Money and Banking
Economic Bubbles: Analysis, Predictability and Aftermath
Currier and Ives, 1875.
Executive MBA Professor: Jean-Claude Oswald Author: Constant Gbaguidi
August 2006
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Table of contents
1. Introduction 3
2. Analysis of Bubbles 4 2.1. Some Famous Bubbles 4 2.1.1. Tulipmania (1637) 4 2.1.2. Poseidon (1969) 4 2.1.3. Beanie Babies (1996) 4 2.1.4. The Internet Bubble (2000) 4 2.2. Basics 5 2.3. Bubble Cycle 7 2.3.1. Inflation 8 2.3.2. Rise Over Fundamental Value 9 2.3.3. Market Mood and Communication 14
3. Bubble Predictability 17
4. Bubble Aftermath 18 4.1. Similarities between the Internet Bubble and the Great Depression 18 4.2. De-bubbling 18 4.3. Bubble Virtues and Vices 19
5. Conclusion 21
6. References 21
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1. Introduction
The business cycle is made up of periods of expansion and contraction. Sharp expansion is called bull and sharp contraction is called bear. This is a normal wealth creation process, in the first place. However, history has witnessed many occurrences of abnormal expansions, with three-digit growth rates on a given market: the appropriate term to qualify such a state is ll u economic bubble. Consider B what happened to Ababacar Diop in 2000 [13]: he was paid Be €4,000,000 to give up the a domain name vizzavi.fr that he rr had bought earlier for a couple of hundred euros. Such an event happens in many markets every year but many such events happened between 1996 and 2000. Asset prices increased without any real value creation: this is the main characteristic of a bubble.
Figure 1Illustration of bear and bull.
An economic bubble refers to a market condition where the prices of commodities or asset classes increase to absurd levels that no longer reflect utility of usage and purchasing power. Bubbles indicate an abnormal market situation that challenges the market equilibrium concept.
The purpose of this document is to analyze the advent of bubbles, investigate into ways to predict them and review the aftermath.
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2. Analysis of Bubbles
Before analysing the mechanisms that lead to a bubble, it is worth describing some of them.
2.1. Some Famous Bubbles
2.1.1. Tulipmania (1637)
Tulipmania is the first inventoried bubble [6]. Tulip, grown in the Netherlands as from around 1593, had rapidly become a luxury item and a status symbol. In 1623, a single bulb of a renowned tulip breed was worth up to 1,000 Dutch florins (the average yearly income at that time was 150 florins). In 1635, a record showed 40 bulbs sold at 100,000 Dutch florins – a single bulb was then worth 2,500 florins. In 1636, tulips started being traded on stock exchanges with non-regulated tulip futures contracts. In February 1637, the demand dropped and the traders began selling the tulips. The traders were left with their futures contracts to be honoured.
2.1.2. Poseidon (1969)
In the late 1960s, nickel was in high demand due to the Vietnam War, but there was a shortage of supply due to industrial action against the major Canadian supplier Inco [5]. These factors pushed the price of nickel to record levels, peaking at around £7,000 on the London market early in November 1969. In September 1969, the mining company Poseidon NL made a major nickel discovery at Windarra in the Shire of Laverton, Western Australia.
In early September Poseidon shares had been trading at $0.80, but as information about the discovery was released, the price rose up to $12.30 on October 1. After this, very little further information came to light, but the price continued to climb due to speculation; at one point, a UK broker suggested a value of up to $382 a share. As the price of mining shares grew, numerous new companies were listed by promoters looking to cash in. Some of these new listings did not even have any mining leases. As the new companies started crashing, the image of mining stocks was tainted, and the prices began to fall.
2.1.3. Beanie Babies (1996)
Beanie Babies are stuffed animals filled with plastic pellets. They were created as from 1993 by Ty Inc. Hundreds of different models had been created, including specials like for July 4th or Lady Di. The success of Beanie babies created faddish craze of collecting. Ty Inc. encouraged the fad by retiring many models and ceasing the production of those. The collectors’ expectation of a price rise never happened to the extent initially thought of.
2.1.4. The Internet Bubble (2000)
The Internet started to attract business interest in 1995. This was a breakthrough technology that was lowering all entry barriers, by increasing the bargaining power of the buyer ( a quick search on the Internet could help compare prices offered by different sellers), and reducing the start-off capital for many businesses, mainly by bypassing intermediaries, especially in the promotion and distribution of one’s product. Although they were right about the breakthrough era that the Internet was announcing, many investors overvalued the potential of the technology. Like for any emerging technology, Internet specialists were rare at that time. In order to attract those rare resources,
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companies had to offer stock options and very good working conditions. The wealth effect was at its top, creating inflation everywhere. The NASDAQ was at its top as well, around 5,100 index points.
The fear for the millennium turn in 2000 was probably a major factor that sustained the bubble. Many companies were paying a large amount of money to alleviate any potential harm from the 2000-bug. That bug never occurred and the turn of the millennium happened without any major information technology breakdown.
As a consequence, the perspective for IT spending decreased and might have played a role in the crash of the Internet bubble in 2000. Also, anti-trust accusations against Microsoft and the threat of a split of that IT giant into pieces (as happened with AT&T in the 1980s) put doubt into investors’ mind.
The crash happened on March 10th, 2000, as illustrated in the below chart.
Figure 2. The NASDAQ Bubble [10].
As reported by Bambi Francesco of MarketWatch [12], 76% of venture funding invested over the past 27 years occurred in 1999 and 2001, citing a Morgan Stanley report. Many companies that were funded might not have been.
2.2. Basics The painting by Currier and Ives (1875) as reproduced on the front page of this document (and in the below figure) gives a very good illustration of the perception of bubbles by a rational person: bubbles are based on expectations (whether rational, realistic or not) and are a good way to “grow poor”, whereas hard work is the guarantee for growing rich. Indeed, bubble-generating ventures are comparable to gambling (forecasting and goodwill: nothing tangible). Hard work is an asset that is valued on the basis of economics and finance fundamentals.
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Assets ExExpectations Assets
FoForecrecasting, potententialtial growthowth,, FFundaundamenmentalstals (e..gg., bbooook vallue,ue, marmarkket value:value: ggooododwwiillll, gamblingamblingg prpricicee to earnearnings,ings, assasseet ratio, ccapitalapital ststrrucucttureure))
Figure 3. Expectations vs. assets: the roots of economic bubbles.
There are different types of economic bubbles:
Bubble
Stock Market Bubble Financial Bubble Commodity Bubble Real Estate Bubble
e.g.e.g.,, IntInteernrnet bubbblble inin e.g.e.g., crcredieditt cruunncchh ofof e.e.g.g.,, ttulipulipmaninia,a, 19919988-20020000 1966,66, andand 1920920s bubbubblble bbeaeanniiee babiabies,es, stampamp collcollecectingting, ongoigoinng oil anandd gogoldld bubbbblleess
Figure 4. Classification of bubbles.
• Stock market bubbles are bubbles that originate from the stock market. An example is the Internet bubble of 2000;
• Financial bubbles mainly affect the banking system. Examples are the credit crunch of 1966 and the 1920s bubble that eventually led to the Great Depression. Indeed, in the 1920s, banks kept lending to companies in construction, radio and automobile but, due to restrictive international trade laws,
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companies could not sell their products, leading to an oversupply situation and to deflation. As the deflation lasted, it became a depression that affected the entire world;
• Commodity bubbles are the like of the tulipmania of 1637 or the oil bubble that starting in August 2005;
• Real estate bubbles relate to bubbles affecting the real estate sector.
2.3. Bubble Cycle Bubbles always start with a real event that has nothing to do with irrational thinking. That event could be a new technology, the expansion into a new market and the overvaluation of the potential thereof, a new product, a political event, a new fashionable trend, or a sudden increase in the demand for a product. That real fact would trigger an irrational exuberance that would lead to a bubble. The burst of the exuberance can be intentionally triggered by governments (de-bubbling) or result into a crash.
3. CrashCrash
1. EvEventent 2.2. IrraIrrationtionalal exuberanceerance
4. De-bubbubblinblingg
-NNeew tteechnonollogyogy -Inflation (low iinntteerest ratete) -New markerkett -SSppececuulalatitionon -NNeew prododucuct -Biases -Polliittiical evevenent (e.g., -WeWealalth eeffffeecctt -Government intterervententioionn (interest wawarr,, eellecectitiononss)) -SSiiddee efffects:ects: bbuubbbblesles inin otherher rate, ffiiscascall ppololicy) -NNeew ttrrendend markets, especiallly rreeaall estateestate -Increase in need fofor a pprroducoduct -…
Figure 5. The Bubble cycle.
The main causes and manifestations of irrational exuberance are inflation, absurd rises over the fundamental value of assets, and critical market states influenced by communication. In a word, economic bubbles are the consequence of irrational valuation of assets. Each of the factors is explained in the ensuing sections.
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GeneraGenerally due to exexcescesss iinn moneymoney supply InInflaflattioionn (low inteinterrestest rates)
Stoockck bububblbblee:: - Market valvalueue too high compared toto book value RisRisee oovverer - PE ratio too high ffundaundamenmenttaall Commodity oror real estatetate bubble: value -Profit margin too high value - PE ratio too high EEconoconomic BubbBubble Price = cost ooff ththee commodity or hhouousse Earnings = annual rental – chargecharges - taxes CritCriticicalal mmaarkrketet ststatateess CommunicCommunicatatioionn amonamongg investors iinnflfluueenncedced byby Socialial comcommunication ccoommunimmuniccatatiionon MediaMedia and market analysts
Consequence of irrational IrIrrationrationaall valuation Exuberancerancee
Figure 6. Main causes and manifestations of an economic bubble.
2.3.1. Inflation
In order to understand inflation, it is necessary to understand the supply and demand curves. Consider that Do and S are the demand and supply curves before the inflation starts, respectively (see figure). When inflation starts, the market becomes ready to pay more for the same quantity of goods: the demand curve moves up- and right-wards. Market equilibrium is broken. In a bubble period, such movements could occur many times a day.
Figure 7. Supply and demand curves.
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Basically, investors are ready to pay a premium as they expect a higher return from the asset (stock or commodity or real estate). In the event of a bubble, investors sell their assets and may cash the money. Additional money is needed to account for the gain made on the transaction, leading to an increase of money supply. An increase of money supply is normal when value is created. It becomes abnormal, or at least questionable, when virtually no value is created: this is the definition of an inflation on the asset market. This inflation creates a wealth effect, whereby people feel like wealthier and spend money. Little saving is made in such a period, leading to balance of payments deficits (see section 4.3). Eventually, all other markets might be contaminated, as consumers might be willing to pay a premium for other products or assets, too.
2.3.2. Rise Over Fundamental Value
A rise over the fundamental value of an asset always bears the risk of a boom and a burst: it is like buying an egg at the price of a luxury watch. That generally would not last. Therefore, a rise over the fundamental value of an asset should raise a red flag, indicating the need for further investigation.
There are two main ways for estimating the value of a company: the book value (based on the company’s balance sheet) and the market value (as traded at the stock exchange, for instance). Each of the methods has its drawbacks:
• The book value can incorporate some non-measurable parameters such as goodwill, which can hide a bad investment: for instance, if a company buys another one at a higher price than the bought company is really worth, the buying company will book the “unjustified” difference in the goodwill line. For instance, eBay recorded about $6.1 billion as goodwill on a total asset value of $11.8 billion in 2005 [17]; this account for its purchase of Skype for $1.3 billion in cash and another $1.3 billion in stock exchange.
• The market value already incorporates the market speculation; therefore, it does not provide the right view on the firm’s fundamental value.
Nevertheless, the book value gives the more realistic image of the value of the company, although a deep look at the details of the financial statements (especially the balance sheet) is needed to factor out non-quantifiable items such as goodwill.
The literature (or theory) is full of financial indicators that can help identify a rise over the fundamental value of an asset. Tobin’s Q ratio, the Fool ratio and the price-to-earnings (P/E) ratio are among the most renowned. The P/E ratio is the simplest of the three and will be described in more detail below.
2.3.2.1. P/E Ratio of Stocks
P/E is the ratio of the price of a share over the earnings realized per share. The mathematical formula is:
Price per share P / E = Earnings _ per _ share
For instance, the stock price of Google on August 3rd, 2006, was $375.36. In 2005, the earnings per share (EPS) were $6.85. Therefore, the P/E ratio is 54.8 (=$375.36 / $6.85). This means that for each $54.8 invested, one would earn back a maximum of $1. The return rate would therefore be 1.71%. If one is rational , s/he will invest in bonds instead of Google shares.
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The above calculation is based on values from different accounting periods. Strictly speaking, the Google P/E estimation is not valid. Nevertheless, it gives a very good indication on the potential overvaluation of the Google stock. Google has certainly realized that, and this might be the reason why it started diversifying heavily. There is no better way to confuse investors than diversifying into businesses that the investors might not understand. Still, the main question here is: is Google overvalued and could it be experiencing a boom?
The P/E ratio can be used to answer that question. According to the P/E benchmark, a P/E ratio higher than 28 raises a red flag for investigating into a boom effect .
P/E ratio Potential over- or under-valuation
0 - 13 Either the stock is undervalued or the company's earnings are thought to be in decline.
14 - 20 For many companies, a P/E ratio in this range may be considered fair value.
21 - 28 Either the stock is overvalued or the company's earnings have increased since the last earnings figure was published.
28+ A company whose shares have a very high P/E either really does have an exceptionally rosy future or the stock may be the subject of a speculative bubble.
NA A company with no earnings has an undefined P/E ratio.
Figure 8. P/E ratio benchmark [18].
A high P/E ratio does not necessarily lead to a bubble:
• Occasionally low earnings (due to high investments, typical of biotechnology companies, or due to a recession) can lead to temporarily high P/E ratios.
• Hype on the stock can lead to a temporarily high P/E ratio.
• Great expectations on the stock due to good past performance, despite exceptional investments or losses in the current year, can lead to a high P/E ratio.
Schiller computed the evolution of P/E ratios of Standard & Poor (S&P) companies since 1881 [4]. He computed two curves: one calculating the P/E ratio based on the financial statements of the year, and a 10-year averaged P/E (which divides the current share stock by the average yearly earnings over the preceding 10 years).
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Figure 9. P/E ratios since 1880 [4].
The 10-year averaged P/E ratio clearly highlights the bubbles, more so than the yearly P/E ratio does. The curves show that it had taken at least 10 years to the stock market to recover from the previous bubbles. Based on that observation, Schiller predicted that the Internet bubble of 2000 would take 10 years or more to be recovered from. As illustrated in Figure, fortune has been better this time, as the NASDAQ grew up to 5100 in January 2006, almost at the index it was during the bubble period. Schiller might not be wrong: right after the Internet bubble, there has been another boom in the biotechnology sector. This event might have accelerated the recovery of the stock market. Such an event did not happen after the previous bubbles.
Figure 10. NASDAQ evolution since 2002.
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2.3.2.2. P/E Valuation for Real Estate
Although P/E ratios were initially defined for stocks, their definition has been extended to many areas, especially real estate. In real estate, the price can be defined as the perpetuity of the cost of the house (= cost of the house divided by the interest rate). The earnings are the annual rental fees for a similar house in the neighborhood, minus the expenses (e.g., taxes).
H / I P / E = R − S where:
H is the price of the house,
I is the interest rate,
R is the annual rental for a similar house in the neighborhood,
S is the annual spending (including taxes).
Dean Baker estimates the P/E ratio to be between 30 and 50 in some regions of the US. Overall, as far as the whole of the US is concerned, Baker and Rosnick [1] determine that the real home prices are 60% above the real rental prices (see figure). They use a price index, instead of a real P/E ratio but the conclusions are the same.
Figure 11. Rent vs. home prices in the US [1].
In order to assess the probability of a bubble, one has to consider also the house occupancy rate in the neighbourhood, in addition to the P/E ratio. The vacancy rate is over its “normal” average of 8%. However, it has
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been decreasing since 2005, mainly due to the raise of interest rates by the Federal Reserve. This indicates a housing bear in the next 6 to 8 months in many areas in the USA.
Figure 12. Home vacancy in the US [1].
2.3.2.3. P/E Valuation for Commodities
P/E valuation is much more difficult to do for commodities. Indeed, many commodities (oil, diamonds) are run by a cartel. As a result, no P/E benchmarking is possible and no prediction can be made.
The situation might be different for commodities traded on freer and more competitive markets. For those commodities, the following approach might be used:
• Identify the current output level for the commodity,
• Identify the maximum output level that can be reached in the near term,
• Assume that the prices will not raise too much due to existing competition and estimate a fair market price,
• Multiply the fair market price by the output and adjust with cost information (check income statements): this is the maximum earnings that can be expected: this is the earnings E.
• The market capitalization of the main suppliers (divided by the total amount of shares) gives the weighted share price: this is the price P.
• Apply the same P/E rules of thumb as for securities markets.
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Fundamental metrics can be used to predict a bubble. They quantify the behavior that leads to bubbles but fail to qualify and explain that behavior. This bubble-prone behavior was coined irrational behavior by Alan Greenspan. The field that studies such behavior is called Behavioral Economics, which is the application of psychology to explain market anomalies. It is not the scope of this document to introduce that field. Instead, this document will extract the main concepts of behavioral economics and finance, and elaborate on their influence on bubble forming.
2.3.3. Market Mood and Communication
Five main concepts will be discussed below in order to explain the somewhat irrational behavior of investors during bubbles. These concepts are:
• Prospect theory (Kahneman and Tversky in 1979)
• Framing
• Crowd effect
• Signaling (rules of thumb)
• Price reactions to information.
2.3.3.1. Prospect Theory
The Prospect theory was proposed in 1979 by Kahneman and Tversky. The theory predicts that individuals tend to be risk-averse in the region of gains (or when things go well) and risk-seeking in the region of losses (such as a leader during a crisis or a patient at the final stage of cancer who wants to go through a medicine test trial).
Kahneman and Tversky propose a value function defined on the gains or losses relative to a reference point, instead of the absolute level of consumption or wealth. The value function is defined in function of deviations from the reference point. The value function is generally concave for gains and commonly convex for losses. The value function is steeper for losses than it is for gains.
The theory was confirmed in many arenas (politics, healthcare, finance). It explains well why people take risks when they have nothing to lose. However, the prospect theory is fuzzy enough (due to the concept of reference point) that it might be true for two opposite situations. The theory does not explain well why people are so reluctant to selling successful securities. According to the prospect theory, they should sell when the securities are high- priced.
Figure 13. S-Curve of the prospect theory.
2.3.3.2. Framing
Framing states that the way that economic agents articulate an outcome or transaction in their minds (and later present it to others) affects the utility they expect or receive.
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The following experiment was conducted [15]: two groups were presented with 2 alternatives from which they have to choose one. The first group of participants were presented with a choice between two programs:
• Program A: "200 people will be saved"
• Program B: "there is a one-third probability that 600 people will be saved, and a two-thirds probability that no people will be saved"
72% of participants preferred program A (the remainder, 28%, opting for program B).
The second group of participants were presented with the choice between:
• Program C: "400 people will die"
• Program D: "there is a one-third probability that nobody will die, and a two-third probability that 600 people will die"
In this decision frame, 78% preferred program D, with the remaining 22% opting for program C.
However, programs A and C, and programs B and D, are effectively identical; a change in the decision frame between the two groups of participants produced a preference reversal, with the first group preferring program A/C and the second group preferring B/D.
In the case of the Internet bubble of 2000, framing was also used in the hype surrounding the new technology. US Vice-President Al Gore mentioned the Information Superhighways that would change the face of the world and enable globalization, new words such as new economy, e-business, B2B, B2C, and new world were extensively used. The marketing idea behind those buzzwords was simple: this is something completely new that resembles nothing ever experienced before. The continuous use of such words contributed to ignoring the fundamentals. How could the old good financial ratios applied to the new economy? Most investors were disoriented. Much of the bubble came from that disorientation.
2.3.3.3. Crowd Effect
Crowd effect is one of the most powerful influencing factors in a bubble state. Many psychological factors explain the crowd effect:
• Difficulty to swim against the stream: due to their inherent belongingness aspiration, most people would prefer to keep their opinions and objections instead of raising their voice and being excluded from the group.
• Absence of risk in following the crowd: by following the crowd, one ensures that s/he would not fail alone. If all people around failed, the relative wealth would still be the same and no shame would result. According to Harbaugh and Kornienko [16], people view their risk taking in relation with their neighbourhood (local status).
It takes courage and energy and confidence to be different but fortunately it takes difference to be innovative and visionary.
2.3.3.4. Signaling Effect
Companies sometimes issue signals that should theoretically not affect their value but that do affect their value, as investors interpret them differently. A non-exhaustive list includes:
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• The announcement of debt for equity exchange increases stock value.
• The announcement of equity for debt exchange decreases stock value.
• The announcement of equity issues causes negative abnormal returns.
• Stock repurchases via tender offers result in sharp price increases. There is no rationality in such behavior but investors psychologically respond to those signals in ways that could ultimately affect an entire industry. One possible reason for the crash of the Internet bubble is the anti-trust problems of Microsoft. Such a signal spread out and potentially affected all other firms in the IT industry.
2.3.3.5. Price Reactions
The analysis of stock market charts generally reveals that there are three phases in the adjustment of prices to given information:
1. In the first phase, investors under-react, especially if the stock has been rising for some time; it seems like they keep their confidence in the stock. This is a phase when technical analysis believers would act;
2. In the second phase, the price adjusts itself. However, the equilibrium reached is very fragile;
3. In the third phase, if there has not been any good news on the part of the firm, the investors would over- react. This would accelerate the decline in the price.
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3. Bubble Predictability
As discussed in section 2.3.2, financial indicators (especially P/E ratios) can help in determining whether a bubble is being formed. The main issue is not the predictability of bubbles, it is the cover of the predictions by the crowd effect. In most cases, bubbles can be predicted, at least recognized. However, the crowd effect is generally so overwhelming that the predictions are simply filtered out and not heard.
« I recognize there is a stock market bubble pr oblem at this point, said Alan Greenspan in September 1996 … I guarantee if you want to get rid of the bubble, whatever it is, [increasing margin requirements] will do it. » [8]. Greenspan was simply referring to the investors to check their “margin requirements”, i.e., their return rate, probably based on the P/E ratio. What about the Fed taking more active actions to stop the inflation? Furthermore, Greenspan coined the term “irrational exuberance” in December 1996. Unfortunately, he forgot about his statement after the Internet bubble had burst, when he stated that it was difficult to tell a bubble until after its occurrence.
Greenspan might have been trying to forgive himself from not acting to de-bubble the bull. Indeed, he was called on by George Reisman: “The inescapable implication is that sooner or later, the stock-market boom must end. The bubble must br eak. It would almost certainly have ended in the Fall of 1998 with the f ailure of Long-Term Capital Management, had the Federal Reserve not arranged for its rescue and quickly re-accelerated its own policy of money cr eation.” [9]. Reisman did a thorough analysis of the bubble from the money supply (inflation) standpoint.
Tony Deden took the same inflation standpoint and reached the same conclusion (published in The Sage Chronicle on September 24, 1998, [8]): “We fully expect a decline in securities prices and the almighty dollar over the next years….There is no new paradigm. Economic sins have consequences. Hopefully, perhaps even economists will learn that inflation is measured by the growth in money and credit rather than in an idiotic index of consumer prices. They might even learn that growth achieved with smoke and mirrors ultimately leads to ruin. “.
A year later, Tony Deden took a different view, based on other fundamentals such as P/E ratios, and reached the same conclusion, again (published in The Sage Chronicle on December 29, 1999, [8]): “Let there be no doubt, that what we are witnessing is , indeed, history’s gr eatest financial bubble. The indescribable financial excesses, the massive increase in debt, the monstrous use of leverage upon leverage, the collapse in private savings, the incredulous current account deficits, and the ballooning central bank assets all describe the very severe financial imbalances which no amount of statistical revision nor hype from CNBC can erase. “.
One could argue that other economists had a different view, more favourable to the bubble. Those include Glassmann and Hassett [8].
Nevertheless, the arguments used by those economists were not serious. As stated by Dean Baker from the Center for Economic and Policy Research: “It should have been very simple for any competent analyst to recognize the bubble as the ratio of stock prices to corporate earnings hit levels that clearly were not sustainable in the late nineties.” [8]
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4. Bubble Aftermath
This section highlights some similarities between the Internet bubble of 2000 and the Great Depression, explains de-bubbling techniques, as well as the impact of bubbles on the economy.
4.1. Similarities between the Internet Bubble and the Great Depression Are there any similarities between bubbles, in terms of the reaction of investors over time? Comparing the Great Depression to the Internet bubble, a study [10] shows some salient similarities, as illustrated in figure. Indeed, the two index curves tend to overlap, in relative value terms. Further research might be needed to understand in detail the behavior of investors. It seems like the percentage of investors that under-react in the same place and the percentage of investors who over-react later on are similar in the two cases, which explains the near-overlapping of the curves.
September 3rd, 1929 MaMarchrch 11th, 2000000
Figure 14. Internet bubble vs. 1929 bull [10].
4.2. De-bubbling De-bubbling is the level of control exerted by governments to manage the bubble aftermath. Bubbles reveal market imperfections for which Keynesian economists would call for government intervention. Indeed, for the sake of social stability and welfare, governments should intervene to alleviate and smooth out the bad effects of bubbles on the society at large.
Governments have the following de-bubbling levers:
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1. Monetary policy: governments can control the money supply (responsible for inflation or deflation) by adjusting the interest rate.
2. Fiscal policy: governments can adjust tax policies in order to reduce the attractiveness of speculating; this is difficult nowadays due to globalization.
3. Growth policy: governments can encourage the increase of production (amount of output per unit of input), instead of encouraging speculation.
The most immediate action taken by governments toward de-bubbling is to raise the interest rate. For some reasons such a policy was not enforced during the Internet bubble. Fortunately, it has been enforced to refrain the housing bubble.
4.3. Bubble Virtues and Vices Undoubtedly, bubbles create value and wealth: people feel like wealthier and consume, generally beyond their capacity, innovation is unleashed, creativity and entrepreneurship are encouraged, GDP is increased, and employment rate is increased.
According to the International Monetary Funds (IMF), the average growth rate during the last year of an equity bubble is 4% [3]. This rate falls to 2.6% the year after the bubble. There clearly is a value and wealth creation, even though some people might be more heavily hurt than others, especially after a housing bubble.
Figure 15. Relative contributions of output growth before and after asset price busts [3].
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Moreover, the performance of the stock market during bubbles is much higher than the decline during the bust: for instance, the performance of the equity market in the US was 165.2% during the Internet bubble years; that performance was -30.8% after the crash (meaning that about 69% of the wealth accumulated during the bubble period had remained). The wealth creation would have been null, had the performance been -100%.
Figure 16. Performance of stock markets before and after booms [3].
Unfortunately, there are some vices associated with bubbles: contamination thread, current account deficits and unemployment are the main ones.
Contamination is the process by which a bubble on one market tends to propagate to others; in particular, a stock market bubble often triggers real estate bubbles. The contamination thread happens as follows: The wealth that firms (or individuals) cannot use for their operations (or living) is invested in other markets. In the case of bankruptcy of the firm (or individual) after the bearish period, the investments will be sold, thus raising the risk of deflation in other markets. The spread of the contamination needs to be stopped by the Central Banks.
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As mentioned in section 2.3.1, wealth savings diminish in bubble periods. As from an accounting point of view, national investment must always equal saving, when there is a lack of saving, one of two things has to happen: either investment must be reduced or an alternative source of saving must be uncovered. America has opted for the latter option. That has been increased during the Internet bubble. A shortfall in domestically generated saving has been augmented by an inflow of saving from abroad -- inflows that can only be attained by running a massive external deficit. The saving rate fell from 6.6% in late 1994 to -1.2% in early 2001. The deficit was 4.4% of the GDP in 2000, a record that beat the previous record of 3.4% in 1986-1987.
According to Dean Baker [2], the approximate costs of the Internet bubble are:
• A current account deficit of about $320 billion that the US has to borrow abroad.
• The extent of the over-valuation of the stock market was in the range of $8 to 13 trillion.
5. Conclusion
Bubbles are mainly characterized by inflation, abnormal rise over the fundamental value of assets and irrational exuberance. Fundamental financial ratios (P/E ratio, for instance) can be used to determine the level of risk of a bubble, in a way that can predict the advent of a bubble. In fact, all bubbles were predicted by economists, based on the fundamentals. Unfortunately, the power of irrational exuberance (i.e., psychological biases, crowd effect, prospect theory, framing and price reactions to information) over-rules all predictions. The question is therefore not whether bubbles can be predicted but whether they would be listened to.
In most cases studied, the value and wealth created during bubble periods clearly offset the further losses after the crashes. The performance and social harm could be alleviated if governments could intervene in order to implement de-bubbling mechanisms, the most common being the control of the money supply via interest rates. Failing to do that would increase the deficit and the people’s poverty, and might lead to social instability.
6. References
[1] Dean Baker, Is the Housing Bubble Collapsing? 10 Economic Indicators to Watch, Center for Economic and Policy Research, Nov. 2005, www.cepr.net.
[2] Dean Baker, The Costs of the Stock Market Bubble, November 27, 2000, http://www.cepr.net/publications/stock_market_bubble.htm.
[3] Thomas Helbling and Marco Terrones, When Bubbles Burst, World Economic Outlook, International Monetary Fund, April 2003, http://www.imf.org/external/pubs/ft/weo/2003/01/pdf/chapter2.pdf.
[4] Michael A. Alexander, P/E, P/R and Irrational Exuberance, April 30, 2001, http://www.safehaven.com/showarticle.cfm?id=73&pv=1.
[5] Wikipedia, Poseidon Bubble, http://www.reference.com/browse/wiki/Poseidon_bubble.
[6] Wikipedia, Tulip mania, http://www.reference.com/browse/wiki/Tulip_mania.
[7] Wikipedia, Beanie Baby, http://www.reference.com/browse/wiki/Beanie_Baby.
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[8] Mark Thornton, Who Predicted the Bubble? Who Predicted the Crash?, 2002
[9] George Reisman, When will the bubble burst?, August 18, 1999, http://www.capitalism.net/Capitalism/articles/stockmkt.htm.
[10] Lowrisk Market Analytics, The 2000-03 Nasdaq Bear Market vs.1929 Crash, April 4, 2003, http://www.lowrisk.com/nasdaq-1929.htm.
[11] Prepared Testimony of Mr. Stephen Roach (Managing Director, Morgan Stanley) before the US Senate Committee on Banking, Housing and Urban Affairs, Hearing on " Risks of a Growing Balance of Payments Deficit", July 25, 2001, http://banking.senate.gov/01_07hrg/072501/roach.htm
[12] Bambi Francesco, Happy anniversary Internet bubble, in: MarketWatch, March 10, 2005, http://www.marketwatch.com/News/Story/Story.aspx?guid=%7BB467A528-C91B-42C8-BCDC- 0F3A5E1F2DD1%7D&dist=¶m=archive&siteid=mktw&print=true&dist=printBottom.
[13] Karine Portrait, Une bourde de Vivendi fait la fortune d’Ababacar Diop, July 24, 2000, http://domain39.altern.com/Une-bourde-de-Vivendi-fait-la.
[14] Adam Hamilton, US Equities: A Strategic Perspective, July 13, 2001, http://www.zealllc.com/commentary/strateq.htm.
[15] Wikipedia, Framing (economics), http://en.wikipedia.org/wiki/Framing_%28economics%29.
[16] Rick Harbaugh and Tatiana Kornienko, Local Status and Pr ospect Theory, January 2001, Claremont College.
[17] eBay Balance sheet, http://finance.yahoo.com/q/bs?s=EBAY&annual.
[18] Wikipedia, P/E ratio, http://en.wikipedia.org/wiki/P/E.
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