Natural Big Lies

FEBRUARY 24, 2014, 1:27 PM  46 Comments

Paul Krugman

The New York Times

I’ve been doing some more Fed transcript readings, and noticing how implausible everyone found it that what did happen, could happen. And I have a small insight as I remember the days of bubble denial. It involves a violation of Godwin’s Law, but in a good cause.

Background: One of the really striking insights I gained from Robert Shiller is his notion that bubbles are natural Ponzi schemes — Ponzi schemes without a Ponzi schemer. What happens is that early buyers make money, drawing in more buyers, who drive prices up and allow people to make even more money, and it just keeps on growing for years. After a while, people insisting that the prices make no sense start to look stupid, and are tuned out — and so it’s a great shock when the bubble runs out of suckers and deflates.

So, my insight: while the process of bubble inflation is a natural Ponzi scheme, a thoroughly inflated bubble is a natural Big Lie — that is, a lie so audacious nobody will believe that anyone would dare to invent it. When you have something like this:

the notion that it’s all a bubble, that market prices could be that far off fundamentals, stretches belief. What? You think home prices in California could fall in half? That’s crazy!

And this cognitive difficulty is reinforced by herd behavior: you don’t want to be the guy shouting that the sky is falling when everyone else who matters is treating it as a minor correction at most.

And so it was very difficult, even once the bubble began popping, for Fed officials (and others) to wrap their minds both around the scale of the housing bust and the financial implications of that bust.