Steven Gjerstad

MONETARY POLICY, CREDIT EXTENSION, AND HOUSING BUBBLES: 2008 AND 1929

ABSTRACT Asset‐market bubbles occur dependably in laboratory experiments and almost as reliably throughout economic history—yet they do not usually bring the global economy to its knees. The Crash of 2008 was caused by the bursting of a housing bubble of unusual size that was fed by a massive expansion of mortgage credit—facilitated, in turn, by the longest sustained expansionary monetary policy of the past half century. Much of this mortgage credit was extended to people with little net wealth who made slender down payments, so that when the bubble burst and housing prices declined, their losses quickly exceeded their equity. These losses were transmitted to the financial system—including banks, investment banks, insurance companies, and the institutional and private investors who provided liquidity to the mortgage market through structured securities. It seems that many of these institutions became insolvent; it is certain that they became illiquid. Liquidity loss and solvency fears created a feedback cycle of diminished financing, reduced housing demand, falling housing prices, more borrower losses, and further damage to the financial system and eventually the stock market and the real economy. There are important parallels with the housing and financial‐market booms that led up to the Crash of 1929 and the Great Depression.

The rate of convergence of continuous fictitious play

Summary. The rate of convergence to Nash equilibrium of continuous fictitious play is determined for a generic set of utilities and initial beliefs in 2 × 2 games. In addition, an example is provided comparing the rate of convergence of discrete fictitious play to the rate for continuous fictitious play. Finally, the convergent dynamic of fictitious play is related to the nonconvergent gradient process dynamic in 2 × 2 games.

Market Dynamics in Edgeworth Exchange

Edgeworth exchange is the fundamental general equilibrium model, yet equilibrium predications and theories of price adjustment for this model remain untested. This paper reports an experimental test of Edgeworth exchange which demonstrates that prices and allocations converge sharply to the competitive equilibrium. Price convergence is evaluated with the tatonnement model, interpreted as a disequilibrium model of across- period price adjustment. Subsequently, the extent of within-period adjustment is compared to that of across-period adjustment. Since most observed price adjustment occurs within trading periods, price adjustment data is evaluated with two disequilibrium models of within- period trades. These models are the Geometric Mean model, which is formulated in this paper, and the Hahn process (Hahn and Negishi [1962]). Price dynamics from experiment sessions fit the Geometric Mean model better than the Hahn process, and in addition, the Geometric Mean model provides direction for development of an Edgeworth exchange bargaining model.

Price Formation in Double Auctions

We develop a model of information processing and strategy choice for participants in a double auction. Sellers in this model form beliefs that an offer will be accepted by some buyer. Similarly, buyers form beliefs that a bid will be accepted. These beliefs are formed on the basis of observed market data, including frequencies of asks, bids, accepted asks, and accepted bids. Then traders choose an action that maximizes their own expected surplus. The trading activity resulting from these beliefs and strategies is suffcient to achieve transaction prices at competitive equilibrium and complete market effciency after several periods of trading.

Retrading, production, and asset market performance

Significance We conduct the first experimental study to our knowledge of production and trade in a stock-flow market for durable assets. When inexperienced consumers are allowed to resell assets they compete with producers and depress prices, disrupting production and causing inefficiency. Consumers with experience specializing as buyers compete less vigorously, which allows prices and production to converge to equilibrium. Prior studies have shown that traders quickly converge to the price–quantity equilibrium in markets for goods that are immediately consumed, but they produce speculative price bubbles in resalable asset markets. We present a stock-flow model of durable assets in which the existing stock of assets is subject to depreciation and producers may produce additional units of the asset. In our laboratory experiments inexperienced consumers who can resell their units disregard the consumption value of the assets and compete vigorously with producers, depressing prices and production. Consumers who have first participated in experiments without resale learn to heed their consumption values and, when they are given the option to resell, trade at equilibrium prices. Reproducibility is therefore the most natural and most effective treatment for suppression of bubbles in asset market experiments.

Rethinking Housing Bubbles: Economic Crises, Economic Policy, and Economic Analysis

The committee determined that a trough in business activity occurred in the U.S. economy in June 2009. The trough marks the end of the recession that began in December 2007 and the beginning of an expansion. The recession lasted 18 months, which makes it the longest of any recession since World War II. – Business Cycle Dating Committee, National Bureau of Economic Research, September 20, 2010 The crisis showed that the standard macroeconomic models used by central bankers and other policymakers…contain…no banks. They were omitted because macroeconomists thought of them as a simple “veil” between savers and borrowers. – The Economist , January 19, 2013 Macroeconomic Policy: Failed Expectations In a speech on January 10, 2008, when the National Bureau of Economic Research (NBER) had yet to declare that a recession had begun in the previous month, Chairman of the Federal Reserve Ben Bernanke stated: “We stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks.” Then, in response to a question following his speech, Bernanke replied that “The Federal Reserve is not currently forecasting a recession” but noted that it was, however, “forecasting slow growth.”

Rethinking Housing Bubbles: Goods and Services Markets versus Asset Markets

Cassano agreed to meet with all the big Wall Street firms and discuss the logic of their deals – to investigate how a bunch of shaky loans could be transformed into AAA-rated bonds. Together with [Eugene] Park and a few others, Cassano set out on a series of meetings with Morgan Stanley, Goldman Sachs, and the rest – all of whom argued how unlikely it was for housing prices to fall all at once. “They all said the same thing,” says one of the traders present. “They’d go back to historical real-estate prices over 60 years and say they had never fallen all at once.” – Michael Lewis, Vanity Fair , July 2009 It’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis. So, what I think is more likely is that house prices will slow, maybe stabilize, might slow consumption spending a bit. I don’t think it’s gonna drive the economy too far from its full employment path, though… – Ben Bernanke, CNBC Interview , July 1, 2005 Two Types of Markets: The Good and the Sometimes Ugly This chapter summarizes findings from two distinct types of experimental markets that are directly relevant to understanding the sources of both stability and instability in the macroeconomy: (1) the class of nondurable consumed goods and services that constitute about 75 percent of U.S. private expenditures (i.e., GDP minus government expenditures); and (2) asset markets, particularly those in which the items traded have long lives and whose market value, therefore, may be importantly influenced by the future price expectations of the participants (prominent examples include houses, securities, and commercial real estate). The parallels between the laboratory and the economy in each of these two cases suggest underlying modes and principles of human behavior that are similar – conditional on the differing characteristics of the items being traded in these two broad categories of economic activity.