Monday, August 17, 2009

On bubbles

There's been a lot of posts on Matt's blog recently, as well as on Brad Delong and Kevin Drum's blogs, about bubble. How to detect them, what to do about them.

Now I'm not a financial expert. At best, I'm financially literate and not a bad investor. I saw the stock market bubble and the housing bubble before they popped, as well as the oil bubble. When things get insanely overpriced, it's not hard to tell. The only part that's impossible is figuring out when investors will finally realize how fast prices have outpaced value and start selling. But from the perspective of policymakers, they don't need to know that. They just need to know that a market is fundamentally overpriced by quite a bit. You don't know precisely when a bubble starts or when it's going to end, but you know when one is going on once it's really gotten inflated.

But that's not really relevant either. What causes bubbles? Is it that investors aren't aware of them? Many investors aren't, but I think most investors are. They just assume it will make them big profits and they'll get out and some other sucker will be holding the bag, usually inexperienced investors who hear during the height of the bubble how they can make massive returns with little risk. So it's probably not ignorance. It's greed.

So how do you deal with that? I have an idea: why not jack short term capital gains rates to 50%? And to encourage investment for the long term, reduce long term capital gains to a nominal amount like 10%, or even 5%. If you're worried about that being regressive since rich people tend to be more likely to have long term investments, you could just keep the current long term capital gains rate on people making more than $250,000 and reduce the capital gains rate to 10% for everyone else if they hold an investment for at least five years.

Something that was particularly to blame for the housing bubble was the recent favorable treatment of capital gains on the sale of a primary residence. Taxes change incentives. Especially for smaller investors, what could make more sense than to invest in your home, since when you sell it, you don't pay capital gains taxes unless your profit is $250,000 or more if you're single? Since it also applied to second homes, it encouraged house flipping. That not only encouraged people to overpay for housing, it also led people to put all their eggs in the real estate basket. The favorable treatment of capital gains on housing should be eliminated, or at least require that the home be owned for longer before sale.