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0:00
- So we're gonna go ahead and get started with a talk by Emma Rasiel. Emma is the Teaching Director of the Duke Financial Economics Center as well as the Eads Professor. So Emma? - Lee, thanks so much. It's a real pleasure to be here at this conference. I was at a similar conference 10 years ago when all of this was going down. And everybody's prognostication about how things would play out, of course, was completely wrong. But what I'd like to do this afternoon
0:31
is put the most recent financial crisis kind of in context with historic boom-bust scenarios and look at some of the characteristics of all of them, characteristics both in terms of the economic environment leading into and then coming out of the boom-bust as well as some behavioral factors. I know some people earlier today were talking about the fact that we're human and we make human decisions not necessarily rational decisions. And I wanna delve a little bit deeper
1:03
into some of what those natural biases that we have, how they tend to steer us predictably in the wrong direction in financial settings. So to start off with, let's look at economic climate, pre-bubble crash scenarios. We've talked a lot about how it was in the credit crisis but do we see these similar patterns in a bunch of historic crises? So some of these crises you may have heard of. Everybody sort of thinks of tulip mania as the sort of first somewhat modern-day crisis.
1:39
South Sea Bubble, if you've heard of that one.
1:43
In the 1840s there was a boom-bust scenario over the railways. Of course everybody's heard of the crash of '29, the dot com boon and bust, otherwise known as dot bomb, and then, of course, to our most recent credit crisis.
1:59
So let's have a show of hands for that first pre-crash economic climate is it always the case that there's sort of easy lending and low interest rates before crises? We know that was true for 2008. I mean it was a credit crisis for Pete sake. But does that tend to be a characteristic of boom-bust scenarios? So let's have a show of hands. Are we gonna see that all of these different scenarios had a easy credit, low interest rate environment kicking them off? Hands up for yes, they really all do.
2:36
Hands up for no, I don't think they do.
2:41
Hands up for I have no idea, I'm really looking forward to hearing. (audience laughing) Awesome! That looked like it was about one third, one third, one third.
2:51
Almost invariably yes, in these crises absolutely.
2:56
Boom-bust scenarios require leverage to give them the extent of the boom and the bust. If there's a lot of leverage in the system, it means that people, when prices go down, people are not just losing their own money, they're losing other people's money as well because they've borrowed to add to their own money to give them a better return. So while we would undoubtedly still have economic cycles
3:29
if lending were not really such a big issue,
3:34
they wouldn't go up as high and they wouldn't come down as low, let's put it that way.
3:40
Another factor that we tend to see some of the time but not all of the time is whether there's some particular technology or some change in the way the world is working that people think of as significant and, therefore, get overconfident about the benefits of it.
4:00
So I've already given you the answers to these. You know, you look at tulip mania and you say yes, the bubble was about tulips, it's in the name. But it wasn't as if everybody thought that somehow tulips were going to change the world. So they were a bubble asset but they're not necessarily sort of changing the world. Similarly with the South Sea Bubble, there was this South Sea Company, there was this one company that people thought would do a lot of business and they were wrong about.
4:27
On the other hand, in more recent manias, the railway mania, everybody saw how much more efficiently people and packages could be passed around. And it made everybody so sure that the world was gonna get magnificently better. And the same with the other more recent bubbles. So what about broad societal speculation? I already asked you about the low rates and easy credit. But do we need sort of everyone in all levels of our society, finance people, business people in general,
5:03
the man on the street, Mom and Pop. Does it require everybody's involvement to get a really big bubble going?
5:12
Hands up for yes.
5:16
Maybe?
5:19
Somebody's brave enough to say maybe. How 'bout no?
5:23
Actually the nos have it. Often yes but not always. And that, whether it's broad societal speculation or not, can have an impact on what happens to the economic environment afterwards. So before we look at predictable irrationality, to borrow from Dan Ariely's book title,
5:49
what about the outcomes of recessions? Well, in the earlier ones that I have here not necessarily a recession. Interestingly even after tulip mania, obviously some people went bankrupt, but the economy there did not go into a downturn, okay? Similarly for the Railway Mania of the 1840s.
6:12
More often though, again because of ever-increasing leverage, we're seeing a bigger impact on economies going into the downturn in more recent crises than we necessarily did hundreds of years ago. So one of the factors that's driving that again is evermore leverage. Another factor that's driving that is globalization, higher correlation, to the extent that the American credit crisis moved all across Europe and around the world because they were investors in Europe
6:46
and around the world, who were investing in the bubble asset, houses I guess.
6:52
We're going to see that have a bigger impact on the economy coming back out again. All right, so are speculators predictably irrational? The answer to that is yes. But which of these particular behavioral biases? And rather than go through each of them in turn, I'm just gonna open it up and let you know.
7:18
We've heard, I think, all of these terms used today.
7:25
They relate to everything from the sense that we have of what we've heard most recently is most likely to be true. I think Doug actually said that in his talk. And absolutely, that people get overconfident. Overconfidence is a huge factor in bubble crises.
7:47
There's a sense of this time it's different. What's interesting about this behavioral feature is we see it from the more recent bubbles. We didn't necessarily see that during tulip mania or the South Sea Bubble. Any thoughts on why not? Why is this time is different a more recent phenomenon? (man coughing) - [Man] And tend to where it starts. - [Man] We've had better sight pattern to show us. - Precisely. There hadn't been enough previous bubble crash scenarios for people to be out there
8:21
saying this one is different. Other people would have said different to what? But now we really do hear a this time is different
8:32
in most recessions.
8:36
My favorite way of determining whether we're reaching the peak of a bubble, it doesn't work as well now after 9/11. All of the different banks on Wall Street moved around to different parts of the city. But pre-9/11, when most of the banks were in the Wall Street, Water Street kind of area in Manhattan, my sense was that if I got into a cab at LaGuardia and I said I was going to any address anywhere on Wall Street and the driver started telling me about his stock portfolio, I kinda knew
9:08
that was the time to exit the market.
9:13
So let us delve a little bit deeper into these
9:20
behavioral biases and what they did and how they impacted the various bubbles and crises that I'm thinking of here. So in the early 2000s, just again remind ourself of the context.
9:39
Home prices were soaring because there was so much more availability of lending to a strata of society, people with so-called subprime credit, who previously had been shut out of the housing market. If you introduce an entire new source of demand, you're going to see that happen. You're gonna see prices go up. House price appreciation in some states, more than 10% in 2002, up to 25% in 2003 to 2005.
10:14
House flipping.
10:16
Everybody and their brother watching housing prices go up was going and buying houses, not for the purpose of living in them, but basically just to hold them for a bit, maybe do a little bit of renovation, sink a couple of grand in to make it a bit nicer, and then sell it again six months later. Availability is the mental bias where, again, the more we hear about something, the more likely it seems to us. If everybody's talking about it, it must be true. Right?
10:48
So everybody was talking about house-flipping, so everybody was getting into house-flipping. There's a little bit of keeping up with the Joneses going on there. If everybody else is making money doing this exercise, why don't I get into it and do the same thing? And that was another reason why house prices were going up so far, both because everybody wanted to do it 'cause everyone else was, and because we're in an environment of easy credit and easy borrowing, okay?
11:19
One of the behavioral factors that we looked at on the previous slide is about sort of not listening to the calm voices of expertise who were out there warning everybody that we're in a bubble. These are sometimes called the Cassandras. There was a Cassandra in Greek mythology who kept knowing when something bad was gonna happen and telling people about it but the gods didn't like her and so they made it so that she knew what was gonna happen but that definitively
11:52
no one was going to believe her. And that's what we tend to see in bubbles as well. Professor Shiller from Yale had basically called the dot com boom and bust and he'd even got the timing right unlike many finance and economic professors. Apparently a lot of academia got it right but they got it right two years too early. Too bad.
12:16
So Shiller had already told us, had already called the bubble crash from dot com. He was out there in 2005 saying we're in a housing boom, we're in a bubble here. Everything's gonna go wrong.
12:31
But we didn't listen. And that's another feature of when everybody is making money we become overconfident.
12:40
We have a sense that we're making money not because we're lucky 'cause we happen to be in an environment where everyone's making money, but because we're smart. There's an expression on Wall Street, "Don't confuse brains with a bull market." If markets are going up, of course you're making money. It's not unfortunately that you're especially smart. It's that you're lucky you're in a market environment that's going up. Don't kid yourself about how much of that is luck versus skill.
13:15
At the very peak, I love this statistic, at the very peak, California had essentially one real estate license for every 75 adults living in the state. (audience chuckling) This term non-regressive prediction
13:35
basically means people think that because it's been going up, it will keep going up and keep going up forever. And that's what we're seeing then, non-regressive prediction. There were so many people who wanted to do the buy-flip, buy-flip exercise that there was ridiculous overconfidence and belief that this would carry on forever. Now it turns out, if you look at the data, it turns out house prices actually started to go down on an aggregate basis across the entire U.S. in late 2005.
14:10
But the thing about house prices is they're very local. Every state was seeing its own extent of going up.
14:19
Within states you had houses in wealthy neighborhoods, houses in poor neighborhoods. It's really to come up hard to come up with an average house price appreciation across the U.S. There are some indices that do that for us. One, for example, the Case-Shiller Index, I mentioned Shiller earlier, that allow us to watch that. People weren't really watching it. They were just looking around and seeing that house crisis, at least in some areas. Most areas were still going up to some extent.
14:50
So it took awhile for the information to seep through to the boarder market which is why we went from 2005 to the peak of the housing market, all the way to late 2007 before we actually had the bust.
15:08
So belief perseverance, it's been happening, it's going to keep happening. And again this overconfidence factor, which again I think Doug mentioned earlier. Overconfidence is one of the biggest factors that give us boom-bust environments.
15:30
There's another way overconfidence is interesting in that it's valuable for us. The fact that we have such an incredible environment of innovation and entrepreneurship in this country is because broadly as a nation Americans tend to be somewhat overconfident. And there are all sorts of reasons behind that. But it's not necessarily the same in all other countries. Aside from the U.S. which country has the most active, and successful entrepreneurial environment in the world?
16:09
- [Man] Israel? - Israel. My father-in-law is Israeli. Overconfident? You betcha! (audience laughing) So I wanna finish up here. There's just one more behavioral bias that I don't think has come up earlier today.
16:32
I'm gonna jump to it.
16:35
And that is something called money illusion. And the reason I wanna draw attention to money illusion, is because it's something that we haven't had to suffer from for the last 30 years. Money illusion is,
16:50
in this context, our sort of inability to take inflation into account. And there are a lot of young people in this room, even older people in this room, who never actually lived in an inflationary environment. We've had relatively low stable inflation since about 1983. It's never really, other than maybe the occasional quarter, gone up about four or five percent. For the last many years it's been more the two or three percent level. We're not used to thinking about inflation.
17:22
We've never been good at thinking about inflation. And when we looked at these charts of house prices going up from the '70s which is about as far back as we have aggregate data, all the way through to 2008 or 2007, 2005 was the peak. All we saw was house prices going up. Now,, of course, we then saw house prices going down and everybody was proved wrong. But if we had adjusted for inflation when we were looking at this house price chart,
17:55
we would have seen this going back to 1975. House prices do not always go up. The number might keep going up but when you adjust for, especially, the high inflation in the 1970s, what do you see here? You kinda see a cyclical market. It's extraordinary that people didn't think of this. But house prices do not always go up. They're cyclical. So on that note, what I'd like to do is open up to questions for a couple of minutes.
18:28
Anyone?
18:31
Yes.
18:40
- [Man] Hi, so do these cycles align with any other cycles of any type, I guess, the ones you have on the screen right now? - In terms of, you mean, of a correlated with other factors in the economy? - [Man] Yeah, like recession, stuff like that.
18:59
- Yes, but not 100%. So If you look at what was happening in the late 1970s, we had basically hyperinflation and also a very weak economy. So yes, house prices coming down, late '70s into the early '80s is fairly correlated with an economic cycle. What was happening in the '90s, early- to mid-'90s sort of not so much. So there's some correlation but it's not perfect. And that's an interesting point because, as we all know, having a diversified portfolio is key.
19:35
And the hardest time to keep your portfolio of financial and real assets diversified is during economic downturns because everything tends to get more correlated.
19:48
But really it was only from the '80s or early '90s that people even thought about houses as an asset as opposed to just a roof over their heads. So in that sense they don't necessarily follow the same cycle.
20:07
Sir. - [Man] What does Professor Shiller think now? (audience chuckling) - [Man] He says he it's nothing like the last two. - [Man] Oh no. - [Man] And the other thing I wanna say too is that there are probably millions of Professor Shillers that aren't gonna look so great in five years. I mean they're just, some of this is just a guessing game. I don't have a book that somebody wrote about the crash of 2016 and now looking back over my shelf, I can't find it. (man coughing)
20:29
Clearly somebody tried to get, promote themselves about their prediction. - Right, so the ability of people to predict crashes is considerably higher than the ability of people to predict when those crashes will happen. I mean, I'll stand here right now and tell you there will be a crash. (audience laughing) I promise you we're gonna have one. I have no idea when. It's a really a interesting question. I haven't actually looked at any recent reports from Shiller.
20:58
Now,, once again, clearly the guy is a genius, I mean, demonstrably, if you read his work. Nonetheless, you can get lucky about timing twice
21:10
and that doesn't necessarily mean you'll get it right the third time. So the timing is the hard part not the ability to know that it will happen. To some extent we can even predict, in some cases, around what asset the crash is gonna come but not the timing.
21:32
- [Man] I realize that three bubbles is not like, (man clears throat) is not a solid, not enough data points but if it seems like high leverage almost inevitably leads to a recession after a bubble happens, how do you sort of remedy that? Do you so limit the amount of leverage people can actually partake in? How do you go about that? - So actually what you've highlighted there rather neatly is another bias that we have in our heads which is, it's called, confusingly, confusion of the inverse.
22:07
So I said that when a bubble happens, it's invariably in the context of lots of leverage and easy borrowing. That is not the same as saying anytime there's lots of leverage and easy borrowing, there will be a bubble, okay? So we have to distinguish between those two things. There have been strong economic environments (coughing) that have lasted give or take decades that have included an environment where people can borrow easily and where interest rates are low.
22:42
That doesn't necessarily mean the bubble, right? Correlation, causation, direction, these things can change.
22:55
Sir. - [Man] Yeah, the bottom of the,
22:59
seems to have hit bottom a couple times there balanced. And that's pretty interesting to me. What's is that 30%? Is that some kind of income level, housing as a percent of income or how does that, why does it balance (man coughing) in the same point almost three or four times? - The index up the side is, I think, it's an adjusted index around the Case-Shiller housing numbers that Case and Shiller will put together every quarter and produce a number that reflects, as it were,
23:30
the average housing index level in the U.S. So the magnitude of the numbers is not that relevant. That just happens to be where their index is.
23:42
- [Man] Emma, what factors do you think we should what for that you think would be the most telling, that we might be in a bubble?
23:54
- When everybody and their brother and sister are talking about the fact that they've been buying financial assets and everybody's feeling really good about it, and nobody's listening to the naysayers. When you put all of these behavioral features together,
24:14
the overconfidence, the not listening to sage words of advice, you can even get to a point where, not only are people not listening to the sage words of advice that we're in a bubble, but actually twisting those words to interpret them being positive for the bubble asset. When we get to that point, unfortunately, I think it's all over. - [Man] Taxi cabs and cocktail parties, right? - Absolutely, absolutely.
24:42
So I'm gonna finish on that note. Thank you very much, folks. (audience applauding)
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