Why Bubbles Can't Be Stopped

Now that we are in the recrimination phase of the cycle, we are seeing more and more of what happened and how do we stop it from happening again questions and investigations. While that linked article focuses on Europe, a parallel process is occurring in the US.

Asymmetric payoff is the problem
I would humbly submit that it is virtually impossible to stop excesses from recurring in a capitalist society. As one quote from a risk manager put it:

…the job we do has the risk profile of a short option position with unlimited downside and limited upside. This is the one position that every good risk manager knows he must avoid at all costs.

Remember the IPO allocation scandals from the last cycle? There were all sorts of controls put into place. In the next cycle, excesses popped up elsewhere. That’s because of the asymmetric nature of risk. Risk managers are burdened with short option position phenomena in risk control: limited upside and unlimited downside.

On the other hand, revenue producers (whether in a hedge fund, broker, or other financial services entity) have the reverse position of being long a call option. These people get handsomely rewarded by making money for their firm and for themselves through financial engineering, but they face limited downside risk if the structure they build all comes apart at some point in the future.

Disclosure: None

Comments

[DaveW:]

I agree 100%, this very asymmetry will ensure that bubbles will happen again and again and again and.......

2008 Aug 28 02:28 PM

[yogisteve:]

But you can seriously control the size of the bubble if a negatively sloped Cap Gains Tax is implemented.

The dot.com and housing fiascos turn back into mole hills rather than mountains if someone has to think about paying a higher CG Tax now vs. a lower tax in 24 months, 36 months, add your own time frame. Stop the gambling investment mentality and this insanity ceases to exist.

2008 Aug 28 02:47 PM

[HARM:]

I second yogisteve --well said.

Even though I agree it is pretty much impossible to prevent speculative bubbles from forming, at the very least THE GOVERNMENT SHOULD NOT BE ADDING GASOLINE TO THE FIRE. As in doing things, such as slashing the FF rate to 1% (negative when adjusted for inflation) then holding it there nearly 3 years. Or, giving the GSEs the full backing of the U.S. Taxpayer, then allowing them to buy $hundreds of billions in dodgy loans. Or, giving speculators the MID for homes they don't actually live in. Or, in making public statements about how much better option-ARMs are than traditional FRMs, like Greedspan did.

Speaking of the Fed, one of its roles is supposed to be *regulator* of the banking sector. As the old saying goes, when the party gets interesting, it's the Fed's job to "take away the punchbowl" --so that a speculative bubble does not turn into an enmormous crisis which threatens the entire economy when it implodes.

Is it really to much to ask our fearless "regulators" to... you, know, put down their pom-poms and actually REGULATE once in a while?

2008 Aug 29 01:49 AM

[youngolf:]

Capitalistic system greed HAS to be regulated...otherwise the masses get screwed royally. But regulators have to regulate and in this they failed us massively, while the powerful and the gamblers were pocketing huge bucks. I am no longer a republican.

Finally a candidate for prez offered that we might get the same healthcare insurance as our illustrious congress is giving themselves! I'm in.

2008 Aug 29 08:25 AM

[alajac:]

Replace all income taxes with a 1/2 % electronic transfer debit tax, and watch how fast excessive speculation dries up. Gamblers never think about the costs on the other end, they need to get slowed up by paying a toll going into a position. This would also be a tax on ``quantity of trades``, and I think that is what we need.

2008 Aug 29 12:06 PM

[John Lounsbury:]

A decreasing capital gains tax levy stepwise over a period of years is only one of the changes that could help stabilize our capitalist system. Another would be an executive compensation formula that defers a large portion of compensation for several years. An example integrates year one performance with years 2, 3, 4 and 5 before starting the deferred compensation payout in year six. Look at how many corprorate bubbles would not have occurred under such a system - Enron, WorldCom, Bear Stearns, ......

2008 Aug 29 01:20 PM

[JWG:]

PARETO’S CIRCULATION OF ELITES covers this quite well.
ocw.mit.edu/NR/rdonlyr...

We're seeing an inflection point where the foxes overreached, got into trouble, and must now surrender initiative for a time to the lions. Holes in the regs will be plugged, life will resume, the public will go back to sleep, and very quietly the innovation by the foxes will begin again and slowly begin to accelerate...

None of which means that efforts at reform are pointless. It would be really stupid not to plug the holes that have been uncovered ("fool me twice...").

JWG

2008 Aug 29 08:46 PM

[Steven Hansen:]

i am on board with alajac. i don't know if 1/2 percent is a good number, but some reward or penalty has to implemented to promote long term investment which is healthy for economic growth.

2008 Aug 29 11:21 PM

[rmenton:]

I disagree in the case of the housing bubble, because this can only occur in an environment of cheap, easy and, as we have come to see, reckless supply of money to unqualified buyers. If the regulators had done their job, they would not have allowed such lending practices to take place, such as 100% loan to value, on arguably inflated appraisals. In Hong Kong, the home of numerous successive housing bubbles, the likes of which we have never seen, loan to value is regulated at 70%, with any additional borrowing required to be insured. There are ways to prevent such bubbles, or their after effects.

2008 Sep 06 10:05 AM