Why Are Bubbles Bigger Than Ever? (Part 1)

by: Gene Phillips

At a “Street Meet” I attended recently, the macroeconomic question was once again put forth: why more bubbles now than before? More interesting (for me) is the follow up question: and why are our bubble-bursting-crises so much bigger?

Many thoughtful suggestions were put forth.

“Our housing bubble was created by herd-mentality behavior: everybody wants to buy a house and everybody wants to have as many houses as their neighbor, and as nice a car.” … “We keep thinking we’re able to measure and manage risk – but we cannot accurately estimate it.” … “We’re subject to greed and severe incentive misalignments in firms’ pay structures: bonus based on short-term performance of long-term structures.” And so on.

These are all important topics and concerns that are a-begging of attention. But for me they don’t quite capture what’s changed: haven’t we always been subject to herd-mentality behavior, greed and incentive misalignments?

However, I am particularly concerned about the situation vis-à-vis risk management, so it’s deserving of a quick diversion.

Many of the big banks (who failed miserably) were unable to estimate their risk, and were horribly under-reserved despite maintaining Basel-like regulatory capital adequacy reserves. Many of the same banks had very advanced risk management divisions, supported by funky tools and state of the art technology. But they failed. Why?

Because the presence of a risk management division, at a bank, is nominal to a degree. Being able to say your risk measurement skills are very advanced only allows you to leverage more.

But the division itself, “Risk,” doesn’t have a voice. Its goal runs counter to the growth objectives of the company. Its members, like auditors, often have no upside in standing up to front office. At best they’re considered by the front-office to be an annoying cost-center. At worst, they’re an impediment. My concern remains that our financial reform will have accomplished little or nothing if it remains unable to rectify this state of affairs.

Returning to our topic of bubbles, I end part 1 by explaining that it is the intersection of rapid and rampant financial innovation with an increased speed of information and communication that creates bigger, more regular bubbles.

While we may have hoped that the proceeds of the Information Age would lead to increased diversification of exposure – and therefore more docile recessions – the opposite seems to be a greater truism: standardization combined with complexity and (its associated heightened ability for) obfuscation, meant poorly-incentivized parties could swiftly reproduce more trades in greater (infinite?) volume across the globe. We’re more inter-connected than we realize – perhaps more than we ought to be.

Part 2 will describe how our inter-dependencies precipitate a greater blow-up if and when each bubble doth burst. More specifically, I will link part 1 to the changing nature of the way money center i-banks operate, and why this matters.

Disclosure: No positions