In June, Nobel economist Vernon L. Smith gave an Acton University speech titled “Faith and the Compatibility of Science and Religion.” While he was in Grand Rapids, he sat down with Victor V. Claar and went into some of the specifics of his lecture, as well as his vast experience in economics, including experimental economics. Their conversation was recorded as the cover feature for the Fall issue of Religion & Liberty. As a preview for this publication — which will be available soon — enjoy part of the conversation between these two esteemed economists:
Victor Claar: How did you first become interested in economics?
Vernon Smith: Well, I was an undergraduate at Cal Tech. I didn’t even know that economics existed. I was studying physics, chemistry, and mathematics. As a senior, we had a course, Principles of Economics. I was just fascinated by economics. By then, I pretty much decided I probably wouldn’t continue in science or engineering. I hadn’t decided what to do instead. But I took that course, and then I knew what I wanted to do next, which was to go back home: to the University of Kansas. I chose Kansas because that’s where I was from and, being entirely self-supporting, I could take advantage of their low in-state tuition. So I got a master’s degree there in economics.
That was a very good experience, so I went to Harvard from there. It came down to either MIT or Harvard. And after tuition, it was better to go to Harvard because MIT cost more. That was really important to me then. Of course I didn’t have much money.
So anyway that’s how I got into economics. And, you know, I’ve never looked back. Although I’ve utilized my engineering and science background.
You received both a masters and a Ph.D in economics, but your undergraduate degree was in science. How did you use your science background?
I can only speculate. But for me it seemed natural to use experiments to investigate questions concerning the operation and efficiency of markets, based on supply and demand theory. My background in science and engineering helped to facilitate that methodological development, but the real driver was my personal curiosity combined with my strong sense of ignorance of things important. At the time economists had little knowledge of how price theory was related to the actions taken by participants in various “trading institutions” a term not yet in our language. Later I and my colleagues were challenged more directly by the desire to study electric power systems and to examine the possibility of using markets to better manage the production and delivery of electric energy to consumers.
My interest in experimental economics began in the mid-1950s. We didn’t begin our laboratory studies of electric power markets until the mid-80s. That involved combining engineering with economics and experiments. It was very exciting! Events that I never anticipated. Specifically, that research led to my involvement in the liberalization of the electric power industry in New Zealand and Australia in the 1990s, based on our ongoing experiments with trading power in the lab.
Tell me about your work with asset bubbles. How did that begin?
We started doing asset trading in the 80s, and we were interested in bubbles. We thought that we’d begin by letting participants in our experiments trade in an asset market where the fundamental value of that asset is well known to everyone. We explicitly told them so that they knew everything they needed to know to make sensible trades. Then we were going to see if we could produce bubbles by manipulating the information. We didn’t have a well-articulated plan yet, but we were starting to get a feel for how these markets would work and whether they might bubble.
And they did! Over and over again, the participants in an experiment – even when we had given them everything they needed to know in order to make sensible trades – generated asset bubbles.
That’s a stunning result: That your experimental subjects would quickly converge to the predicted equilibrium in a market for something like a haircut—even when they didn’t each possess full knowledge of the market, yet in asset markets they made trading mistakes—even when you equipped them with full information.
Exactly. Under conditions that none of would have believed, you get bubbles. So we thought, “Well, okay. That’s what inexperienced subjects do.” Bring the same subjects back a second time and a third time and they will learn to behave themselves.
What about a good like electricity? And might computers aid in the convergence of a market to its equilibrium position?
Computer-assisted markets work even better in complex cases, and you can’t get a more perishable commodity than electricity. You cannot store it effectively and cheaply.
What’s been proven all over the world is that you can organize just about any industry for the production of non-durables based on “free”—meaning property rights governed—markets. But American regulated utilities don’t want to do that. That’s not where they think the money is for them. Beware of businessmen that come bearing the “gift” of regulation or its continuance. The utilities oppose de-regulation and we have to live with it, the airlines opposed de-regulation but we won out. I believe they are wrong in thinking that regulation is where the money is. The airlines opposed de-regulation, but today they are far more profitable with far lower prices than in the days of regulation. The profit comes from eliminating waste.
They’ve had the opportunity to learn.
Yes. But what’s interesting, you see, is that they learn by actually doing it. They don’t get there by just thinking about it. We economists normally expect that reasonable people should make sensible choices–that they ought to be able to figure things out. Well, they didn’t. And so, with naïve subjects in an asset trading environment, you get bubbles. But remember, even more naïve subjects in consumption markets didn’t have any trouble in our experiments.
At first we wondered whether there might have been something wrong with the experiments. But when we explored that particular possibility we discovered, “Well, no. That’s what the people want to do.” That was pretty neat, because we had a bubble factory.
My co-authors and I, on those bubbles papers, started to get a lot of citations. Eventually that quieted down. Then we had the Great Recession—and all the talk about housing bubbles—and people got interested in our work again.
Do you suspect that other economists have similar experiences in arriving at their publishable work? That they learn more through their own trials and errors than they let on in the published piece?
The standard scientific paper doesn’t have very much biographical experience in it. And that’s terrible, because it makes it seem like the results happened at once.
What’s your assessment of the Great Recession?
I moved to Chapman in December of 2007, the beginning of the Great Recession. It lasted from the fourth quarter of 2007 to the second quarter of 2009.
In our book RETHINKING HOUSING BUBBLES my colleague, Steven Gjerstad and I began by studying the Great Recession, and the build up to it. Median national house prices started upward in 1997 and peaked in the first quarter of 2006. We think that was not an accident, that what jump-started the 1997 price increase was one of the most popular bills that’s ever gone through congress. Democrats loved it. Republicans loved it. Libertarians loved it. You could realize as much as a $500,000 capital gain on a home–and pay zero tax. Everybody loved that. But if you take one asset and sweeten its after-tax return that much, you can expect money to flow into it. This is why I summarized the housing bubble with a quote from the POGO cartoon: “We have met the enemy and he is us.” The interesting thing about that bubble is that, if you look at the price chart, prices were increasing at an increasing rate, 1997-2006. In the lab that’s pretty rare. Most of the lab bubbles look like gently rounded hills not the Matterhorn.
If you look at recent previous housing bubbles, they are far less impressive than this one, which collapsed in a spectacular fashion. My first impression from our study of the Great Recession was, “Wow, this must be really unique, quite unusual.” We then went back to study the Great Depression. And we saw a lot of exactly the same phenomena. The data weren’t as rich as the data we have access to today, but what data existed seemed entirely consistent with housing and mortgage markets as the source of the 1929-1930 economic collapse.
Based upon what you discovered in an experimental setting regarding asset bubbles, should we be less surprised than we are when bubbles burst—like the ones at the front end of the Great Recession? And are there policy lessons for us all in terms of reducing the future likelihood of such bubbles?
I think so. I often argue that there’s really not any such thing as a free market in the sense that there are property-right rules that limit, constrain, or guide what one can or cannot do. Those property-right rules are basically the way they are because we’ve inherited them. Society still argues about those.
What separates the Great Depression from the Great Recession? How are those episodes different when it comes to bubbles?
The Great Depression was a more severe drop, but it also came back faster. Now, everyone believes we got out of the Great Depression because of Second-World-War spending. That’s the common explanation. And many economists have studied the effect of deficit financing on the recovery, but it’s basically ineffective.
Consider home equity, though. Equity in all homes peaked out in 1929, dropped by about 35 percent. Then it slowly recovered. The 1929 level of equity in all homes didn’t get back up until 1941; that’s 11 years.
In the spring of 2005, Greenspan’s Federal Reserve, the Open Market Committee, had a conference after the committee met. And the conference was about housing bubbles, specifically asking whether there was a housing bubble. This is 2005! Yes, there was a housing bubble. And the evidence was that when you looked at the ratio of home values to median incomes, it was way out of line.
Yes, they concluded, there was a housing bubble. And its consequences? Well, nothing too bad. They were estimating maybe a 20 percent drop in the housing market. And this wouldn’t have a major impact on the economy. But what data were they looking at? The 2001-02 recession, which was a fairly mild one: the stock market crashed and we had the tech bubble. So people looked at the effect that crash had had and it was not that significant. I was astonished that they were coming up with that.
Vernon L. Smith was awarded the Nobel Prize in Economic Sciences in 2002 for his groundbreaking work in experimental economics. He has the George L. Argyros Chair in Finance and Economics, and is a research scholar in the Economic Science Institute at Chapman University. He is the president and founder of the International Foundation for Research in Experimental Economics. Smith completed his undergraduate degree in electrical engineering at the California Institute of Technology, his master’s degree in economics at the University of Kansas, and his Ph.D. in economics at Harvard.
Victor V. Claar is professor of economics at Henderson State University in Arkadelphia, Arkansas, where he teaches courses in economics to undergraduates and graduates.