Financial Crisis Lessons From Experimental Economics

Economic scholarship tends to operate in silos. That is, banking scholars don’t talk to macroeconomists, etc. Sadly, this is even more so between finance, monetary and experimental economics. In his latest book, Rethinking Housing Bubbles, Nobel Prize winner Vernon Smith, the father of experimental economics, offers a number of lessons that could greatly improve the stability of our financial system.

Some of these include:

• Markets for perishable goods behave generally well and do not tend to display bubbles, whereas asset markets commonly display bubble behavior in experimental settings.
• Allowing margin buying (leverage) significantly increases bubble size and duration for inexperienced buyers, but not for experienced.
• Even sophisticated buyers, when inexperienced, display bubble behavior.
• Experience helps: repeated play in an experimental game brings price behavior closer to fundamentals.
• Informed “inside traders” can reduce size of bubbles.
• Presence of futures markets can stabilize prices in spot markets.
• Additional liquidity increases size and duration of bubbles.
• Bubbles can develop even when participants are fully informed as to operation of the market (they know with certainty future incomes streams and how the market functions).

In terms of policy recommendations, the list above suggests a few things to me. First, policymakers should pay close attention to asset markets. Second, higher down-payments, particularly among first-time buyers, are likely to reduce housing bubbles. Policy should be tolerant of informed buyers, such as hedge funds, buying-up foreclosed homes.

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Consumer disclosures, like Truth in Lending, are likely to be useless. Financial literacy should focus less on information and more on experience. Excess central bank liquidity is likely to contribute to asset bubbles.

Perhaps the biggest lesson is that bubbles in experimental asset markets are quite common, especially markets were buyers have little experience and engage in few transactions (sounds like the housing market).

We will touch upon some of these issues, and others, when Vernon Smith comes to Cato next week to discuss his new book. You can register (or watch streaming) here.