'We don't face any good options': Nobel Prize-winning economist Vernon Smith on the financial crisis, Adam Smith's underrated insights, and his journey from socialist to libertarian.

• Author: Gillespie, Nick

"I REMEMBER THE '30S like it was yesterday" says economist Vernon Smith. And he's not kidding. In 1935, when the future Nobel Prize winner was 7 years old, his family decamped to their Kansas farm to wait out the hard times. "On the farms," Smith explains, "you can eat." His parents only made it to eighth grade, but "they were people who read," and they expected their son to go to college. They got their wish--and then some.

Smith's higher education began with remedial work at a local Quaker college ("I was not a good student in high school," he says) but eventually took him from a Caltech electrical engineering degree to an economics Ph.D. at Harvard. Beginning at Purdue University, and then at the University of Arizona and George Mason University, Smith founded and developed the pioneering field of experimental economics, which studies actual human behavior--a major breakthrough in a discipline obsessed with abstract models. This work culminated in 2002, when Smith was awarded the Nobel Memorial Prize in Economic Sciences "for having established laboratory experiments as a tool in empirical economic analysis, especially in the study of alternative market mechanisms."

Over that time span, Smith's political views evolved in tandem with his economic insights. He left behind the socialism he learned at his mother's knee for a more libertarian outlook. He says "experimental economics destroyed whatever was left in me of the notion that somehow you could do better than to find institutions that organized this decentralized information and create." Now continuing his lab work at Chapman University, Smith is riding out the second most serious economic crisis of his 84 years in sunny California.

In July, Smith sat down with reason.tv Editor in Chief Nick Gillespie to discuss his ideological journey, how FUR (and perhaps George W. Bush) saved capitalism, why some of Adam Smith's most important intellectual contributions are overlooked, and what experimental economics has to say about the collapse of the housing market.

reason: We're sitting in your office at Chapman University, a beautiful campus in Orange County, California. Tell us about your setup here, what kind of experiments you're running, and what you're hoping to find with them.

Vernon Smith: We're asking some questions that came out of the economic crisis. We started doing asset-trading experiments in the '80s and discovered bubbles, quite unintentionally.

reason: In your experiments, you were able to create bubbles, or did they just pop up?

Smith: They popped up. We thought we would create bubbles, but we never had to.

reason: How does a bubble take place?

Smith: Right now, we don't understand why people get caught up in self-reinforcing expectations of rising prices. The first time you're in this experiment, you may have bought early and you may have sold before the break. Bring those same people back in another two or three days, put them in the same environment, and we get a lower-volume bubble. Typically, it booms earlier and crashes earlier; they are expecting a bubble. Bring them back a third time, and they tend to trade fairly close to fundamental value.

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reason: How does this type of experiment map onto, say, the last five years in America?

Smith: If you think about the housing bubble, buyers, sellers, borrowers, lenders, real estate agents, government regulators--everybody believed that prices would rise and continue to rise. And that is the essence of a bubble. Suppose a regulator in 2003 or 2004 said, "Hey, this thing is not sustainable. We've got to do something to stop it." I think he'd have been fired. If the bubble had been stopped in 2003 or 2004, it probably would have been a lot less damaging. But who's going to know that?

reason: Why has it taken so long for economics to become more seriously empirical in its operations? It really seems like it's taken forever for economists to want to...