Sunday reading - Krugman and Zitron on the Bubble markets

Somehow, the US stock market was still reaching record highs in a week where President Trump tried to fire Fed Board members and tariffs were being put back in place. Shouldn’t the uncertainty of monetary policy and future costs of business lead people to bail out until we know the future course?

Economist Paul Krugman put out a theory on that this week. He says this is part of a history where markets tend toward inertia, where no one wants to admit that what they’ve bought into is set to crumble.

The muted market reaction to The Crazy doesn't tell you much about what will happen. Markets almost *never* react in advance to large but only potential disruptions. paulkrugman.substack.com/p/why-arent-...

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— Paul Krugman (@pkrugman.bsky.social) August 28, 2025 at 11:09 AM

My read of economic and financial history is that market pricing almost never takes into account the possibility of huge, disruptive events, even when the strong possibility of such events should be obvious. The usual pattern, instead, is one of market complacency until the last possible moment. That is, markets act as if everything is normal until it’s blindingly obvious that it isn’t.

The inimitable Nathan Tankus summarizes this by saying that the market is not, as stylized economic models would have us believe, a mechanism that pools the knowledge and informed judgment of millions of investors. It is, instead, a “conventional wisdom processor.” That is, it reflects views that seem safe to hold because many other people hold them — and the crowd only abandons those views when they become blatantly unsustainable.

John Maynard Keynes said something similar in Chapter 12 of his General Theory of Employment, Interest and Money. Market investors, he argued, pay little attention to the question of what assets are truly worth. Instead, they worry mostly about the market value of those assets a few months in the future. In a memorable albeit sexist passage (it was 1936), he declared that

professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view … we devote our intelligences to anticipating what average opinion expects the average opinion to be.

Krugman goes on to say that we had numerous signs that the housing market was in a significant bubble in the mid-2000s, and likely to crash sooner than later. But the Great Recession didn’t start until late 2007, and Krugman says this is a classic example of no one wanting to be the first to admit the ship is taking on water. So everyone shut up and hoped the money kept rolling in, until they couldn’t ignore the bad stuff any longer.

So if the conventional wisdom is that economic conditions will remain more or less normal despite highly abnormal policy, markets will remain calm until the illusion of normality becomes unsustainable. At that point market prices may “change violently.” The current technical term for this phenomenon is a “Wile E. Coyote moment” — the moment when the cartoon character, having run several steps off the edge of a cliff, looks down and realizes that there’s nothing supporting him. Only then, according to the laws of cartoon physics, does he fall.

With that in mind, let's include this graph from Krugman's article, which shows the Case-Shiller index of housing prices for the 2000-2010 period.

And now let's see where the housing market is today.

Oh, an increase of nearly 70% in 6 years. But things are different this time, right?

Writer and podcaster Ed Zitron has a similar thought on the "FOMO/can't leave" mentality, when discussing the added investment in Artificial Intelligence and related technology stops, and leads to the bursting of a Bubble that is one of the few sources of growth in the US economy these days. Zitron says the breakdown will be slow for a while, then speed up as more businesses try to escape.

The AI bubble is bursting, and the things that will accelerate the collapse are NVIDIA's growth slowing, the death of AI startup funding, the collapse of a major AI startup, big tech turning on AI, and a collapse of neoclouds like CoreWeave. www.wheresyoured.at/ai-bubble-20...

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— Ed Zitron (@edzitron.com) August 27, 2025 at 10:04 AM

For the bubble to burst, I see a few necessary conditions, though reality is often far more boring and annoying. Regardless, it's important to know that this is a bubble driven by vibes not returns, and thus the bubble bursting will be an emotional reaction.

This post is, in many respects, a follow-on to my previous “pale horse” article (called Burst Damage). Many of my original pale horses have already come true — Anthropic and OpenAI have pushed price increases and rate limits, there is already discord in AI investment, Meta is already considering downsizing its AI team, and OpenAI has done multiple different "big, stupid magic tricks," the chief of them being the embarrassing launch of GPT-5, a "smart, efficient router" that I reported last week was quite the opposite....

I also think it might "take a minute," because "the bubble bursting" will be a succession of events that could take upwards of a year to fully happen. That’s been true for every bubble. Although people associate the implosion of the housing bubble with the “one big event” of Lehman Brothers collapsing in 2008, the reality is that it was preceded and followed by a bunch of other events, equally significant though not quite as dramatic.

Since no one wants to admit that there is no sustainable growth behind the Bubbles in both AI and the stock market, because that would cause disruption and losses for a lot of people, few want to be the first mover off the boat. In addition, the fear of missing out on more asset price growth and/or not having any option for a stable future income beyond a 401k/pension fund or home price (me included) keeps people invested in markets and an economy that may not deserve it.

That sure seems to sum up things these days, doesn’t it? It's a good theory as to why bond and currency markets have yet to freak out over Trump trying to plunge interest rates in a time when budget deficits (and the supply of bonds) are set to explode in the next few months and years. Consumer inflation is already likely to pick up as tariffs finally start to be passed on by businesses, and a tanking dollar and lower rates would likely speed that further.

It also helps explain to me why people keep pumping up tech companies when the amount of money coming in is billions short of the amount of money that these companies are feeding into the new infrastructure and other companies that promise the "next great thing in productivity". Much like we saw in 1999 and 2000, the amount of money flowing in isn't going to pay off in many cases, or consumers sure aren't going to see where it's an improvement over what we already have (and/or the "new developments" make the user expereince worse . Right, Alexa?), and a lot of wreckage will happen in the wake of the implosion that follows as some of the larger players pull the plug.