Bryan Caplan  

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Scott Sumner just replied to a piece I wrote back in April on the crash of 2008.  Having lived through the crash - and lost a ton of money - it seems like a big part of the explanation has to be a sudden mood swing on the part of investors.  Doesn't this violate the Efficient Markets Hypothesis?  Not if these mood swings are unpredictable and subsequently affect the real economy.

Scott's not convinced:
My first observation is that it is very hard to know what the market is thinking about, as the market is much smarter than any of us, and gets "news" long before we do.


A second factor is policy credibility.  It may be coincidence, but right around the time of the three crashes there was a major loss of trust in the government.  In 1929 and 1937, investors lost confidence in the President, and in early 2008 there was a loss of confidence in Paulson and Bernanke's ability to manage the situation.


By early October I think the markets came to the conclusion that the world economy was falling fast, and that the Fed would be unwilling or unable (take your pick) to prevent a sharp downshift in NGDP growth.  The exact same thing occurred in October 1929 and October 1937.


My theory is that stocks don't have much independent effect on AD.  When expectations for NGDP growth do not fall sharply, then we don't see a recession after a stock crash.  We often see stocks fall before a recession because the market often sees the recession looming ahead.
Scott goes on to point out problems with the panic story:

1.  The law of large numbers.  People don't independently all become nervous at the same time, for no reason.

2.  I presume Bryan had some contagion effect in mind.  But what causes the contagion?  Why does it occur in some stock declines and not others?  There is a lack of serial correlation in stock prices.  When prices have fallen for three straight days, there is still a roughly 50-50 chance they will rise on the 4th.  So if the panic was internally generated, if the beginning of the crash created panic, which led to a bigger crash, then why wouldn't stocks that had fallen three straight days be likely to fall on the 4th day?

3.  If the panic was triggered by an external news event, why wouldn't the crash have occurred on the day after some big event like the Lehman failure.  Instead it occurred in early October when there was relatively little financial news.  The only news I recall during that time period were persistent reports of very bearish forecasts about real growth and steeply falling commodity prices.  Put the two together and you have very bearish forecasts about NGDP growth.  The other news was a growing sense that Paulson and Bernanke were in over their heads, but that fits in with my "monetary policy failure" argument.

What do you think?

Comments and Sharing

COMMENTS (5 to date)
Scott Sumner writes:

Thanks Bryan, I guess I rushed things a bit, as there is a typo. The loss of confidence was in early October 2008, not early 2008. Sorry for being so long winded (what did Arnold mean by "shorter" Scott Sumner?) but it's hard to shut up a monetary crank.

Remember that not a single brain cell in your head knows what the hell is going on, but collectively your brain cells know a lot. We shouldn't be surprised that individuals, even very smart individuals like you, aren't able to ascertain why a market is crashing, as it is crashing. I also lost money.

Ironman writes:

If I may, since you're entering into my particular bailiwick....

The stock market has behaved exceptionally rationally throughout the period you've identified as the "Crash of 2008". What happened back in October 2008 is that a large number of publicly-traded companies began announcing that they would be slashing their dividends per share going forward (particularly the financials, which still represented a large portion of the market capitalization of the entire stock market.)

The growth rate of stock prices then changed in direct proportion to the changes in the expected future growth rate of their underlying dividends per share, and since that rate of change was negative, stock prices fell. This post has snapshots of that process.

In March of this year, that process changed. Companies stopped slashing their dividends per share and the rate at which investors expected the future growth rate of dividends per share to change responded by turning positive. That change in outlook from "rapidly falling future dividend growth" to "much less bad falling dividend growth" provided the positive acceleration we've observed in stock prices during the period in which they've rebounded.

The rules behind changes in stock prices turn out to be pretty simple, it's their application that's complex.

fundamentalist writes:

Since Kling, Sumner and Caplan are so opposed to Austrian economics, I have to tell you that I didn't lose money in the stock market, thanks to Hayek's business cycle. I was fully invested in the stock market until the summer of 2007. Then something I read in Hayek made me think the end of the boom was near and I got completely out of stocks and into cash. The market peaked about 6 months later. I should have switched to bonds. I got back into stocks in March of this year.

Make fun of the ABCT all you want, but I doubt many investment advisers who follow the ABCT lost money in the market crash. Proof is in the paper "No One Saw This Coming": Understanding Financial Crisis Through Accounting Models" by Dirk J Bezemer, Groningen University available at

fundamentalist writes:

I hope my post above doesn't give the impression that I take pleasure in anyone's losses in the stock market. I certainly do not. I have too many friends who lost a great deal of money. Some will have to put off retirement indefinately. Others have had their standard of living in retirement reduced dramatically. At the time I got out of the market, I was relatively new to the ABCT and didn't have the courage to advise others to get out when I did. Still, I knew people who did offer such advise and no one took it.

Walt French writes:

in early 2008 there was a loss of confidence in Paulson and Bernanke's ability to manage the situation.

So, had the duo not inspired the confidence in the first place, would the October meltdown have happened earlier in 2008? ... 2007? ... 2001?

In other words, the first answer begs the question. What caused market participants to worry, even if they held off acting for months?

The second answer is, to my mind, even more problematic than the first. Surely, the market, which "gets 'news' long before we do," must have received dramatically better news starting in early March of this year -- much better than they had even weeks before.

With four months of hindsight for those of us in the boondocks, what the heck was it? That the March Geithner was so much better than Paulson or the February Geithner? That Barney Frank amped up his speeches? Or that compared to Bush, who was apparently told to shut up after August so he didn't spook the markets, Obama seemed suddenly better than he campaigned? It couldn't have been the economic news -- orders, employment, income, home prices, etc were all dropping at near-maximum rates.

'Most every evening I enjoy the little joke by the radio stations and online news sources in the form of "the Dow went up by X% today because investors [embraced | shrugged off] Y news, that was [better | worse] than predicted. Analysts said that future gains were now expected to be [stronger | weaker]." I'm afraid Mr Sumner's fantastical explanations, summed up in his third answer, fall into that same category of certainty about a very fragile understanding -- by us investors and by Mr Sumners -- of how others will vote in the Beauty Contest.

No, the amazing thing is that anything resembling an equilibrium, with reasonably-valued inputs, ever appears to take place.

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