My Expedition

When times are unusually hard, as in the current Great Recession and 80 years ago in the depth of the Depression, markets and businesses are widely demonized, and we see a surging increase in «class warfare». This lashing out arises from a natural sense of anger one feels from being overpowered by external circumstances outside out control. As a reasoning species, we want to believe that such dire circumstances should and ought to be controllable by having people in charge who use reason and follow the right policies. Unfortunately that ideal continues to be well beyond human knowledge and its ability to implement that knowledge for avoiding  risk and uncertainty in our collective lives.

I grew up in the Depression in the midst of a socialist family and friends; the enemy was «capitalism» believed passionately by many to be the root of inequality, stagnation, poverty and war. My parents lost their Kansas farm in foreclosure to their mortgage lender in 1934 when I was seven years old; they personally lived and experienced the grapes of wrath. Invisible to my family and friends was that the typical foreclosed mortgage loan was larger than the lender could have collected from the sale of the collateral asset pledged against the loan. The total loss was distributed between both lender and borrower.

Both sides suffering under the loss in value might wistfully recall the words of Shakespeare’s Polonius in Hamlet, «Neither a borrower nor a lender be, For loan oft loses both itself and friend, And borrowing dulls the edge of husbandry.» But the ancient notion would not help the current circumstance any more than suggesting that the Depression was all a consequence of the excesses of the «roaring twenties.»

In my family, however, it was destined that «We shall overcome», but because we enjoyed the incomparable benefit of living in a free society where feeling downtrodden could be outgrown and outmaneuvered by somehow finding or seizing opportunity. My great fortune was to have had self-motivated parents devoted to using their eighth grade language skills for life-long learning; this was my launch-pad and I was the first in my extended family to both graduate from college and earn higher degrees. ¹

Although I would become a student in science and engineering in college, the Depression crucible would leave indelible marks that eventually prevailed in inspiring me to study economics and discover marketplaces as the field of complex human interaction. ²

Searching for a New Understanding: Could the Marketplace be «Rational?»

In 1955, as a beginning assistant professor at Purdue University, I was blessed yet again; this time in having many young colleagues tolerant and supportive of exploring paths of research and teaching that were not in the familiar traditions that had constituted our graduate educations at Chicago, Harvard, Stanford, Oxford and Johns Hopkins. In teaching introductory principles of economics, I felt seriously uninformed in trying to articulate connections between equilibrium market theory and the choices and actions that human agents made in the marketplaces of the world. Theory was concerned with stories about the resting state of equilibrium, not about discovery processes, change and path evolution. I therefore resolved to use the bid/ask rules of commodity trading to explore in an laboratory environment how experimental subjects fare in a simple supply and demand market wherein each participant knows only his own value as a buyer, or her own cost as a seller; the first profits by buying below value, while the second profits by selling above cost. In this environment, each trade creates consumption surplus for the buyer and producer surplus for the seller. Unexpectedly, and contrary to prevailing beliefs and teaching in economics, the participants tended through trial-and-error repeat trading quickly to approach the equilibrium predicted by theory—an outcome unknown to both sides, but unintentionally found, by the group. They are using the market place to better themselves through specialization. These experiments resulted in a gradual, but unintended, transformation of my own thinking during the 1960s and 1970s.

But the New Learning Did Not Extend to the Asset Marketplace.

Then in the 1980s, I and my coauthors began to explore a much different kind of marketplace harbouring insights with crucial implications for financial markets. We conducted experiments in  which the participants are trading an asset that yields a dividend and «lives» across the whole horizon of the experiment. In every period of the experiment each person receives a common surplus yield value (a cash «dividend») based on his or her units held at the end of the period: the good’s value comes from holding it (or renting it out), not from consuming it. But you can freely buy and sell more or less of it. The idea was that people would rationally trade at prices near the «fundamental value» (FV) remaining in each unit of the asset—the average yield value per period  times the number of periods remaining. This the participants most dramatically did not do; we observed price bubbles and crashes – developments that deviated blatantly from  the predicted path of declining value.

The manifest question was then: what conditions would eliminate these unsustainable and «irrational» group divergences from FV? Conducting the experiment over and over again under different conditions showed that what matters first is experience: bring the participants back to the laboratory twice more, and finally they would trade near FV. This was hardly encouraging, for in the marketplace of the world outside the laboratory you could not give people experience while holding constant their circumstances. (That would be like putting everybody through a repeat play of the roaring twenties, and the subsequent pain of the Depression, until they modified their behavior). Second, we started to vary the participants’ ability to borrow money, or we varied their endowments of cash relative to asset shares. The result: more money or credit produced bigger price bubbles. Third, we tried paying no cash dividend after each trading period, instead paying the entire amount as a lump sum, based on shares held at the end of the experiment. Presto: we observed no price bubbles. Bubbles in these experiments were entirely fueled by the availability of cash, or the amount of «liquidity» in or flowing into the marketplace.

Experimentalists routinely ask whether the subjects make a difference. So, instead of undergraduate students we used small business men and women, several different groups of middle level corporate executives and at one point recruited a group of over-the-counter stock market traders. But it was all to no avail: we still observed the same bubbles.

New Perspective on Experimental Marketplaces and the Economy: The Great Recession.

This experimental background led me to a new perspective on the role of markets in the Great Recession and the current crisis.  Before explaining how rule changes fostered irresponsible and short-term oriented behavior,  let me first emphasize that this recession is most accurately described as a household-bank balance sheet crisis. The historically immense housing bubble in the U.S., 1997-2006, was accommodated by mortgage debt financing. Houses are the most durable of all assets produced for consumptive use, and buyers relied on easy credit expansion to buy them, especially in the frothy three years from 2003 through 2005 when the Case-Shiller home price index rose 35 percent. As house prices flattened out in 2006, many homeowners who had relied on rising prices to refinance their loans were not able to refinance, and late 2006 brought a rapid rise in homeowners who were unable to meet their mortgage payment obligations.³ Consequently, home equity plunged. Since the banks hold this mortgage debt, their asset value declined against fixed deposit liabilities, and the banking system suffered a decline in equity that was the mirror reflection of household reductions in equity. When household and bank equity is low or negative, and may fall even further, households are not in a mood to spend and their banks are not in a mood to lend.

Moreover, our study of the last 14 recessions, including the Great Depression, revealed that although they vary in severity, 11 of them were preceded by declines in new home construction expenditures, while sustainable recoveries in the economy are always associated with a recovery in new housing expenditures.

Hence, market behavior in the world of houses (and other durable goods markets!) exhibit striking parallels to the asset experiments from the laboratory. In both environments we can see similar human behavior at the most fundamental decision making level. And it is these durable goods that are the source of instability in the national economy.

The often neglected distinction between the two sorts of goods is crucial for the perception of markets: In a national economy the great bulk of private output is non durable and consumed – think of food and personal services.⁴ Consumed output corresponds generically to the markets examined in the original experiments in which buyers and sellers find through trial-and-error-processes the price predicted by equilibrium theory. And the high performance of consumer nondurables parallels their stable behavior in the economy. Durable goods do not dominate in the total output of an economy. Thus it is not their dominance in total product which is the problem, but their volatility. And here we get to the source of the reputational damage of markets in general.

Rules and Order

The findings and conclusions about different behavior in different markets  imply that the demonization of markets needs a more informed focus on where the trouble spots are, and on finding solutions instead of finding blame. The important characteristic feature of asset market bubbles is that there is more than enough blame to spread around among those participating. Asset market bubbles are a form of contagion in which people are infected by self-reinforcing expectations of rising prices—here we meet the enemy, and he is us. During the recent housing bubble home buyers, sellers, borrowers, banks, mortgage originators, investors, public housing agencies, issuers of mortgage derivative «insurance,» all believed that prices would continue to rise. In the midst of those unsustainable expectations the daily wealth-creating work of the vast majority of markets were silently and dependably addressing people’s freedom to search in satisfaction of their desires, and these markets were not part of the daily news.

If we focus only on the volatile parts, we tend to forget that consumer markets for non durable goods worked during the financial crisis – and that they work today. What are called property rights—the rules of civil order and law that govern actions that are acceptable or unacceptable—are not today in question for these high performing consumer markets for perishables. To be sure there are always ongoing questions of consumer product safety, truth-in-labeling, smokers versus non-smoker’s rights, and drug control versus liberalization; rules that are not at issue in asking how we can avoid crises like the current balance sheet recession. The bottom line is that these markets, governing 75 percent of output, function quite effectively, and are never a source of national economic instability. Here property rights adapt easily to changing culture and technology, and perform relentlessly their task of human economic betterment. It’s the other 25 percent consisting of durables, particularly credit financed houses that are a persistent source of instability. And it is for these trouble spots that we need to find solutions. The question is then; do we have the right rules for housing-mortgage markets?

My view is that we do not; we had reflectively found better mortgage market rules in the past than we had in the recent housing bubble, but we mistakenly modified or abandoned them. To understand what I mean requires me to revisit two major rule-change developments that came out of the late 1920s and the Depression that followed:

(1) Securities markets, particularly margin rules; these rules have served us well and have persisted.

(2) Mortgage markets, particularly amortization rules. The modification of those amortization rules contributed significantly to the housing bubble.

I. Margin Rules Found and Retained

Ten trillion dollars came off the value of stocks in the dotcom crash, 2000-2002, with no adverse effects on household or bank balance sheets; only a mild recession in 2001 ensued, attributable to weak private nonresidential domestic investment. Similarly, the enormous stock market crash of Oct 19, 1987 yielded no recession. Why? Because of long standing limits placed on the use of bank credit for investments in securities. Beginning a year and a half before the stock market crash in October, 1929, private brokers had begun raising the cash margin requirements for stock purchase loans, from 25 percent to 50 percent on the best companies (higher for riskier stocks). Four years after the crash, in 1933 the New York Stock Exchange, for the first time in its history, required all member brokers to apply minimum 50 percent margin rules to all their customer accounts. Then in 1934, the SEC Act codified this private experience and learning into civil law.

The governing consequence of this change in property rights is simple: it confined the primary damage from stock market crashes to  the investors responsible for the preceding bubble; there is minimal external financial fallout at large for the banks, and for the economy.

II. Mortgage Amortization Rules Found Then Abandoned

When the Great Depression began in 1929, new housing expenditures had already declined 37 percent from its peak four years earlier. Although Savings and Loan banks had long amortized practically all mortgage loans, between 1925 and 1929, 85 percent of mortgage loans by insurance companies and 88 percent by commercial banks were interest only loans or were only partially amortized.⁵ Like in the current crisis, this meant that there was a large balloon payment at the end of the loan period. Moreover, the average bank mortgage was for only three years. The experience of the Depression brought a dramatic change in these private practices, as well as new legislation governing mortgage terms. By the late 1930s only 10 percent of bank mortgage loans were not fully amortized.

High mortgage standards for both Federal and privately financed homes remained the norm for decades, but began to erode in the 1990s with the growing political consensus, and widespread private financial accommodation, that U.S. society should be more aggressive in mortgage lending to low-to-middle income families.

Regrettably, our attempt to help people of modest means backfired. We may have raised their expectations, but the effort did not work and quite unintentionally we may have done far more harm than good. It might even be possible that there was a problem deriving from Polonius’ recall that «borrowing dulls the edge of husbandry», but I don’t think we will ever know. I think we can say that the best way to help those who are disadvantaged is to try to find ways of helping them to help themselves – and applying insights about fundamental decision making behavior might help to improve self-help.

Looking back on history and data from the laboratory, I believe that the current episode of «class warfare» and the pulse of anger in finding who to blame, will pass. Human economic betterment, on average and in reducing inequality, has been advancing rapidly since about 1800, and is likely to continue after several years of substandard growth from the Great Recession.