Smith, emeritus professor here at GMU, ran experiments that I think give us
a good reason to blame the Fed and Fannie and Freddie for a fair amount of the
financial crisis--but for some reason, I don't see other economists connecting
the dots the way I have.
Back in the 80's, Smith and his coauthors ran the first bubble experiments:
Students (and professional traders!) kept creating asset price bubbles in these
experiments. Lab subjects routinely traded these assets at freely-negotiated
prices that were far above their objective cash value. But he found that as subjects played the same
game again and again, bubbles became less common--people learned the lesson of
The Who: "Won't Get Fooled
One lesson a person could draw at this point: Perhaps lab
bubbles don't really tell us about real life.
After all, real life lasts a long time, and people in real life hear stories
about bubbles, so maybe normal people are already at the Won't Get Fooled stage.
But a funny thing happened: The bubble literature grew. A key finding:
When you add liquidity to the market--even with the same set
of experienced players--you can reignite bubbles. Liquidity
Did we see liquidity pushed into the housing market? Of course we did. Not just the Federal Reserve's low rates in
the mid-2000s (lower
than the Taylor Rule recommended); we also saw the massive entry by Fannie and
Freddie into the fringes of subprime, the most dangerous portion of the market.
The private sector created the housing bubble in the same
sense that college students created bubbles in Smith's experiments: They voluntarily
made the trades but Fannie, Freddie, and the Fed created a liquid, bubble-prone