So shorting and buying are not symmetric (as you might treat them in a mathematical model, only differing by the sign on the quantity of assets bought). Shorting is much harder and much more dangerous.
In fact, my current model [1] is that this is the very reason financial markets can exhibit bubbles of “irrationality” despite all their beautiful properties of self-correction and efficiency.
[1] For transparency, I basically downloaded this model from davidmanheim.
That model works, but it requires irrational agents to make it work. The bubble isn’t really “stable” in a game-theoretic equilibrium sense; it’s made stable by assuming that some of the actors aren’t rational game-theoretic agents. So it isn’t a true Nash equilibrium unless you omit all those irrational agents.
The fundamental difference with a signalling arms race is that the model holds up even without any agent behaving irrationally.
That distinction cashes out in expectations about whether we should be able to find ways to profit. In a market bubble, even if it’s propped up by irrational investors, we expect to be able to find ways around that liquidity problem—like shorting options or taking opposite positions on near-substitute assets. If there’s irrational agents in the mix, it shouldn’t be surprising to find clever ways to relieve them of their money. But if everyone is behaving rationally, if the equilibrium is a true Nash equilibrium, then we should not expect to find some clever way to do better. That’s the point of equilibria, after all.
If we buy into Bryan Caplan’s model, then it’s not really a bubble so much as zero-sum arms race. It’s less like tulips, and more like keeping up with the Joneses. Keeping up with the Joneses doesn’t pop; it’s a stable phenomenon.
In the case of education, people who are diligent/smart/conformist get a degree, employers mostly want to hire those people, so then everyone else tries to get a degree in order to keep up, and the diligent/smart/conformist people then have to get more degrees to stand out. That’s a signalling arms race, but it’s stable: nobody gains by doing something else.
We shouldn’t expect to find ways to “short the bubble” for exactly that reason: it’s stable. If there were ways to gain by shorting, then it wouldn’t be stable. Sure, we’d all be better off if we all agreed to less education, but the Nash equilibrium is everyone defecting. Policy position for 2020: ban higher education!
Asset bubbles can be Nash equilibria for a while. This is a really important point. If surrounded by irrational agents, it might be rational to play along with the bubble instead of shorting and waiting. “The market can stay irrational longer than you can stay solvent.”
For most of 2017, you shouldn’t have shorted crypto, even if you knew it would eventually go down. The rising markets and the interest on your short would kill you. It might take big hedge funds with really deep liquidity to ride out the bubble, and even they might not be able to make it if they get in too early. In 2008 none of the investment banks could short things early enough because no one else was doing it.
The difference between genius (shorting at the peak) and really smart (shorting pre-peak) matters a lot in markets. (There’s this scene in the Big Short where some guy covers the cost of his BBB shorts by buying a ton of AAA-rated stuff, assuming that at least those will keep rising.)
So shorting and buying are not symmetric (as you might treat them in a mathematical model, only differing by the sign on the quantity of assets bought). Shorting is much harder and much more dangerous.
In fact, my current model [1] is that this is the very reason financial markets can exhibit bubbles of “irrationality” despite all their beautiful properties of self-correction and efficiency.
[1] For transparency, I basically downloaded this model from davidmanheim.
That model works, but it requires irrational agents to make it work. The bubble isn’t really “stable” in a game-theoretic equilibrium sense; it’s made stable by assuming that some of the actors aren’t rational game-theoretic agents. So it isn’t a true Nash equilibrium unless you omit all those irrational agents.
The fundamental difference with a signalling arms race is that the model holds up even without any agent behaving irrationally.
That distinction cashes out in expectations about whether we should be able to find ways to profit. In a market bubble, even if it’s propped up by irrational investors, we expect to be able to find ways around that liquidity problem—like shorting options or taking opposite positions on near-substitute assets. If there’s irrational agents in the mix, it shouldn’t be surprising to find clever ways to relieve them of their money. But if everyone is behaving rationally, if the equilibrium is a true Nash equilibrium, then we should not expect to find some clever way to do better. That’s the point of equilibria, after all.