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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