29/05/2009: Asset bubbles, cavemen and central bankers

Imagine you are a happy Pleistocene, a caveman hunting where saber-toothed tigers roam. Suddenly there is a soft, rustling noise behind you. You have two options: either you run, assuming a tiger is near, or you dismiss the sound as meaningless and continue to hunt. You may have made the right choice or the wrong one. In fact, there are two wrong choices here. If you run and there is no tiger, you miss the hunt. On the other hand, stay and you might end up a saber-toothed snack.

Behavioralists call the first mistake, spotting a pattern where there is none, a Type 1 error, and the second, missing a pattern when it is there, a Type 2 error. Humans generally make far more Type 1 errors than Type 2s. We are specialists in finding meaning or causality where none exists, as documented in psychologist Bruce Hood’s recent book, “SuperSense.”

Obviously Type 1 errors bear costs. As investors, they make us susceptible to “narrative fallacy,” when we succumb to the charm of a story purporting to explain why a particular asset rallies even though it may be pure fantasy. Nassim Nicolas Taleb illustrates this impulse profoundly in his book, “The Black Swan.”

We seldom make Type 2 errors, though we may do so implicitly when we choose the wrong pattern or explanation in a Type 1 mistake. Type 2 errors are usually much costlier than Type 1s. For our caveman, missing the hunt is far less costly than being eaten by a saber-toothed tiger.

During the past fifteen years, Type 2 errors obscured two costly asset bubbles. Not only were individuals wrong, but so were large financial institutions and even central banks. As with our caveman, a Type 1 error—running from a nonexistent bubble—only costs a missed investment opportunity. The Type 2 error of failing to recognize an asset bubble as it swells and quivers and hisses behind you, we now know, can be far more costly.

Central bankers seem particularly Type 2-prone in the face of asset bubbles. Former Fed Chairman Alan Greenspan didn’t recognize the Tech bubble, bloated by its fantastical valuation metrics, because he liked the narrative of a new economy spurred by technology-driven productivity gains. Current Fed Chairman Ben Bernanke argued as late as 2005 that pumped-up US house prices “largely reflect strong economic fundamentals.” The few who rang the bubble alarm over house prices were dismissed as Type 1 phobics, though we now see it was their detractors who committed a massive Type 2 error. And once that bubble burst, almost everyone got very, very wet.

These two big asset bubbles should make the case for central banks acting early, at the mere hint of a bubble-in-the-making, since early intervention costs far less than a Type 2 meltdown. But I suspect this is not the path central banks will chose, even after the current crisis. At the end of the day, central banks cannot defy political will: if they remove the punchbowl from the party too early, they invite the public’s wrath. So, like an ignored saber-toothed tiger, bubbles will surely continue to catch their prey.