To his credit, economist Brad DeLong "who stands here repentant" lists "five things that I thought I knew three or four years ago that turned out not to be true." I would like to visit each of them, since I think highlights economics' need for 'economic natural history' and sociology. Over to DeLong:
1) I thought that the highly leveraged banks had control over their risks.
My take on this is very different. First, my personal experience: back when I was a post-doc and living on Long Island, shortly after the turn of century (Eek....), I went to the bank for some other business, and they tried to convince me to take out a loan to buy an apartment. While I wasn't in ninja terrority (no income, no job, approved), they had no business whatsoever offering me that loan, especially since they could easily see which direction my (small marginal) account balance had been trending. On top of that, I knew a lot of people who were refinancing or using their homes to buy crap they didn't need--they too were credit risks. Caveat mutuor was not the operating principle. You can have all of the supposed hedges you want, but a steaming pile of shit is still a steaming pile of shit. It seemed like a bubble to me.
The second is bubbles burst, and it seemed this one would too (housing kept going up, while wages were stagnating). Third, when you're living paycheck to paycheck, experiencing the 'fist-end'* reality of the rent extraction economy--and the morality of the Masters of the Universe who enabled that rent extraction--it was pretty obvious they didn't care about long-term consequences, since they thought (wrongly, in many cases) they could cash out before things went pop. It was also pretty clear they would have no ethical problems with fraud and perjury (I am surprised that they didn't have smarter lawyers, however) The last two points are nothing new to anyone familiar with John Kenneth Galbraith's work; they're endemic to a large financial sector.
However, Galbraith the Elder is often looked down upon by many economists since he was essentially a historian and sociologist. The bias towards mathematical deduction and away from natural history and sociology is a real problem for economics (don't worry, your Big Swinging Calculus Penis won't turn into a Sociology Vagina. AAIIEEE!!!). I would argue some really good Wall Street sociology would have been far more useful in mitigating Big Shitpile than another mathematical modeling paper. In fairness, DeLong has repeatedly called for more history in macroeconomics. Then again, he's one of the few who, to use his own phrase, is repentant.
2) I thought that the Federal Reserve had the power and the will to stabilize the growth path of nominal GDP.
I don't know about power, but it seemed pretty clear to me that the Fed, during the last decade, was allergic to full employment. In other words, they would fight like hell to stop inflation, but wouldn't even be able to recognize, until it was too late, an imploding economy.
3) I thought, as a result, automatic stabilizers aside, fiscal policy no longer had a legitimate countercyclical role to play.
The reason I never thought this was largely fortuitous (the intellectual equivalent of the Decline Effect). Long-time readers will know that I discuss poverty often. While U3 unemployment (the strict measure) was around 4-5% for much of the last decade, in many places and for certain socioeconomic groups, it was much higher. Throw into the mix stagnating median incomes, and underemployment, and I always thought we needed more stimulus. We were not at full employment by a long shot (living in a decaying Northeastern industrial town or two made that abundantly clear). We needed a stimulus a decade ago. Besides, even if it's not 'stimulatory', our infrastructure was falling apart. It needed to be fixed.
4) I thought that no advanced country government with as frayed a safety net as America would tolerate 10% unemployment. In Germany and France with their lavish safety nets it was possible to run an economy for 10 years with 10% unemployment without political crisis. But I did not think that was possible in the United States.
I have to admit I screwed the pooch harder on this one than DeLong did. I still can't wrap my head around this. Even during the Reagan Era, there was more outrage over high unemployment. I failed to understand two things:
a) The political system in this country is almost completely disconnected from the consequences of the actions taken by that system.
b) I underestimated the effect of the massive 'D.C stimulus' (e.g., all of the federal contractors) on the Washington area. The Washington area has been booming, and has been recession proof. Not only that, the Washington area's wealth and incomes have been skyrocketing. This has denied the political class (and pundits) any sense of how bad things are. Further exacerbating the problem was the Wall Street ballout which meant that the news media capital of the U.S., New York City, wasn't as hard hit as it could have been.
Having said that, it amazes me that employees for JP Morgan or Goldman-Sachs don't continuously feel like they're painted with bullseyes (I'm not advocating violence at all, but there are a large number of armed and angry people out there, and eventually some of them are going to stop blaming 'feminazis', blacks, or Unitarians (?!?), and go after these guys). It's astonishing.
5) And I thought that economists had an effective consensus on macroeconomic policy. I thought everybody agreed that the important role of the government was to intervene strategically in asset markets to stabilize the growth path of nominal GDP. I thought that all of the disputes within economics were over what was the best way to accomplish this goal. I did not think that there were any economists who would look at a 10% shortfall of nominal GDP relative to its trend growth path and say that the government is being too stimulative.
I think this relates to #4 above, although this didn't surprise me. There are a lot of people, including economists, who really don't see ten percent U3 unemployment as a crisis. If that's your starting point, then a shortfall in GDP isn't really a problem. That's the key for me: DeLong, to his credit, views our problems as a nine-alarm fire, that our current economy borders on the catastrophic. A lot of people don't. I don't know what we do to fix that.
To sum up, I think economics hasn't focused enough on the economy as a human enterprise, although behavioral economics has. More natural history and sociology would have allowed economists to test their ideas more concretely. I bring this up not to be snarky (that's just a bonus), but because we need economists to get it right (or at least, get it less wrong).
*By which I mean, rent extractors have their fist all the way up your ass.
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Regarding point five: Whatever 'consensus' there may have been among economists, it should have been clear to any observer that the Federal Reserve didn't care a bit about asset inflation. In 2006, Don Kohn, a Fed governor, said in substance 'because of huge uncertainties, it is too risky to respond to bubbles and therefore it is safer to âmop upâ by easing policy after a bubble bursts.' ("The Issing Link", The Economist, March 23 2006).
Moreover, it must be remembered that we experienced not one but two asset bubbles within a decade. The first asset bubble was amongst dotcom stocks, the collapse of which led to sharply lowered interest rates and precipitated the flow of money into higher yielding mortgage backed securities. The Fed's response to the dotcom asset bubble was no different vis-a-vis the property bubble. This raises the question- are today's low interest rates fueling tommorow's asset bubble?
(See also, "Should central banks try to target asset-price inflation?" The Economist, May 7 1998.)
Given the prescient writings of Robert Shiller and The Economist, I am incredulous when economists profess to be shocked that the value of housing prices (and the securities based thereon) could double in a decade without dropping so suddenly. I accepted the madness of my mother-in-law, but am apoplectic with DeLong and his ilk... they should have known better.
I have been fortunate to watch the housing bubble and its aftermath from the sidelines (I bought in 1998, just as prices were starting to take off around here, and missed a lot of the HELOC-for-toys mania as most people I know are quite frugal), but I had my doubts about point #1 earlier than Prof. DeLong did. I have been in this state (NH) long enough to remember the aftermath of the 1980s real estate bubble, and remembered in particular the sad story of several homeowners who had taken out negative amortization loans to buy houses in this state. So when I heard, circa 2006, that neg-am loans (mostly in the form of option ARMs) were becoming commonplace, I knew that some people were in for a world of hurt. I did not yet know how systemic that was.
If we had a functional regulatory system in this country and I were in charge of it, I would issue lifetime bans from the financial industry against anybody involved in making those loans happen. If you don't know arithmetic well enough to recognize that that kind of loan is bad news for both bank and borrower, you have no business handling other people's money.
Mike: The bias towards mathematical deduction and away from natural history and sociology is a real problem for economics
...I'd somewhat agree. More exactly, I think it's the bias away from checking the results of the mathematical deduction against real-world experiential data - and paying attention to edge conditions. This seems to be a weakness particular to the Chicago school; behavioral economists like Dan Ariely may be starting a counter-trend. (Not that that will help for another couple decades.)
When I was an undergrad, my economics 101 prof muttered frequently that the sociology majors tended to do the best on his exams....
For these reasons and more, I am now a former libertarian.
I hear this view an awful lot in my profession (where it normally translates to "hire me for $500/minute"), and I couldn't disagree more.
Say I'm pricing a bermudan option or other complex financial derivative. A sociologist comes up and says "hey, you know, sometimes markets crash". Oh, that's helpful. So should I tweak the volatility, or add another term to the SDE, or what?
This kind of sociobabble always sounds incredibly significant after the event. But I know for a fact that no sociologist predicted the recent market crash with enough specificity to have made any difference.
How do I know this? Because, if they could have done so, they'd have shorted the market (or bought an appropriate option structure) and made a fortune.
"Professional judgement" may sound a lot better than an actual numerical prediction, and it may be easier to spin-doctor once the shit has hit the fan. But in practice it is no more useful than a psychic's cold reading. Unless, of course, it can be codified in one of those awful mathematical models.
"We needed a stimulus a decade ago."
You had one. It was intended to prevent the equity markets freezing up after the dot-com crash and 9/11. With hindsight it appears to have been poorly targeted and left in place too long. But few commentators started saying these things before 2006, aby which time the course of future events was probably already set....
For a conservative government, unemployment per se is not a problem, and full employment is certainly not an objective. Full employment is a situation where the balance of forces is against employers and in favor of salaried workers, and where the pressure on wages is to go up.
On the other hand, the higher the unemployment rate is, the easier it is to say to trade unionists who ask (and go on strike) for better wages: "if you're not happy, you can go away, there are thousands waiting in line to take your place". It's a situation where the workforce can be paid as little as possible, that is, just enough so it can afford housing, food and a few bills.
Of course, there's a limit. When unemployment becomes too massive and salaries too low, you have a social explosion of the Tunisian kind.
The difficulty of making conclusive sense of real-world data has allowed the profession to wallow in models with no concern about whether they even make sense. General equilibrium remains the ideal because it is so mathematically impressive: minimal assumptions and maximal conclusions that certainly do correlate well with many real-world issues.
As it is, behavioral economics has a long long way to go. At the macro level, it simply means a return to Keynes. At the micro level, there is pretty much no model, just trivialities.
Missing the 2008 bank failure is comparable to a doctor missing a 25 pound tumor. He should be dismissed from the practice of medicine as should all economists who failed to see the crash coming. The fellow who threw out all the commentary about the importance of pricing derivatives fails to see that the derivatives are the problem. These and every other financial instrument divorced from underlying productivity. Therein lies the rub. For thirty years owners have been squeezing the productive workforce. And economists have been their willing accomplices. Like the farmer who fails to rotate crops or put something back in the land becomes exhausted as the workers have. The economy has to work in balance. It has been out of balance with too many exploiters in the finance, insurance, real estate and marketeering world getting by on salesboyship and long winded talk not producing anything. It will be a long time before the system can be rebalanced. Till real work and production is recognized as the true source of wealth and that fianace games produce nothing, only take away, the disease will not be cured.
"This kind of sociobabble always sounds incredibly significant after the event. But I know for a fact that no sociologist predicted the recent market crash with enough specificity to have made any difference."
Actually, you're missing two separate points. First off, there were indeed rumblings about a bubble popping before it did and these warnings were largely ignored or downplayed. If you wanted to buy property in San Fransisco and are warned that they have earthquakes, you might ignore that warning for the similar reasons (not specific enough, they don't get them often, we have safeguards now to limit any damages that might occur). However, the warning signs were there for everyone to tread lightly and most didn't.
Specificity of the market crashing is only a necessary requirement for shorting the market & making tons of money doing it. (See Paulson's & Goldman Sachs' deal). One could simply do the prudent thing, and not invest in risky assets when said market is hot. This is the opposite of Soros' advice, but sound for the financially conservative...and no timing required. And even in Soros' case, it appears that he does put a lot of time into researching what is actually happening rather than simply crunching equations.
As an example, a friend saw problems coming in 2005 and moved his retirement to safer investments and refused to buy a house or anything else he couldn't afford (he was in no position to short the market). Upon returning heavily to the stock market in 2009 after the long anticipated crash, he had a banner year.
So, what's the best way to handle complex options? Perhaps the sociologist's appropriate response might be: Make doubly sure you did your homework and only price them for as much as you'd be willing to lose if they flopped.
From an economics perspective, this last comment makes absolutely no sense. There is no such thing as "underlying productively". There are, instead, the things that people want--as proven by people's willingness to pay for them. Derivatives were part of what people wanted.
"There is no such thing as "underlying productively"."
Thanks. New keyboard needed here.
Bakery. Whilst it bakes bread, the bakery is a going concern. Underlying productivity: loaves baked.
Derivatives were a method of betting on something and hoovering up all the money in other people's pockets you can get.
Go take a look at the size of the derivatives market in the US alone, before the crash. Compare with the total worth of the USA.
"While I wasn't in ninja terrority (no income, no job, approved), they had no business whatsoever offering me that loan"
This is an example of how derivatives can be used to hoover up the money from less wealthy people.
They don't care you can't afford the loan. To the bank, your loan is an asset. An asset they can sell on to any sucker they can hoodwink into buying it.
And derivatives (more explicitly Credit Default Swaps) was how you hid the ninjas from those you could hoover *just enough* money from.
Just take a look at how much your house costs if you're rich enough to pay outright and how much it costs if you need a mortgage.
That difference is the "trickle-up" economics that is the truth of the capitalist system. The rich hoovers up money from people who can't afford a home outright. Making the rich richer and the poor poorer.
For CDS, just leaven the bread with enough middle-income families and you can sell a lot of ninjas.
They were indeed a method of betting on something. Do you have a point?
Except, of course, when the hoovering went the other way. Do you have a point?
Golly, it's 20 times as big as the total worth of the USA! Is it impossible for you to realize that you are obviously comparing apples with oranges? The "size" of the derivatives market people quotes refers to the total bets at stake, so to speak, not to actual money changing hands.
Which meant that suckers paid for some ninjas' homes. What does that have to do with the economically meaningless concept of "underlying productivity"? So far as I can tell, you don't have a point.
When you take into account the fact that the original point of derivatives contracts was to act as a form of insurance, the question of "underlying productivity" becomes a little bit fuzzier than you seem to make it. What's the underlying productivity of fire insurance? Is fire insurance a product that should not exist?
There are ways of using derivatives that don't do anything more than shuffle cash around, but I think we should be skeptical of assigning a True Value to something based on our intuitive feelings about what the "right" thing is for a product to do. Personally, I can't understand the cell phone ring tone market, but I wouldn't argue that it's without "underlying productivity."
"What does that have to do with the economically meaningless concept of "underlying productivity"?"
It has, specifically, NOTHING to do with that because it's a demonstration of how the banking crash was based on NO UNDERLYING PRODUCTIVITY.
Ergo it cannot be used to demonstrate the meaning (or lack of) "underlying productivity".
If you weren't such a thoughtless idiot preaching Teh Free Markets, you would be looking instead at the baker's business and seeing that there IS such a thing as "underlying productivity".
However, the problem for numbnuts like yourself and the avaricious turnipheads trawling in the money, "underlying productivity" is reality based and therefore is limited by the natural limits of a genuine real universe.
Whereas derivatives and CDS are not based on any underlying productivity and therefore not limited by any reality constraints.
Which then leads us back to the point of that other poster you have rhetorically denied because you don't like the reality he showed you. The crash was due to finances based on things that had NO underlying productivity and therefore were inevitably going to crash when the promises had to be turned into something tangible.
Just because you want to live in woo-woo land where money and productivity and therefore growth is eternally exponentially growing because you can skim more and more off the top doesn't make "underlying productivity" a meaningless concept.
It just makes it an anathema to your pyramid selling scheme where you suck up all the money as it passes you by, adding NOTHING to the sum of civilisation's produce.
"Personally, I can't understand the cell phone ring tone market, but I wouldn't argue that it's without "underlying productivity.""
It's based on the underlying productivity of a middle class who has disposable income.
Just like music, movies, dance clubs etc.
But since the ringtone industry requires intevention via
a) copyright to enforce payment on unproductive replication
and
b) contractual and technical interference in the purchase after sale to stop people putting anything they want on there as the ring tone
should indicate to you that there IS no "underlying productivity".
However, that this doesn't exist in one (or many) cases doesn't prove it doesn't exist.
After all, my bike doesn't have a differential gear. This doesn't prove differential gears don't exist.
What such products without an underlying reality base of worth mean is that they are inherently unstable in a free market.
It demands disposable income and the limit to that is the limit of the value of the middle class whose product is via some actual real productivity.
It would be like moving everyone to a service industry.
When everyone is working in a shop selling goods to people, who is free to go to the shops and buy stuff? Everyone working is working in a shop.
Ford understood this.
Modern management see the workers who HAVE productivity as explotable work units and paying them is entirely a cost burden.
Because they've learned the Holy Writ of the financier: underlying productivity is meaningless.
You seem to be implying that we want everybody to go into finance. That would be kind of a stupid idea. Then again, having everybody go to work in a "productive" industry as well. If we all go to work making computer chips, we'll all starve. That doesn't exactly say much about the nature of "unproductive" industries.
You never did answer: Is insurance unproductive? Should we eliminate it?
"You seem to be implying that we want everybody to go into finance."
No, it seems more like service industry, not finance. Just as Vampires don't want more vampires, it increases competition for food.
"If we all go to work making computer chips, we'll all starve."
So don't do that. Why suggest it if you already know it to be silly?
What you do is you have some people producing food. Then people don't starve. Forgetting that food can be "produced" is an unfortunate side effect of belief that there is no such thing as "underlying productivity". After all, if underlying productivity doesn't exist, then the product underlying that can't either and since food is an underlying product of a productive and viable civilisation, food therefore cannot exist, except in the abstract.
"You never did answer: Is insurance unproductive? Should we eliminate it?"
What does that have to do with whether "underlying productivity" exists or not?
I'm not going to follow your bum steer in the gish gallop.
Uh, no. Since the concept is meaningless, you haven't identified a cause. You've just gibbered stupidly.
At which point, you've just contradicted yourself, revealing that you are beyond stupid, as I pointed out the first time.
What are you talking about? Where have I preached Free Markets? Nowhere.
If you weren't such a self-made loon for all seasons, you'd have bothered to notice.
Because you say so? I see goods and services and money changing hands in both businesses. I have no idea what you mean by "underlying productivity", and you haven't given me one clue except that you think one business has it and another one does not.
You have pointed out a situation where there was a crash involving certain products, during which there was no crash involving certain other products. So what? The reason for the crash had much to do with fraud, runaway feedback, and confidence failurees. Now your telling us that we can have as much fraud, runaway feedback and confidence failures as we like, so long as there's "underlying productivity".
So far it seems to be imaginary, and is limitied by the natural limits of your minuscule pinsized brain.
Again, you are not defining what you mean, so the above sentence is gibberish.
What "underlying productivity"? I follow the news, I learn about fraud that went on. I learned about dangerous feedbacks that happened. And more. Not once did I learn about "underlying productivity".
The total lack of any definition suggests it is a meaningless concept. Try harder.
If I sell something, honestly described, than I have contributed something to civilization. Whether it's bread or derivatives.
Sort of like the horse and buggy market? Now you see it, now you don't.
I mean, I once had my heart imaged using technetium-99m. The stuff has a half-life of 6 hours, emitting gamma rays the whole time. Free market or no free market, it is "inherently unstable"! And yes, it was paid for by insurance. Private insurance. But you're telling me I actually caused the crash? Woo, that's profound.
And, oh yes, I once won $10 at backgammon. Maybe that was the cause of the crash? Sneaky bastard that I was in my youth, I hoovered those bills right out of some fool's pocket! To be honest, I'm grasping at straws here, because you're simply refusing to make any sense.
What is an "underlying reality base of worth" anyway? Sounds like marketerspeak for something, but I never could understand their lingo.
Really? Golly, who would have thought that?
How does that follow? The criticism has been that you are gibbering, and are just throwing around a meaningless concept. You do not refute this criticism with more gibberish. You refute this with some explicit notion. Not examples. Not wishful thinking. Not tautologies.
I believe, for example, that the reason food exists and is available is because there is a demand for food, evidenced by the willingness of many people to pay for it. Similarly, I believe that the reason CDSs exist and are available is because there is a demand for CDSs, evidenced by the willingness of many people to pay for them. I also believe that honest financial transactions, wherein each party gives the other something defined to mutual satisfaction, is usually a benefit to society. As such, such transactions should usually be encouraged, and discouragement should be practiced with the exceptions, and with all dishonest transactions.
Now you're telling me I should instead look for this mysterious notion of "underlying productivity" or something.
I mean, in Wowbaggerland, it seems that cyanide-laced bread is good, but stable wheat prices are bad. I don't get your concept whatsoever.
That's sort of like saying that if underlying productivity doesn't exist, then the product underlying that can't either and since financial derivatives are an underlying product of a productive and viable civilisation, financial derivatives therefore cannot exist, except in the abstract.
In other words, you still haven't given us a clue that have some viable concept in mind.
A yes or no would help us determine if you've given any thought about what "underlying productivity" could possibly mean.
Frog is not engaged in the gish gallop. You are engaged in the dembski evasion. You are throwing out technical sounding notions and then point-blank refusing to spell out what it could possibly mean in other instances. The suspicion is that your concept is just a word salad.
Just some thoughts, if I'm not butting in too much.
"Underlying productivity" makes some intuitive sense, in that there are fundamental inputs to the economics system, e.g. natural resources and available labor. (Multiplied in some complicated way be technology,
education, etc.) Aside from the obvious building, baking and candlestick-making, labor can be used to arrange large-scale agreements about the use of other labor and resources. To some degree we do this all the time and it is clearly desirable in many cases, e.g. insurance.
But insurance and all sorts of financial transactions are dependent on an underlying good, they cease to exist without it. That is, no one wants "insurance" as a thing in itself, they want the builders and materials to fix their home. Without the builders the insurance is worthless. No one wants derivatives, they want money, which is itself a proxy agreement for actual goods and services.
It seems like these agreements are often manipulated and snarled in ways that cause problems far beyond what the "underlying" resources warrant. Obviously though there are a lot of nice features that can't be had in a direct barter economy.
Anyhow, my ultimate concern is the just distribution of resources and share of labor. One gets the sense that the layers upon layers of rents, debts, and bets can obscure and distort that distribution. The value of these things lies not in the fact that people pay for them, it is (something like) 'what would people pay for them with a perfect knowledge of the future and all possible alternatives'.
Josh tries to offer a reading for Wow's "underlying productivity" notion, which Frog and I found incomprehensible:
A good that exists not for itself but because it helps make other goods is known as "capital". And yes, insurance is such a good in today's world.
But you can only get by without insurance and the like if your wheat is from your family farm and you plan to feed just yourself and maybe a few friends and neighbors. Anything larger and you are absolutely reliant on these "software" goods. Were the insurance or banking or commodities future markets to collapse, bread as we know it would become very very scarce. So while it is true that all insurance depends on other goods, in point of fact, almost all other goods depend on insurance.
So in your attempt to figure out what Wowbagger the Infinitely Confused could possibly mean, you seem to be saying he disapproves of all capital, and of any economy well past subsistence. That could be true, but he'll have to enlighten us. Rather than put should strong claims in his mouth, I prefer to wait for some sort of coherent definition. Classical economics, for example, distinguished between land, capital, and labor, but modern neoclassical economics has long ago put all "goods" on the same footing. And for a very good reason: the economy itself doesn't seem to distinguish them.
The original Black-Scholes pricing model for options treated options as a perturbation, so to speak, on the stock and bond markets. Modern day pricing models acknowledge that where the options market is big enough this won't do anymore, and all three--stocks, bonds, and options--mutually feed into each other. We still speak of stocks as "underlying", but stock purchases can be used to hedge option positions just as well as options purchases can be used to hedge stock positions.
The mathematics is pretty much symmetrical, so I flat out do not believe that Wowbagger has a clue about anything.
Although Wowbagger the Infinitely Confused has run away like a crackpot who has dimly figured out he was talking about something he knew nothing in front of people who actually knew something, I'd like to give an example of how "underlying productivity" can't be very meaningful. In particular, the idea that "real" goods exchanging-now for money-now makes for a stable economy, while anything else is inherently unstable will be shown to be obvious nonsense.
Try and figure out what the economic difference is between a pay-as-you-go auction versus a pay-when-you-win auction. Let bidders A,B,C,D bid 10,20,30,40 in that order on X's prize. In a standard pay-when-you-win auction, D pays X 40 and wins the prize. In a pay-as-you-go auction, A pays X 10, B pays A 10 and X 10, C pays B 10 and X 10, and D pays C 10 and X 10, and then wins the prize.
The money and the prize end up in the same places either way, yet somehow the first one is stable and the second is unstable? Of course not.
Sorry for the very belated response, only just noticed Always Curious' response.
First off, there were indeed rumblings about a bubble popping before it did and these warnings were largely ignored or downplayed.
This would be relevant if you could point me to a single country, in a single industry, at any point in recorded history, where there was no-one at all yelling about an impending apocalypse.
There are always "rumblings" about possible market failure. And they always sound very convincing after the event. This is not terribly helpful without hindsight, though.
Now, if you could point to someone who has consistently spotted several such disasters coming, then I would accept their wisdom. But any such person would be too busy making a fortune to bother with this blog thread.
Specificity of the market crashing is only a necessary requirement for shorting the market & making tons of money doing it.
I'd contend that, if a prediction of financial doom is specific enough to protect yourself against, it's specific enough to make money off. If you can't make money off it, it's too fuzzy to be reasonably avoided.
If you disagree, please feel free to present a counter-example. I'd appreciate it if you'd include example numerical values for the various outcome probabilities and losses.
One could simply do the prudent thing, and not invest in risky assets when said market is hot.
In the vast majority of cases, it's only in retrospect that we can say a market is running hot.
For example, currently China's economy is either running comparatively hot and will collapse soon... or it is running comparatively cold and will really take off in the next decade.
It's also fairly hard to decide what's a risky asset. For example, a couple years back, everyone was treating Eurozone sovereign debt as risk-free. These days, Greek government bonds are not seen as low-risk investments.
Upon returning heavily to the stock market in 2009 after the long anticipated crash, he had a banner year.
An alternative interpretation would be that your friend happened to get lucky. Five years ago, for all we knew, the crash could have been due in 2035. By then, your friend's nest egg would have lost a hell of a lot of value compared to equity-based investments.
So, what's the best way to handle complex options? Perhaps the sociologist's appropriate response might be: Make doubly sure you did your homework and only price them for as much as you'd be willing to lose if they flopped.
Even for products as simple as European call options, the potential loss to the seller is unlimited. If your hypothetical sociologist stopped people selling them, this would be a bad thing - many companies (e.g. some of the smarter insurers and pension funds) use such options quite legitimately to hedge equity risk.
So the "sociologist's response" would lead directly to some pension schemes becoming less secure. I personally don't see that as desirable.