Beware the Next Bubble

The earliest known bubble was the “Dutch tulip mania” in 1637 which resulted in tulips contracts being sold for more than 10 times the annual income of a skilled craftsman (according to Wikipedia). And of course, shortly thereafter, the price of tulips crashed back to normal “flower levels”. All bubbles since have shared one thing in common – large groups of people thinking irrationally, all at the same time.

The clean-up act

Alan Greenspan has maintained that the government’s focus should be to reduce the effects resulting from a bursting bubble, as opposed to discouraging its development in the first place. When the tech bubble burst, the Fed reduced interest rates to 1% for an extended period of time and this is what many believe to have caused the next bubble.

With interest lost in the stock market, the cheap money went into the housing market and housing prices across the US and many other countries started inflating. Robert Shiller has done some fascinating research on this topic in his book “Irrational Exuberance” which supports this point of view. Housing prices continued to rise throughout the decade up till 2006 at which time housing starts (indicative of the supply of new homes) in the US peaked at roughly 2.3 million and have since fallen to a low of 488,000 in Jan, 2009. The domino effects of the collapsing housing market are now clear for everyone to see.

However, the policy response chosen by Ben Bernanke is hardly discernable from that of Alan Greenspan a decade ago, except in its magnitude. Interest rates are now at 0.25% and the Fed has done enough “quantitative easing” to result in the biggest expansion of money supply in history. And the steps of the Fed have been emulated by central banks all around the world. I question why policy makers are inclined to focus on reactive policies which address the fallout from a crisis as opposed to focusing on proactive policy making, addressing the factors that cause bubbles in the first place. Is that not a better long term solution?

Riding the bubble, reluctantly

Lou Jiwei, the chairman of China’s $298 billion strong China Investment Corp, said recently that, “Both China and America are addressing bubbles by creating more bubbles and we’re just taking advantage of that. So we can’t lose.”

Indications show that the money which central banks are pumping into economies is flowing straight into the stock markets. Global equities have been risen 50-60% with hardly a hiccup and if the markets are accurate, then they are pricing in a perfect V-shaped recovery without any chinks. However, reality and fundamentals disagree. Companies have not reported any revenue growth, unemployment has yet to peak and industrial production has been stumbling. Such a disconnect points to signs of irrationality characteristic of Bubble-ville.

Should investors have nothing to do with the exuberant market because they disagree with the fundamental reasons behind it? The biggest challenge is to profit from a bubble while consciously knowing that it is one and pulling out before the proverbial pin pricks it. Unfortunately, by definition, a bubble pulls in many un-informed investors who cannot resist the rising prices and have no recognition of a bubble’s existence.

Are we trying to avoid becoming like Bubble-ville through our policies but in our efforts to do so, inadvertently becoming more and more like it? Or is our society and capitalism as a whole simply incapable of surviving without the existence of bubbles? Regardless of the answers to those questions, we are in for a rocky ride thanks to a few people who seem to be making all the decisions for us. So the next time you hear a POP, don’t be alarmed! It’s probably just another bubble bursting after hyper-ventilating on self-generated fumes of optimism, greed and euphoria.

POP!

Comments

[Pauly B:]

Whether it be beanie babies, oil, or housing; a bubble is a bubble. Each of these each have their own little nuances in their own way though.

Your right, irrationality has a lot to do with it, but with the FED you have an added element: POLITICS.

Right now I think the street is in the "recovery bubble" with everyone thinking the same way and coming on CNBC to tell us how wonderful things are.

What happened to the ISM numbers and the Unemployment rate a week ago? Long forgotten I guess.

Oct 08 09:02 AM

[waf76:]

I certainly agree that we're in a bubble and knowing that we're in one is half the battle. The government has taken the approach of asking itself the following question: How do we dig ourselves out of this hole? Answer: We dig a bigger one.

Oct 08 11:09 AM

[Daniel Eskin:]

Well said waf76; seems like the government is really intervening more than they have the past and it's almost like the whole paradigm of government intervention is shifting. They're spending more money and as you said, it's leading to a bigger hole of debt which I'm sure somebody is going to trip into.

Oct 08 12:10 PM

[leo.vip:]

Interesting article, very duly noted and perhaps will prove correct in the long term. You seem like a person that likes to stay informed. I would urge you to read a recent article in the New Yorker titled "Inside the Crisis: Larry Summers and the White House Economic Team". It gives great insight as to what went on in the Obama administration for the decision they made in regards to the bailout and the economy.

www.newyorker.com/repo...

Oct 08 01:29 PM

[Shishir Nigam:]

Thanks for that link leo.vip, it was good piece. Another great video that covers the Lehman crisis in great detail and from a very global perspective is the following documentary: trading.jr-print.net/2.../

It's hard to question the Fed's actions in the core of the crisis, such as injecting huge amounts of liquidity, opening its discount window for overnight lending etc, because the situation at that time. And frankly, I think most of us would have been hard pressed to come up with better responses faced with the pressure of a collapsing financial system in Sep, 08. But more questionable are the subsequent path/actions chosen as the continued to bailout more and more institutions that didn't necessarily needed bailing out such GS. The govt also contributed money to the automakers which definitely seems like money down the drain.

So what the government did in Sep, 08 was probably necessary, but what it did in the months after was overkill.

For more analysis, check out my blog: youngandinvested.com

Oct 08 05:14 PM

[Michael Clark:]

'Alan Greenspan has maintained that the government’s focus should be to reduce the effects resulting from a bursting bubble, as opposed to discouraging its development in the first place.'

Ben Bernanke has maintained that the government's focus should be to encourage the development of a second, third and fourth bubble as the plan to reduce the effects resulting from the bursting bubble.

Greenspan is funny. Let the entrepreneurs (and the Super Rich) make a killing off the bubble...and let the government finance soup kitchens and riot police the kill poor anti-government demonstrators, rather than merely raising interest rates to avoid the 'irrational exuberance' stage. That man is brilliant, no matter what everyone else says.

Nov 09 05:33 AM