Why Governments Can’t Stop Market Crashes

Published by at 12:27 pm under Economics

Globe and Mail Update
January 7, 2009 at 6:00 AM EST

Vernon Smith, the American economist who won a Nobel Prize in 2002 for his laboratory scrutiny of abstract economic theory, demonstrated that you can’t end market crashes by imposing more government regulations. Born to a poor Kansas farm family on Jan. 1, 1927, he turned 82 last week. His early life was inextricably shaped by the Great Depression – by hardships that provided an enduring incentive to succeed. (As a child, one of his chores was to keep the woodstove in the kitchen supplied with dried corncobs and dried cow chips.) “Like many of my generation,” he says in his unassuming autobiography, posted on Nobelprize.org, “I am a product of strange circumstances of survival and of successes built on tragedy.”

Like many of his generation, too, he was “born socialist.” His mother’s first vote was for Eugene V. Debs, the socialist candidate for president, in 1912. His own first vote was for Norman Thomas, the socialist candidate for president, in 1948. Well into his adult years, he believed that the best society, economically and politically, would be a society mostly governed “by a few wise men.”

In later years, in the lab, things looked different. Obsessed with the task of determining why people act as they do in market decision making, Prof. Smith developed ways to observe them doing comparable things in controlled and simulated settings. He conducted his first experiment in 1956; it lasted six minutes. Subsequently, across 50 years, he conducted thousands of experiments, using tens of thousands of subjects from all backgrounds – from school kids to business tycoons. As he studied the results, he came to believe that people are, in fact, “born traders,” inherently savvy in marketplace transactions regardless of education or professional status.

“I think that people are natural traders,” Prof. Smith told Reason magazine in 2002. “We’re social animals. We’re very much into social exchange. We’re surprisingly generous. You do something for me and I do something for you. The benefits of market exchange are easy to see in personal interactions. Out there in the markets, though, they are not always clear.”

Prof. Smith turned decisively libertarian. People, he concluded, should be left as free as possible to make their own economic decisions. “Whether we’re talking about politics, or economics or social interaction,” he said, “the best systems maximize the freedom of the individual, subject only to the constraints of others in the system.” This is, of course, the definition of classical liberalism, which affirms decentralized decision making.

The formats for Prof. Smith’s market experiments vary. In one version, a number of people (traders) are given the same investment opportunity – an investment, say, that pays a 24-cent dividend every four weeks for 60 weeks. The guaranteed return is thus $3.60. In the lab setting, the times get compressed; the dividend is paid every four minutes. The traders engage in the computer-assisted buying and selling of this income stream. The process may be repeated, with variations, 15 times in a single session. Invariably, as Prof. Smith (and other economists) have repeatedly shown, traders bid each other up well beyond the actual worth of the investment. In 90 per cent of the sessions, trading ends in market crashes. Author and editor Virginia Postrel, by the way, has written a lucid and illuminating account of this research (“Pop Psychology”) in the December issue of The Atlantic magazine. Experimental economics demonstrates that people don’t normally buy and sell assets based on fundamental worth. People normally are momentum traders, trying simply to buy low and to sell high – a process that, repeated enough times, must eventually end in crashes. Laboratory research by Dutch economist Charles Noussair shows that the lab traders who make the most money are not people who determine fundamental worth; they are people who buy a lot of assets at the beginning of a trading cycle and then sell out midway through the game.

Prof. Smith’s experiments remain relevant. In his most recent research, published last year in the American Economic Review, Prof. Smith and his associates – he holds academic posts on both the East Coast and the West Coast – tested the theory that easy money, by itself, can cause bubbles. In this experiment, the economists used only experienced, old-pro traders (to eliminate any chance that “newbies,” or market novices, might warp the results). Part way through the experiment, the computer abruptly doubled the amount of cash in “the system.” The result? The savvy traders took bidding far above fundamental worth and generated a bubble equal to the bubbles regularly produced by novices. In essence, the lab anticipated real life.

In her own analysis, Ms. Postrel offers a couple of fundamental alerts from the economists who work in labs. Beware easy-money markets. Beware novel investments (such as dot-com and bundled-mortgage investments). Beware also savvy investors. Who should you trust? Prof. Smith holds that markets are highly decentralized institutions that can function properly only with highly decentralized decision making – the very opposite of the government-directed markets of the moment.