Bubble Economy

Noah Smith asks:

What is a “bubble”?

Well, it’s something that looks like this:

Prices go way up, then they crash back down. Look at any long-term plot of any asset price index (stocks, housing, etc.) and you’re likely to see some big peaks like this. That’s what I call a “bubble.” It’s also the definition used by Charles Kindleberger in his book Manias, Panics, and Crashes.

That sounds about right. We see these patterns everywhere — from Bitcoins, NFLX, and copper today, to the DJIA, NASDAQ and many commodities and stocks during the last century. Smith continues:

But the real question is why we care about bubbles. Some people believe that bubbles are merely responses to changes in expected fundamental value of an asset (the “fundamental value” is the expected present value of  the income you get from owning an asset). According to this view, the NASDAQ bubble happened because people thought that internet companies were going to make lots and lots of profit, and when those expectations didn’t materialize, prices went down again. This view is held by many eminent financial economists, including Eugene Fama, the most cited financial economist in the world.

If bubbles represent the best available estimate of fundamental values, then they aren’t something we should try to stop. But many other people think that bubbles are something more sinister – large-scale departures of prices from the best available estimate of fundamentals. If bubbles really represent market inefficiencies on a vast scale, then there’s a chance we could prevent or halt them, either through better design of financial markets, or by direct government intervention.

Smith goes on to quite elegantly show that a lot of evidence suggests that bubbles are probably an entirely natural phenomenon.

As an Englishman, there is an example much closer to home:

Gordon Brown claimed that his government had abolished boom and bust; there would be no more foundering capitalist bluster, no slump after the boom, just slow, steady centrally-planned growth.

Then 2008 happened, his claims were made to look infantile, and he was shunted from office by a man who at the very least has some backbone.

Bubbles are expressions of human exuberance. That is because value is subjective (and as such, the notion of incorrect “fundamentals” is extremely fuzzy — how can any subjective value be “fundamental”?) Humans are herd animals — we move where the money is. If an asset value is rising, speculators will want a piece of the action. And why not? Money made speculating is money made with little or no effort. Sometimes there is some underlying reason as to why an asset value is rising: expectations of rising earnings, or a prospective takeover. Sometimes it is just hot air and animal spirits.

A simple heuristic: bubbles happen. Even when central planners have explicitly gone out of their way to prevent bubbles, they still seem to happen.

On the other hand, it is possible to make societies more robust to bubbles. For a start, if a bubble is built on debt-acquisition (e.g. 1929) its collapse will be more painful than otherwise due to counter-party risk, because of the resultant default cascade. So, basing the banking system around debt is by default quite fragile. So too is allowing a humungous scheme of credit creation via securitisation and rehypothecation. And so is allowing the unregulated trading of huge quantities  of exotic derivatives and swaps.

Andrew Haldane, writing in Nature, describes the bubble that emerged:

In the run-up to the recent financial crisis, an increasingly elaborate set of financial instruments emerged, intended to optimize returns to individual institutions with seemingly minimal risk. Essentially no attention was given to their possible effects on the stability of the system as a whole. Drawing analogies with the dynamics of ecological food webs and with networks within which infectious diseases spread, we explore the interplay between complexity and stability in deliberately simplified models of financial networks. We suggest some policy lessons that can be drawn from such models, with the explicit aim of minimizing systemic risk.

Regulators overlooked huge systemic fragility because they had no concept of its existence. That is the very definition of a black swan. And the nature of reality suggests that no matter how good we get at modelling reality and behaviour, those black swans will keep clusterflocking.

Bubbles happen: what matters is how resilient we are to them. And  — with gross derivatives exposure as high as ever before, with government and private debt as high as ever before, and with unemployment still perilously high — it would be quite hard to say we look very resilient.

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15 thoughts on “Bubble Economy

  1. “The fact that we are here today to debate raising America’s debt limit is a sign of leadership failure. It is a sign that the U.S. Government can’t pay its own bills. It is a sign that we now depend on ongoing financial assistance from foreign countries to finance our Government’s reckless fiscal policies. … Increasing America’s debt weakens us domestically and internationally. Leadership means that ‘the buck stops here. Instead, Washington is shifting the burden of bad choices today onto the backs of our children and grandchildren. America has a debt problem and a failure of leadership. Americans deserve better.”
    – Barack Hussein Obama, Senator (2006)

  2. The future WArs in the developed world will be Generation wars. The old ones, who are the majority in voting, racking heavy debts living much longer but refusing to died. They younger ones will say to them eventually: ” Hey you had you time of life. Enough is enough. We can’t take it anymore!”

    • p.s. What makes the future generation wars more likely to happen is the fact that the people, who are having the babies in certain developed countries, are mostly the immigrants from the 3rd world countries. These people are from different cultural religious backgrounds. Some of them refused to adopt their new countries’ culture, language, and values belief.

      • Absolutely correct!

        In Australia, the younger generation of the non immigrant section of the community, is delaying birth, because there are enormous pressures. Many have to rent, because of tax policies that favour the elderly, who continue to live in 4 bedroom houses because of sentimental attachment and generous capital gain tax exemptions.

        • Yes the defining issue of our age will be intergenerational warfare. That makes me very sad; not all boomers are assholes, but as a generation they have rigged the governmental and societal game to benefit them at the expense of everyone else.

  3. Billions of ‘pounds’ have disappeared, where were they before? Where did they go? How come after they disappeared the tax payers were asked by ‘their’ representatives the democratically elected politicians to bail out the bankers? Who actually rules? Who is in debt and having to pay off the bankers, is everything healthy or something very wrong? Do economists help with the situation?

  4. I got burnt by the Nasdaq Bubble. I recall at the time, valuations were hard to compare on a historical P/E ratio, because tech was so hard to quantify. I remember feeling like I was going to miss the opportunity of a lifetime, because tech was new to me. I leveraged up and got badly burned.

    Lesson learned, the zeal I have for understanding my mistakes, makes the loss justified.

    I now understand how the 1929 crash felt. People invested in the “Radio Tech” age just the same.

    • The main bubble then (as now) was the real economy (in 1929, farmers) acquiring excessive debt to maintain a status quo that no longer existed (in 2008, homeowners eating their equity to fund consumption).

      • What to think about recent Gold/ Silver fever? Although understandably people are into those metals because central banks are buying gold around the world while there is very limited supply of physical silver beside the solar industrial especially the solar panel usage, still it feels weird that street signs everywhere “We buy Gold!” And then there are lots of people who behave like cult when there gold is concerned. Seeing a familiar picture of the housing bubble during the piking year.

        • I agree. I feel that Gold is in a major bubble. This is why I bought productive agricultural land. We just came out of a 12 year super drough, land was cheap, and I don’t believe in global warming. So far I have had 2 summers of rain, and I am not having to spend money on feed.

          150 years ago, the pioneers and explorers said the region was an agricultural utopia. I am hoping for a reversion to the climatic mean.

          If Global warming is true and causes a rise in sea levels, my land will be a few KM from the coastline! I can sell to coastal developers.

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