Bubbles and Crashes

Bubbles and crashes In a great book “The Penguin Guide to Finance”, the author, Hugo Dixon, discuss the cause of bubbles and crashes. ‘Some degree of irrationality is always present in financial markets. When it reaches epidemic proportions, it leads to bubbles and crashes. The difference between the sort of momentum investment and a bubble is one of degree. In a bubble, a large proportion of the population jumps on the bandwagon. The herd mentality predominates and prices are driven far away from fundamental value. As a result, when the bubble bursts, the fall in asset prices is large and sharp. Because so many investors get stung, the economic damage can be long- lasting. Bubbles, like epidemics, are rare. Once investors have been infected, they tend to be inoculated for life. Events like the Tulip Mania in The Netherlands in the 17th century, the South Sea Bubble in theUK in the 18th century, the Wall Street Crash of 1929 and the Japanese bubble economy of the late 1980s become part of folklore. The disease therefore normally has to wait at least until the next generation has grown upbefore it can strike again – and may last much longer. Although all bubbles are one-off events, they share many common characteristics. Charles Kindleberger, in his book Manias, Panics and Crashes, argued that they follow a standard pattern. First, there is a displacement, an external event which kicks off the process and normally justifies some increase in asset prices. Then there is positive feedback, as investors spot that there is easy money to be made from the asset in question and pile into the market, pushing prices up. This gives way to euphoria, when investors become manic and large proportions of the population are sucked into the market, pushing prices still higher. Then comes the crash. Kindleberger’s schema suggests that bubbles are not totally irrational. The initial rise in market prices is normally warranted either by advances in technology or general economic prosperity. (See Table A.) Both factors contributed to theUS bull market of the1920s: the automobile and radio were revolutionizing communications, while America had emerged as the world’s economic superpower. New technology provided a similar justification for the UK Railway Mania of the 1840S. It is even possible to view the South Sea Bubble through the prism of innovation: the heart of the South Sea Company was new financial technology that allowed investors to convert illiquid annuities into tradeable securities. Japan’s bubble economy of the 1980s, by contrast, was less to do withnew technology and more to do with general prosperity – at the root of which was an extremely efficient applicationexisting of technology. As a www.capitalideasonline.com Page - 1 Bubbles and crashes result, Japan was expanding fast and rapidly catching up with the US. Indeed, many thought it was on the point of becoming the new superpower. Similarly, there was not really much new technology in the Tulip Mania. But the bubble came at a time of great prosperity in The Netherlands, when the population had money to spend on luxury items – of which tulips, a relatively new import from Turkey, were the most prominent example. All these were genuine developments. The railway, automobile and radio did revolutionize communications. The Netherlands, US and Japan were (and are) important economic powers. But the rise in market prices went well beyond what was justified by fundamentals. The market ran away with itself. Part of the explanation is financial. If investors bet that recent trends will continue, asset prices can be carried ever higher by momentum. Moreover, bubbles are often supported by cheap money and lax lending by banks. Table A Bubbles and crashes (a very simplified history) Date cause of bubble cause of crash after-shock Tulip Mania 1636-7 Rising prosperity Delivery of tulips and Minimal as most big (Netherlands) New luxury item payments were Dutch merchants did coming due not take part South Sea Bubble 1720 New financial Government crack- Quick economic technology down on rival bubble rebound Tight provided liquidity to companies regulation for a annuities century Railway Mania 1845 New technology Proliferation of Excessive leverage (UK) railway schemes Rise contributed to 1847 in interest rates Calls banking crisis on partly paid shares Wall Street Crash 1929 Automobiles and Economy peaked Banking crisis, (US) radio Low inflation after interest rates depression Tight had risen regulation for many decades Bubble economy 1980s New economic Bank of Japan raises Long-drawn-out power interest rates banking crisis Slow growth through 1990s www.capitalideasonline.com Page - 2 Bubbles and crashes But the spirit of the time also plays a role in determining whether a population is susceptible to being swept up in a bubble. In his excellent recent history of financial speculation,Devil Take the Hindmost, Edward Chancellor highlights social and political factors. He argues that nations are prone to speculative manias when self-interest is the principal economic motivation. He also argues that they thrive whenlaissez-faire political philosophies predominate. The greed of individuals provides the driving force, while the lack of tough regulation means there is little restraining action. Chancellor’s history also provides a wealth of material on the euphoric stage of a bubble. Three common features stand out: conspicuous consumption, corruption and new-age theories. As the market rises, people become more extravagant in their consumption. The US in the 1920S spawned the Great Gatsby set; Japan’s bubble economy was accompanied by a mad scramble to buy European impressionist paintings at exorbitant prices. Boom times also often lead to monumental architectural projects: the Empire State Building, for long the world’s tallest skyscraper, was planned at the peak of the1920S bull market; while Kuala Lumpur’s Petronas Towers, now the world’s tallest buildings, were completed just before the Asian crisis of1997. Financial skullduggery is also often rife at the euphoric stages of bubbles. The population is then less suspicious and so fraudulent schemes are not easily spotted. Meanwhile, those who are profiting from shady operations can find it in their interest to keep those in authority onside by bribery. For example, John Blunt, the architect of the South Sea Bubble, bribed members of parliament and several ministers, including the chancellor of the exchequer, with cheap shares. Similarly, during the Japanese bubble of the 1980s, a large number of ministers were embroiled in the Recruit Cosmos scandal, which involved giving politicians cheap shares to buy influence. Finally, bubbles generate new-age theories. These aim to justify not only the original rise in the market but also the subsequent stratospheric levels. A common theme is that this time things are different and therefore old valuation yardsticks no longer apply. In the 1920S in the US, the theory was that the establishment of the Federal Reserve System meant financial crises were a thing of the past and ensured low inflation. Meanwhile, technological advances and better management were improving industry profits. In the Japanese bubble, a strong line of argument was that the Japanese were different. Their accounting techniques, for example, were different – and therefore what might be considered normal price/earnings ratios by international standards did not apply in Japan. Much the same arguments – that inflation has been conquered and that the internet has revolutionized communications – are being used to justify the US bull market of the late 1990S. Disconcertingly, people even speak of a ‘new paradigm’. www.capitalideasonline.com Page - 3 Bubbles and crashes Bubble trouble It is in the nature of bubbles to burst. There is, of course, always a dispute over the fundamental value of assets. But once prices get seriously overvalued, it is only a matter of time before something triggers a crash. But predicting the timing of the bursting is impossible. Even identifying the event that pricks a bubble is often difficult. That said, one of two causes is often present: growing competition; or tight money. When asset prices are shooting up, people can join the party either by buying shares in existing companies or by creating new companies. So long as investors concentrate on buying existing shares, the bubble is in good nick. The weight of money drives up the prices of a limited number of stocks. Demand exceeds supply. But the higher share prices rise, the more attractive it becomes for entrepreneurs to form new companies. This helps prick the bubble. Not only do the new companies compete with the existing ones for business, so threatening to depress profits; they also compete for the attention of investors. When this occurs, supply exceeds demand. A flood of new companies was one reason the South Sea Bubble collapsed. In 1720, according to Chancellor, 190 so-called bubble companies were founded. Only four survived. A similar phenomenon occurred with the UK Railway Mania. In September 1845 alone, 450 new railway schemes were registered. Meanwhile, a flood of new internet stocks in mid-1999 was one reason they came off their highs. The other way that chickens often come home to roost is when investors have to pay their debts. If they have bought shares with their own money, this is not an issue. But when markets are rising, the temptation to get a slice of the action by borrowing money can be irresistible. Sometimes, tightening credit conditions make the investors’ lives difficult. This can occur as a natural consequence of the bubble. Investors borrow money to bet on the stock market; companies raise capital to invest in physical assets. The demand for capital then pushes up interest rates. And this makes life uncomfortable for those who have borrowed too much. Some of them may have to liquidate their assets.

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