Join 10,000+ savvy traders that get Michael's exclusive insights & podcast episodes.

as seen on:

Ep. 178: Vernon Smith Interview with Michael Covel on Trend Following Radio

Vernon Smith

Vernon Smith

Subscribe to Trend Following Radio on iTunes

Today on the podcast, I speak with Vernon Smith. He is a professor of economics at Chapman University in Orange, CA. He also shared the 2002 Nobel Memorial Prize in Economic Sciences with Daniel Kahneman.

Smith and I discuss economic bubbles. He talks about the lab experiments he conducted during his career, and why he concluded that bubbles were a fundamental human behavior.

We then talk about how the bubbles are created, the types of goods that tend to produce bubbles, and what types of goods are mostly immune to them. We then discuss the major differences between a stock market bubble and a housing bubble.

Smith finishes by talking about the history of economic bubbles throughout the last 2 centuries, and explains his ideological journey from socialist to libertarian.

In this episode of Trend Following Radio:

  • The difference between non-durable consumer goods and re-tradable goods in the market
  • Setting up experiments to produce artificial bubbles in the lab
  • Why bubbles are a fundamental human behavior
  • The difference between a stock market bubble and housing bubble
  • What factors affect bubbles, and why we still can’t predict them
  • The history of the free economy
  • What types of rules can prevent predatory loaning in the housing market

Mentions & Resources:

[toggle Title=”View Full Transcript”]MICHAEL: Today on the show I have Vernon Smith. Vernon is a professor of economics at Chapman University in California. Orange, California. He is also a former professor at my alma mater, George Mason University. He also shared the 2002 Nobel Memorial Prize in Economic Sciences with Daniel Kahneman. So that’s pretty strong credentials right there. Today, our conversation is about bubbles. Vernon is quite famous for going into the lab and learning, studying bubbles, bubble behavior. He has some strong views and some great insights. I hope you enjoy this conversation.

Hi, Vernon. This is Mike Covel. I think you’re expecting me this morning.

VERNON: That’s right, Mike.

MICHAEL: How are you?

VERNON: I’m fine, yeah.

MICHAEL: We last spoke at your office in George Mason, fall of ’07, fall of ’08, I believe. I fondly remember our conversation. But I wanted to jump in today, because I think you are someone who has an immense amount of experience in an area of economics that I still think, even though you’ve gotten quite a bit of recognition for it, I don’t think the average person – the average person could be a doctor, an attorney, a hedge fund manager – I don’t think the average person still wraps their arms around the idea of financial or market bubbles. And I wonder if you could maybe, out of the gate, jump in and let the audience know some of your experiences, some of your lessons, the things that you learned in the lab.

VERNON: Yes. My first experiments that I probably first established myself as an experimenter were actually published in the 1960s, and those were not asset trading experiments. They were kind of flow, supply and demand experiments, and important features that exist in asset market trading were absent there.

Those markets really work well. I mean, they converge quickly; people, without knowing anything about supply and demand, knowing nothing about this theory, could, through a bid ask trading process, over time, they would converge really within two or three periods of trading – it would depend upon how thick the market was; it’d even be faster if it was a very thick market – but even thin markets converged.

What I realized, but not until the great recession, is that those markets were like perishables. What is in the national income accounts that is closest to the representations that we did for the markets in the lab, what’s in the national accounts is what’s called nondurable consumer goods and services. Actually, the lion’s share are services. So it’s like haircuts and hamburgers, hotel rooms, passenger seats that you rent. Those things are not storable; they’re not re-tradable, expect maybe in an extremely narrow, limited way.

MICHAEL: And you weren’t seeing bubbles at that point in time?

VERNON: You see no bubbles there. Whether you’re a buyer or a seller, it’s sort of well-known and fixed in advance and it doesn’t depend on the price. Whether you’re a buyer or a seller of stocks, and also homes, as we have seen so prominently, it depends upon the price. You may decide to switch to a seller because of the price, you see. And that re-trading feature is the critical difference.

Now, the nondurable consumer goods, they’re very important. They’re by far the most important single category in the national income accounts. We’re talking about if you take total private product – and that’s gross domestic product minus government expenditures – if you take that difference, that’s gross private domestic product, nondurable consumer goods are 75% of that. Well, thank goodness that most of the GDP behaves itself really well and is very stable. And all of the trouble comes from the other 25%, and in particular, housing.

Does that give you an idea where I’m coming from?

MICHAEL: It does, and I think I’ve seen the comment from you; you say that we’re all born traders.

VERNON: Yes.

MICHAEL: There’s good and bad things to that, right?

VERNON: Right. In the 1980s – see, originally the experiments were done in the ’60s. We studied those under a great variety of different conditions, and they just all behaved themselves so well. It was a real victory for markets, for the general idea, are markets functional, are markets tendable, and wow, did this underline that.

Well, then in the 1980s – and you understand, we started doing asset trading really pretty much with the idea that we would simply find that markets did well there too.

MICHAEL: You had no preconceived ideas, really, though, other than they might mimic your early experiments, no real preconceived ideas that a bubble might happen.

VERNON: No, and in fact, the initial conditions, the whole idea – we’re going to make these markets so transparent that we’ll get convergence to the rational expectations, trading value. And then the idea, we’re going to build on that baseline and see if we could create bubbles. Well, we never got to the second stage of that grand plan, you see, because we had bubbles already.

MICHAEL: When you first started seeing that, what was that kind of “aha” moment you were having to yourself? What were you saying to yourself? Because you knew, in classical economics, you had to have known at that moment, “Uh oh, I’m kind of stumbling in or bumbling in, or something unexpected is happening, and this is novel.”

VERNON: Well, what’s interesting is that it was just as novel as the original experiments, but it was on the other side. That is, the original experiments I didn’t expect to work nearly so well, because it just seemed remarkable that people with no information except their own private, local information would, through market process, come to produce outcomes that you couldn’t improve on. I mean, they were really – it’s just remarkably efficient. So that surprised me. I got used to it, and then in the ’80s, we were going to extend this to asset trading, and whoa, we were getting wide differences, wide variation and bubbles.

So my first response was, “Well, let’s just lean on them harder. Let’s just remind them every period.” What we would do at the beginning, we would explain the setup and then point out to them what the fundamental holding value of the share was in the first period, and then we’d – of course, that was based upon dividends.

MICHAEL: I should point out, you’ve got a lab setting set up where you’ve got participants in a lab that you’re walking through an experiment, but you somewhat expect to see certain results, and then all of a sudden you’re seeing something completely unexpected.

VERNON: Yeah. So we went back and we thought, “Let’s just remind them every period.” Suppose the average dividend is 24 cents per period; they’re going to trade 15 periods. We’d not only tell them going into the first period – that means the holding value is – see, you’re looking ahead in the first period to 15 draws that would average 24 cents each. The idea is, the holding value, if it didn’t do anything but sit there, you would collect, over 15 periods, on average 24 cents each, so that’s $3.60. That would be the first period fundamental value.

So we’d tell them that. It would start out way below that and then tend to go up after the second, third, after two or three – by the fourth period, you had fundamental value falling as you used up draws, and then the trading value would go through that and soar above it.

We modified the instructions, and we would remind them each period, before they had the end of the period, “Okay, next period – there’s 10 periods left, so the holding value, dividend value, would be 10 periods times 24 cents per period average dividend draw, so it’s $2.40.” They didn’t pay any attention to this. So we’d bring them back a second time and then a third time, and by the third time, hardly anyone was trading very far from fundamental value. Very, very low.

MICHAEL: Vernon, what did you figure out was the time differential between those three periods? You say they had to go through the experience three times to have their wake up moment. How much time?

VERNON: Here’s the thing: people learn from experience. The problem is, we were giving them a thinking exercise, an information exercise. “Look, this is the information you have, and makes sense, this is the fundamental value, the holding value.” Well, if it’s the holding value, then surely you’d think people would infer that that’s also – no one should sell below that and no one should buy above that. So it ought, theoretically, to trade at that level.

Well, what happens over time is people, they come to have rational expectations, but it’s through an experience process. You don’t get there by just figuring it out. The way I often tell people is that they don’t think like economists. Why should they? And why should we get it right, you see, in terms of knowing what people will do and buy, in terms of their own understanding of their world?

MICHAEL: But some of your work was actually upturning long-held economic beliefs. This was, to some degree, for some people, I’m sure it was heresy.

VERNON: Well, yes, and it upturned my own beliefs, because I had a very traditional economics training. Harvard University. So I had these beliefs that surrounded all of the technical learning you had. But I always had a curiosity about how things worked. In fact, I started out, as you may know, not in economics, but in science and engineering at Cal Tech. Then I got into the economics when I was a senior, and I ended up changing. But that curiosity about how things worked and kind of an on-the-ground testing of things, of propositions, carried over into my interest in economics.

MICHAEL: And you also had, even as a young man, you had no real fear of upsetting the apple cart, so to speak. If you just were curious and you wanted to go down a path, you were going down that path, and you really weren’t too worried about what other people might say about you.

VERNON: Well, yeah, but it was out of naïveté more than any kind of fundamental understanding of how things worked. And I did, of course, do more traditional and conventional things. My first book that came out of my thesis – let’s see, it would’ve been published in 1960 – was on investment and production. Now, that had actually empirical stuff in it from engineering. But still, it was all quite traditional in terms of economic theory and what we in those days believed about markets.

The prevailing belief in supply and demand was that this is just kind of some competitive ideal, and unlikely to happen in the real world. You could get it out there if people have full and complete information on supply and demand. And this, remember, is in a hamburgers and haircuts world of perishables.

Well, it turned out that was false, that people were very good in that environment. But you see, there’s no re-trading. You’re buying something that fits your subjective utility value, and then you repeat that. You see, every time you go into the haircut or the hamburger market, or the hotel or rental room market, why you’re repeating that. And then sellers, on the other hand, are planning out what they can get out of the market in a competitive world. These markets just behave very well.

MICHAEL: When you get to the asset markets, though, people start thinking about getting rich.

VERNON: Yes, and also “I can resell this. I can re-trade it.” Hope springs eternal that you’ll be able to make money by reselling it to somebody else at a higher price.

MICHAEL: Can you explain, early on, you – and I’ll let you tell the story, but you ended up not having, if I’m saying this right, not having the greatest participants in your lab experiments, and you ended up going towards Chicago traders and bringing them in. Could you explain that story?

VERNON: Yes. You see, the first experiments we did would’ve been in asset market trading, would’ve been about 1983, ’84, when we’re getting these pretty wild results. And then when we were able to show that they converged with – bring them back a second and a third time, the same group, they would get there. We were starting to understand sort of what kind of learning responses we were getting from people.

But the question arose, well, these are just undergraduates. How about people out there in the world? Early on, I did do experiments with small business persons in the Tucson community. We brought them in – there was a guy at Hughes Aircraft in Tucson who was a member of the Kiwanis Club, and he was fascinated by these experiments that were going on in Arizona. So he contacted me once and said, “Would you be interested in if I were able to bring in groups from Kiwanis Club?” I said, “Well, sure. That’s great. They’ll earn the same money that the undergraduates do.”

So we had done some of these supply and demand experiments with them and then thought “We’ll try the asset trading.” Well, they produced just as big a bubble as we had gotten from anyone else. Now, we didn’t have the opportunity to do a second and third time. These were inexperienced in the experiment traders.

And then in 1989, I had a friend in Chicago who was able to recruit some over-the-counter traders. Those over-the-counter markets hadn’t been wiped out by electronic trading. They way they are now, everybody trades for himself, of course. So we had these over-the-counter traders, and we brought in a group of them at the university up there. We had our software set up. I figured, “Well, these are pretty sophisticated people; they can buy on margin and we’ll let them short sell.”

MICHAEL: This is their territory. They have some experience.

VERNON: Yeah, that’s right. They ought to do well with this. Well, they gave us the same kind of a bubble. Now, turned out it didn’t collapse at the end as much, but that’s because they had sold shares short, and then to cover their position they had to buy them back. That prevented the market from actually dropping, because people were covering all their short positions. It was really a very interesting experiment, but it didn’t disabuse us of the idea that bubbles were pretty fundamental to human behavior.

MICHAEL: Let me let you walk into an example which I think everyone can relate to. I look at the .com bubble bursting, and then I look at the spring of ’03; for whatever the policy reason might’ve been, the Fed brought interest rates down to about 1%. You could say the real estate bubble probably started earlier – you probably know more about that than I do – but we essentially had the bubble of all bubbles in real estate.

Why don’t you give me your perspective on that in watching it with your experience, and then maybe talking about how you see it all today? And if there’s been any lessons we’ve even learned.

VERNON: Okay. Well, let me first talk about the .com bubble, because one of the things that has struck me in looking over the last say 20 years, the buildup to the – see, the housing bubble started in 1997, peaked out in 2006, prices did. The .com bubble, which was strictly stocks, kind of peaked out around 2000, 2001, and crashed. It was a pretty big stock market crash.

One of the things, though, that’s interesting about stock market bubbles and crashes – and we went back and looked at earlier ones – they don’t cause anything like the problems that a housing bubble crash does. And in fact, if you look at credit to the stock market, that not only moves up as values go up, but it comes down right with them, in step. And the reason is that some market credit is short-term credit and it’s callable.

So if you have a stock position and you borrowed money, and the value of the portfolio falls so that you’re crowding the margin requirements – and basically, the margin requirement is like a down payment, except you have to maintain that position. Well, you have to put up more cash. So you either sell some and put up some cash, and if you don’t do it, that broker – you may have already authorized him to sell you out.

MICHAEL: The game’s over.

VERNON: You see, that’s a much different world. It’s a world in which you do not have negative equity. You don’t have a situation where what you owe is greater than what your assets are worth that plunges these people into negative equity. It’s all cleared out. The balance sheets are cleaned up as you go. So as stock market prices fall, the amount of credit outstanding just falls right in step. Maybe a very, very minor, slight lag.

Well, it’s completely different with the housing, because if you look at say from 1997 to 2006, you have total household wealth market value of all homes in the United States rising. Total debt rising in step with that, not quite as fast. And of course equity, home equity is rising with that. When the value of all homes starts to fall because the ones on the market you see are commanding a lower price, the value of homes starts to fall, but the debt doesn’t. In fact, the debt continues to rise very modestly, and then finally turns down.

So what you have is that people’s home values are falling against the fixed indebtedness, and all of that impact is on their equity. And the equity can easily go very fast.

MICHAEL: And to this day, what percentage of residential homes in America are still underwater? It’s a huge number.

VERNON: Well, I haven’t looked just recently, but 22% was what it was here earlier in the year. I’m sure it must be down some now, because prices have come up. But they were very high. Right away, people were plunged into negative – anyone who bought a home from about 2004 to 2006, the last two years of the fall from that bubble, their equity disappeared fast – if they had any.

One of my favorite data points is in 2005, 45% of first-time homebuyers paid no money down. So people were coming into the market for the first time – they’re buying a house entirely on the cuff.

MICHAEL: The great housing casino.

VERNON: Yeah. And guess what? A house lasts, what, 75 to 100 years? And you bought it with somebody else’s money? Actually, it’s bank money, of course, and credit. This is of course why, when those prices come down and you have all sorts of households plunged into negative equity, their banks are also being plunged at the same time into, if not negative equity, at least far lower equity. So as soon as the households are financially stressed because of their commitment to a purchase of a home, that distress is catapulted immediately into the banking system.

So you would have households just be very reluctant to spend in that world because they’re trying to pay down debt, and the banks that are holding the mortgages, they’re reluctant to lend. We still have – today, we don’t have a net flow of mortgage funds. They turned negative, meaning when the net mortgage fund is negative, that means that old loans are being paid off faster than new loans are being made. And that turned negative probably by about 2007; I’ve forgotten now just when that turned. And then it’s been negative; still is. But it’s coming up.

During the Depression, same thing. In the Depression, the net flow of mortgage funds didn’t turn positive until 1938. So that was a long period where the home mortgage market was just really in shambles.

MICHAEL: As we’re in the middle of this, one of the pieces of insights – and you’re going to correct me if I’m wrong about this – but you really didn’t come from your research with an idea of, in your findings, that you don’t really know why these bubbles happen. Is that a fair assessment?

VERNON: That’s a fair assessment in the sense that – now, we know quite a bit about the kinds of things that can influence them. For example, if people have more access to credit, or in the laboratory, if we just endow them with larger upfront cash amounts relative to shares they’re trading, you get a bigger bubble. More money, bigger bubbles. And that is clearly the case for these bubbles that you find out there in the economy.

But why it is that people get caught up in self-sustaining expectations and rising prices over and over again – if you’ve just been through one of these, then the people that are hurt may be reluctant to get in there. But that doesn’t mean that some others aren’t deciding, “Well, these things have bottomed out. We can start buying them again.” It’s interesting; about a third of the homes that have been sold the last few years were for cash. There’s a lot of cash buyers coming in because of the big drop in prices.

What did that do to those homes? I guess one of two things, or both. You’re going to rent them, because rental prices were pretty good. In fact, a lot of people had to move into rental properties because of foreclosure. So some of those people are, no doubt, buying houses to rent them. Some probably are buying them with the idea “I’m going to sell them to somebody else when the prices come up.” Well, that’s going to – there’s many people in there, whether in the short run or in the long run, they’re intending to resell; that doesn’t make me very comfortable with the idea that these prices are going to be involved now in a sustained inverse.

MICHAEL: You know, Vernon, I’m not one to make predictions, and I’m sure you’re not really either, but you’ve had a lot of experience, and you’ve seen a lot of different cycles and a lot of different bubbles, and I think for people that are paying attention, that’s a little ominous, that you just said that.

VERNON: Well, I just think it’s – if you’re speculating in that home market, be sure that you can afford it. Because you know, it can reverse on you, and your best laid plans may not work out.

MICHAEL: Yeah. Before I have to let you go, I want to see if I can get a few different thoughts from you, because you have a wealth of experience, and there’s a lot of people listening to my podcast these days, and I know they want to learn and they want to have a different perspective.

One thing, though, before I move to that: the idea that you’ve done this research, these findings, this wealth of insights that you’ve brought to academia, to the real world, is there any bit of you that kind of has this feeling of like “Wow, I kind of got in the middle of this. I’ve figured some of this out, and the world just keeps going along creating new bubbles”?

VERNON: Yes.

MICHAEL: How does that make you feel, to some degree?

VERNON: They’ve been around for a long, long time. I know my colleague that I’ve worked on this with, Steven Gjerstad, he was looking at when Chicago was being – the city of Chicago – this would be back in the late 1830s. They were plotting out lots in what became downtown Chicago. Well, these were selling, as I recall, these lots were about $50 apiece. It got caught up in a bubble, and so help me, they soared up into the hundreds, thousands, and so on, and crashed. So now there was a land bubble. Of course, there was a pretty remarkable land bubble in Florida in the ’20s, around Miami.

So these things happen, and they’re just remarkable how prices can just really, really soar. Of course, they’re just not sustainable. But good luck in predicting turning points. Really, they’re very hard, very unpredictable. Even our lab bubbles; the general patterns are similar. Some of them will maybe peak out by Period 5 and then start to fall, but with a big drop at the end, or they may go along to Period 12 or 13 and then drop in the last two periods in a 15-period trading horizon.

There’s just a lot of variation. Each group seems to have its own individuality. Even having seen a lot of these, it’s hard to make a very precise prediction. Now, we do have some data that give you some indication of when they’re going to crash, but without that data – and it’s the kind of data we can get in the lab that’s not that easy to get out there in the world – that improves it quite a bit. But still, it’s astonishing how rapid these things can turn around.

MICHAEL: Exact timing is always unknown.

VERNON: Yes.

MICHAEL: I saw a comment from you, and it was essentially describing – kind of shifting gears on you a slight bit, but it was describing your ideological journey, and it was saying that you started out as a young man as an avowed socialist, but these days you take a very staunch libertarian position. The quote that I saw from you that I really liked, which is whether we’re talking about politics or economics or even social interactions: “The best systems maximize the freedom of the individual, subject to the constraint of others in the system.”

VERNON: Yes.

MICHAEL: Be a great professor for me for a second and elaborate on that. Because I think that’s terribly important for society today.

VERNON: Well, what I learned – I grew up – in the ’30s, I tell you what, it just was socialist all over the place because there was this seeming failure of capitalism. That was a very common interpretation of the excesses that were going on in the ’20s, and of course, everybody loved it while it was happening.

Then came the crash – and by the way, my colleague and I have documented the importance of housing in that episode, and particularly credit financed housing. Credit financed housing expenditures grew very rapidly in the ’20s. Started well before, in ’27, ’28, ’29, three years before the stock market crashed. Stock market crash was really – historians I think are generally in agreement that that wasn’t the cause; it was just one of the responses.

So I grew up in the ’30s, and socialism was strong then. Of course, it made a lot of inroads around the world. What people discovered is that socialism fails. It spectacularly fails in the sense you don’t even get the good times.

MICHAEL: But a lot of people like it.

VERNON: Oh yeah, because the idealism expressed – it has a sound good, feel good characteristic or image that people associated with it. But the problem is, no one’s been able to figure out how to make it work in terms of wealth creation and the betterment of human betterment, including those at the lowest end. It’s very hard to beat the free economies that essentially got their kick-start in northern Europe.

It was really Netherlands and Britain, and we’re talking about – oh, even before the 19th century, but by the beginning of the 19th century, you have all the instruments of GDP per capita are starting to take off. From 1800 on, there’s just a spectacular increase in world per capita GDP, and most of that is coming from northern Europe, and then the United States, Australia, New Zealand, Canada. Those free market ideas and property rights that were supportive of wealth creation, providing good incentives, that just really spread like wildfire among these.

And then of course, Britain, they eventually gave independence to the colonies and everything. The Revolutionary War put Britain through an agonizing reappraisal of all they had been doing. But you see, the United States, the rule of law, we kept that. We just kind of cast out the Redcoats.

I think there are continual property right issues. Is it the right property right system when you have, in 2005, 45% of first-time homebuyers paying no money down? The problem with that is it endangers the other depositors in a bank if that sort of…

MICHAEL: But the political system allowed that to happen.

VERNON: Yes, the political system, and of course…

MICHAEL: Far from a libertarian political system at that point in time.

VERNON: Well, yeah. Democrats, Republicans, libertarians all thought that was okay. Or at least there was a wide acceptance of that. It’s just like in 1997, Bill Clinton got through a bill that was very popular, and all three of these political groups loved it, and that is you would not have to pay a capital gains tax from reselling a home up to $500,000. If you held it two years, minimum holding period, and it was your primary residence – there’s rules governing that – then you can resell it and pay no capital gains tax, unless it’s more than $500,000. Everybody thought that was great.

Well, I don’t think it’s an accident that 1997 is when the housing prices started to take off. Because what we did was to say here’s one capital good that you can buy, a home – it’s really not a capital good; it’s a consumer good. You’re just buying shelter services well in advance. You take one asset like that and make it tax-free, it’s capital gains; you can expect money to flow into it, and that’s exactly what happened.

MICHAEL: And if I recall, too, in the late ’90s when it started, it started and spread so fast. I mean, the average person making $50 grand knew that this bubble was on and had a deep feel in their gut that they could get rich quickly. Buying some condo in Miami or whatnot. It was amazing how fast it spread.

VERNON: Yeah, sure did. And the prices were growing all out of proportion to median income, all out of proportion to the rental value of homes. I mean, it was all financed by funding money, by credit.

MICHAEL: Let me bring you back, though, to liberty, because I know it is something near and dear to your heart. But why don’t you talk to the audience for a second, from your perspective, and why liberty – as long as the individual is doing his own thing, maximizing his own gains, but is not hurting other people – why you see liberty as such a strong ideal at this stage of your life.

VERNON: Well, it empowers people to make decisions in response to their incentives out there. And they can’t help but do well for others when they do well for themselves. But the property right restrictions, you see, are really important there, because if you have an incentive to take actions that may endanger other people in the system, then you have to ask whether you have the right rule of law. To me, these rules don’t have to be so complex. They can be fairly simple. The focus should be on incentives and not what seems to be kind of good right now for the economy to make it expand.

MICHAEL: So no more short-term letting the Fed run the economy, and perhaps maybe let Congress do something occasionally?

VERNON: Yeah, everybody recognizes that the housing bubble came from too much housing stimulus, not only government, but also private excess that stimulated that. So now, what’s the solution? Well, more stimulus. Surely that can’t be the solution to the problem; that was the original problem in the first place. But it’s the way we tend to approach these, because they’re politically popular. We met the enemy and he is us. Either it’s a ballot box or our…

MICHAEL: That takes us back to the beginning of our conversation, which is bubbles again. I think it’s the enduring part of the human condition.

VERNON: Right.

MICHAEL: I guess it’s best to learn to enjoy them and make sure that when they pop, that one at least doesn’t get killed, so to speak.

VERNON: Individual incentives and access to credit has got to be limited to keep individuals from making decisions that hurt others. You see, people who don’t buy homes, who were renting, who were never part of the problem, were hurt by this catastrophe. That’s the thing that – it’s not a trivial thing to get the incentives right and the rules right. For most of the economy, look at, as I say, how well the nondurable goods markets work. The problem is to get those kind of constraints on individual behavior that make us all better off, to get that extended to some of these asset markets that have caused trouble.

MICHAEL: I think trying to give protection to those that are trying to play by the rules, that don’t want to be hurt by other individuals that might be taking advantage of the rules, that’s difficult perhaps when societies are clamoring for more and more government programs. We can look at what’s happening in America right now.

VERNON: Yes. Here’s a really bad incentive rule in the whole housing catastrophe: if you were an originator of a loan, of a mortgage, you fee was upfront. Your incentive was much different than the incentive of a lender. See, the older banks, what I call the Jimmy Stewart banks –

MICHAEL: Where are those? Do those still exist?

VERNON: They’re still in the country, and in fact, the country banks were not as hurt. You see, that’s still true. The real estate bubble was primarily an urban thing. But where the loan originates by the entity that’s also advancing the capital, then those incentives are quite different than when the loan origination is separated in its own specialty and the originator gets an upfront fee.

Steve Gjerstad and I have a book – we just sent the manuscript to Cambridge University Press – on housing bubbles, and what we point out is you need a rule that says that whatever your fee is, it’s spread over the life of the mortgage in proportion to the repayment of principal. So what does that mean? You just escrow the fee into your payment. It means that if you originate a mortgage, and it’s an interest-only mortgage for 10 years, no principal payment, then you don’t get any fee for 10 years. So right away, your incentive is much different, and it now would be aligned with an ordinary lender.

MICHAEL: I think Goldman Sachs is listening right now, and they’re not happy.

VERNON: Well, I’m sorry. But these are the kind of incentives that you need. Now, I don’t know whether loan origination should be separated from lending. That’s a market decision. But however the market does that, the loan originator needs the same incentive as the lender. And then when he sells that loan, it’s bought by a lender that he can feel comfortable this guy was well-incentivized to do due diligence on the mortgage.

MICHAEL: It makes a lot of sense, a lot of practical sense. I think a lot of your views make awesome sense.

VERNON: Dodd-Frank has a lot of stuff in there to prevent predatory lending. Well, a simple rule like this does away – just completely undercuts the whole idea that I’m going to go out there and push loans on people, because I can’t push them and get an upfront fee. So if I don’t do due diligence on every mortgage I make, I’m not going to make any money.

MICHAEL: When will your new book be out?

VERNON: Probably in about 9 or 10 months.

MICHAEL: Hopefully we can get you on again. I have one final question, if you’ll entertain me. You’ve got so much knowledge and so many insights; if I was to look back into your influences – and I think I’ve seen this in other interviews, but I wonder if you might speak for a few minutes about Adam Smith, and perhaps either a lesson or a nugget, some type of insight from his early works that really influenced you.

VERNON: As far as I can tell, Adam Smith is the originator of the phase “other people’s money.” In fact, he used that phrase in the context of his discussion in The Wealth of Nations, of what was known as the South Sea Company bubble. It was a bubble in their stock. It’s interesting that his view of the banking system was one that was very much aware of the problems that could arise if you have excessive credit expansion and banks caught up in that process. Because he had studied the bank failures in England and in Scotland and his own country.

So there’s a lot of lessons, I think, in there that are very appropriate for today. He did not argue for a completely free mortgage market or lending market, the way he would argue for free markets generally. The reason is that he said lenders are tempted – if you can get a higher interest on a loan and the borrower is willing to pay it, they’re tempted to just ask a higher interest rate and make the loan and not do due diligence on the loan.

In fact, he was the guy who thought sealing interest rates were a good thing, because it forced lenders, to increase their return on lending, they always had this incentive to do due diligence on the loans, and only make them to borrowers that provided less risk.

It’s really interesting, because it’s not the case that Adam Smith stood for the same kind of free market rules everywhere. He recognized that there were fundamental differences in markets. And of course, that’s exactly what our experiments have found. There’s two kinds of markets that behave very differently. One is the most important; it’s nondurable consumer goods. And then the smaller market, but it’s much more volatile, is markets for capital goods and items that live a long time and you’re financing with credit. And of course, homes are the premium example. Those markets cause trouble, and he was very well aware of that.

MICHAEL: I think you’ve given my audience a lot to think about today, and I appreciate you taking the time. Believe it or not, our nice connection today, I’m actually calling you from Saigon in Vietnam, so we have a pretty clean connection. So I’m quite pleased with that.

VERNON: Notice how well that market works?

MICHAEL: Over here?

VERNON: The whole telecom market. Those markets have done – you know, and the technology and everything. That’s an example of really quite a well-functioning system, and it’s stimulated and encouraged technical change and improvement. It’s great. Okay, your questions were excellent questions, and I enjoyed this very much. Thank you.

MICHAEL: Thank you, Vernon. I appreciate your time today.
[/toggle]

Rate and Review Trend Following Radio on iTunes

Want a FREE trend following DVD? Get it here.

Join over 12,000 others on the Trend Following mailing list.

Have a question or comment about this episode? Post it below.

Tagged with: , , , , , , , ,
Posted in Economics, Interviews, Podcasts
Free Market Wizard Video!

Receive FREE expert trader video now!

Covel Books & Film
Massive Performance

Trend following performance numbers.

Trend Trading Systems

Pricing for trend following systems. 1000s of clients across 70+ countries.

Live Trend Following

Michael Covel's live events.

Trend Following Podcast

Michael Covel's podcast. 3M+ listens; 400+ episodes: iTunes & Android.

 

Free Market Wizard Video!

Receive FREE expert trader video now!

Online Payments

 

Regular guy makes Trend Following fortune. His free video lesson: Watch It Now.