How and Why Do Bubbles Form?

What causes bubbles? Here's one set of views:

Bernanke's Bubble Laboratory, by Justin Lahart, WSJ [Open Link]: First came the tech-stock bubble. Then there were bubbles in housing and credit. Chinese stocks took off like a rocket. Now, as prices soar on every material from oil to corn, some suggest there's a bubble in commodities.

But how and why do bubbles form? Economists traditionally haven't offered much insight. ... Now, the study of financial bubbles is hot. Its hub is Princeton..., home to a band of young scholars hired by ... Ben Bernanke...

[T]he Princeton squad argues that the Fed can and should try to restrain bubbles, rather than following former Chairman Alan Greenspan's approach: watchful waiting while prices rise and then cleaning up the mess after a bubble bursts. ...

The Fed is giving the activist approach some thought. ... Yet the very concept of bubbles is at odds with the view of some that market prices reflect the collective knowledge of multitudes. There are economists who dispute the existence of bubbles -- arguing, for instance, that what happened to prices in the dot-com boom was a rational response to the possibility that nascent Internet firms might turn into Microsofts. But these economists' numbers are thinning. ...

Bubbles don't spring from nowhere. They're usually tied to a development with far-reaching effects: electricity and autos in the 1920s, the Internet in the 1990s, the growth of China and India. At the outset, a surge in the values of related businesses and goods is often justified. But then it detaches from reality. ...

Mr. [Harrison] Hong ... argues that big innovations lead to big differences of opinion between bullish and bearish investors. But the deck is stacked in favor of the optimists.

One who believes a stock is too high can short it, borrowing shares and selling them in hopes of replacing them when they're cheaper. But this can be costly, both in the fees and in the risk of huge losses if the stock keeps rising. Many big investors rarely short stocks. When differences between bullish investors and bearish ones are extreme, many of the bears simply move to the sidelines. Then, with only optimists playing, prices go higher and higher.

In housing and the credit markets, the innovation was slicing and dicing loans in novel ways. As investors bought the resulting mortgage securities, they provided abundant capital for home buyers; buoyed by this and falling interest rates, house prices surged.

Betting against house prices is hard; only a few sophisticated investors found roundabout ways to do it, in derivatives markets. Most skeptics about the housing boom just sat it out; the optimists were unchecked.

At some point in a bubble, optimists' enthusiasm runs its course. Prices turn down... -- and then they tumble. ... Mr. Hong and Harvard's Jeremy Stein ... say ... prices fall more rapidly than they go up. ... That ... offers a strong argument, in Mr. Hong's view, for government to restrain bubbles and the borrowing that fuels them.

At the height of the tech bubble, Internet stocks changed hands three times as frequently as other shares. "The two most important characteristics of a bubble," says Wei Xiong, are: "People pay a crazy price and people trade like crazy." ...

According to a model [Wei Xiong] developed with Mr. Scheinkman, investors dogmatically believe they are right and those who differ are wrong. And as one set of investors becomes less optimistic, another takes its place. Investors figure they can always sell at a higher price. That view leads to even more trading, and, at the extreme, stock prices can go beyond any individual investor's fundamental valuation. ...

Bubbles often keep inflating despite cautions such as Mr. Greenspan's famous warning of "irrational exuberance." Tech stocks rose for more than three years after he said that, in late 1996. Markus Brunnermeier ... thinks he understands why this happens. ...

Inspired by Mr. Hayek's work, Mr. Brunnermeier studied economics. But in the 1990s, soaring tech stocks made him skeptical of the quality of information that prices convey. ...

Under the Hayek view, bubbles don't make sense. As soon as some group of traders irrationally pushes prices way up, more-rational traders should take advantage of the mispricing by selling -- bringing prices back down. But the tech boom reinforced an oft-quoted warning from John Maynard Keynes: "The market can stay irrational longer than you can stay solvent."

So investors who spot the bubble attack only if each is confident that other skeptics are on board. In work done with Mr. Abreu, Mr. Brunnermeier concluded that if all the rational investors could agree to bet against the bubble, they could make big profits. But if they can't coordinate, it's risky for any one of them to bet against a bubble. So it makes sense to ride it up and then get out quickly as soon as the bubble's existence becomes common knowledge. ...

Looking through security filings, Mr. Brunnermeier and Stanford's Stefan Nagel found that hedge funds on the whole "skillfully anticipated price peaks" in individual tech stocks, cutting back before prices collapsed and shifting into other tech stocks that were still rising. Hedge funds' overall exposure to tech stocks peaked in September 1999, six months before the stocks peaked. They rode the bubble higher and got out close to the right time.

Mr. Brunnermeier saw the bubble, too. He thought people were crazy for buying tech stocks. But as both the hedge funds' gains and his theoretical work suggest, even if you know there's a bubble, it might be smart to go along.

"I was always convinced that there was an Internet bubble going on and never invested in Internet stocks," he says. "My brother-in-law did. My wife always complained that I studied finance and her brother was making a lot of money on Internet stocks."

Comments

[reason]

If I read this right, it seems what is needed is financial innovation. Something to give the bears an equal chance with the bulls. The problem for the bears is TIMING. You know what is going to happen but not when.

Any ideas?

[reason]

Maybe you need some security that pays if peak to trough exceeds some strike level. Then money will flood in as prices become overvalued. But how will that counteract the run-up in the original security, and who will sell this security?

[save_the_rustbelt]

When good intentioned amateurs get sucked in by the professionals, the amateurs lose.

The pros take a pile of money at the front end, and then hedge so someone else loses at the bursting point.

Don't get greedy. Don't join a stampede.

says...

If I read this right, it seems what is needed is financial innovation. ... Maybe you need some security that pays if peak to trough exceeds some strike level. Then money will flood in as prices become overvalued.

Such securities already exist: they're called derivatives (including futures, options and the like). The article argues that derivatives are "roundabout and sophisticated" but this sounds very implausible, since financial innovation was a critical mechanism in the housing & credit bubble. AIUI, there was ample opportunity for any single investor to bet against the bubble with limited downside risk.

It should be mentioned that "bubble"-like dynamics are quite common outside financial markets: it is very difficult to estimate the impact of a disruptive technology, and it's quite common to see inflated expectations followed by exaggerated pessimism and rejection.

[reason]

Lets forget futures they don't do what need, lets concentrate on options. An option is a sort of insurance (if this happens then that). Yes that is what I am talking about, but in this case I don't look at a specific price, but a particular change in price. I don't know what the peak price will be, or when it will happen, but I know at some stage a large fall in price in a relative short period of time will happen. I want to bet on it. Apart from a negotiated OTC option there is no readily available instrument to allow me to do it. I could buy options at one price and sell at another - but to cover all the possibilities is difficult and expensive.

[VG]

"The two most important characteristics of a bubble," says Wei Xiong, are: "People pay a crazy price and people trade like crazy." ...

Why should people trade like crazy and pay crazy prices - Greed, want of more money. And who actually invests in the markets - only those who have excess money.
And why do people have excess money - because they earn much more than the average person, Income disparity. An average middle class person who earns just enough to meet the ends hardly invests in the markets.
So bubbles actually lessen Income disparity. In a Boom-Bust cycle some make and some loose money. And people who make easy money loose it the same way.

[zinc]

The bubble society came from Reagan then Clinton then Reaganbushhagee with the common denominator of Greenspan. The globalization red herring is and has been a cover for massive, worldwide liquidity injections designed to ignite the big bubble in credit. Always the master of deception, as in the 1980's budget bailout through Social Security taxes, things were never what they seemed under Greenspan. He was always, first and foremost, a type of John Birch libertarian republican. I try to look past the rhetoric to the agenda, for whatever good it does.

However, Is the current commodity bubble a bubble? IMO, yes.

Excerpted from Alan Greenspan, "The Age of Turbulence", pp 192-193.

"It is just not credible that the United States can remain an oasis of prosperity unaffected by a world that is experiencing greatly increased stress......

Behind the scenes, Bob Rubin and I began contacting the finance ministers and central bankers of the G-7 nations to coordinate a policy response. We argued quietly but urgently, for the need to increase liquidity and ease interest rates throughout the developed world.
Some of our counterparts were difficult to convince. But at last, as the markets in Europe closed on September 14 (1997), the G-7 issued a carefully written statement. " The balance of risks in the world economy has shifted", it declared. It went on to detail how G-7 policy would shift too, from single mindedly battling inflation toward also fostering growth. "

[bakho]

Why do people buy lottery tickets? Uncertainty. Risk. Large upside. Acceptable downside. The larger the pot, the more people buy tickets. Lottery tickets are like a mini-bubble that bursts with each numbers drawing.

Why would primitive humans participate in a dangerous big game hunt? Large upside, low risk to the downside.

Bubbles only burst when the large upside disappears. The possibility of a large payoff overrides the risk. Bubbles can be limited by limiting the amount an individual can risk or by limiting the upside through redistribution of large gains (windfall profits).

[groucho]

Replace "bubble" with "pyramid" and you can start to comprehend the evolution of the scheme.
I break pyramids into 2 types; organic(sustainable) and ponzi. Determining which scheme is predominant is critical in understanding the boom/bust cycle. Housing was a no-brainer, since underlying lifetime cashflow streams could not support housing values in many markets.

[bullbust]

One who believes a stock is too high can short it, borrowing shares and selling them in hopes of replacing them when they're cheaper. But this can be costly, both in the fees and in the risk of huge losses if the stock keeps rising. Many big investors rarely short stocks. When differences between bullish investors and bearish ones are extreme, many of the bears simply move to the sidelines. Then, with only optimists playing, prices go higher and higher.

The mind games economists pay to rationalize their mop-up-bubble theory blunders!

The prudent investor has to be bearish? HA HA HA HA. With the Bernanke Greenspan put, who can be bearish?

The prudent investor has to sit on the sidelines? HA HA HA HA HA. With negative real interest rates?

Bubbles don't make sense! My ass. Yeah, without Fed abetment and collusion, bubbles wont make sense in today's world. They make PERFECT SENSE when the FED IS THE ONE BLOWING THE BUBBLES.

The Fed herded the masses to Wall Street casinoes, where the house skimmed their 15%.

Since economists live off the casinoes, do not expect them to see anything wrong with this setup.

Today's economist creed goes - Gambling is good.

[americaseale]

one night, most for the I'd hoped leaf they had pirates were punished

[Bruce Wilder]

M3?

[Alex Tolley]

"People pay a crazy price and people trade like crazy." ..."

In "Kluge", psychologist Gary Marcus explains that our deliberative, rational minds have great difficulty in winning out over our earlier, reward driven ones. It seems highly consistent to me that the allure of a $ today in a rising marketing outweighs the "but the price is insane" of the rational. The fast trading is exactly what one might think should happen if the allure of quick rewards is important.

So bubbles start with some event that gets the prices moving in the +ve direction (cheap credit, changing desires, buzz) then investor psychology takes over which becomes self-reinforcing on the way up until the bubble bursts.

[donna]

Bubbles aren't that big a problem until they are the only game in town.

What real value are we creating is the question. At least we got new Internet technologies and services fromt he dotcom bubble. The housing bubble was more like eskimos selling each other ice. What value did we really add to the country and the economy? Instead we've all ended up in greater debt.

[Jas Jain]

--
"How and Why Do Bubbles Form?"

The real answer is to be found by asking: How profit, long-term (including the period of the bubble formation and the bust), from the asset bubbles?

During 1995-2007 we have had two of the biggest bubbles of their kind in US history. Who have benefited the most from these bubbles? Bankrupters and Fraudsters of New York City (BFNYC, I coined the term in 2003), in particular, and Corporate Crooks of America (I coined the term Scam Options, a device of crookery, in 1998), in general. American People have more in Scams, aka stocks, and lot more in debt.

Moral blindness of the economics profession prevents economists from seeing the criminal nature of the US economy aided and abetted by the Fed and the USG (constantly helping the bad and irresponsible people).

Jas

[lonesome moderate]

And why do people have excess money - because they earn much more than the average person, Income disparity. An average middle class person who earns just enough to meet the ends hardly invests in the markets.

VG - if the average middle class person is someone who spends all his/her income, what is that person supposed to do when the time comes to retire?

[Andrew]

An average middle class person who earns just enough to meet the ends hardly invests in the markets.
So bubbles actually lessen Income disparity. In a Boom-Bust cycle some make and some loose money. And people who make easy money loose it the same way.

Several problems with this statement.
1. Anyone with a 401k or an IRA is investing in the market.
2. Commodity and real estate prices effect pretty much everyone, and in an extremely regressive manner.
3. Highly leveraged investments have been continually bailed out with tax dollars, often after losing vast sums of tax dollars from pension fund investments.

[Worker]

Donna, so I guess you are not a fan of granite countertops?

[Jas Jain]

--
VG: “An average middle class person who earns just enough to meet the ends hardly invests in the markets. So bubbles actually lessen Income disparity. In a Boom-Bust cycle some make and some loose money. And people who make easy money loose it the same way.”

VG, are you an economist?

Thanks. If someone else knows the answer, please...

Jas

[Eric Dewey, Portland OR]

Ultimately, bubbles and busts are merely indicators of the bi-polar nature of the human psyche.

When we get excited about something, we stop thinking clearly and are no longer "ational" in the way the economics assumes us to be.

When the excitement leads to actual peril, we overcompensate the other direction.

Some of the most intriguing findings of the behavioral finance school involve the investments made by seriously depressed individuals. Their investments consistently avoid bubble-type trading behavior, and are usually much more successful than the investments of non-depressed individuals.

What economists are really trying to do is to find a way to predict societal mania/depression using only behavioral signals. The problem is the the macro equivalent of the Heisenberg uncertainty principle comes into play when a predictive method (such as risk-modeling) shows signs of success, and then the predictive method ceases to function as it "should".

In order to understand what they're up against, economists need to ask questions that are the macro equivalent of Schrodinger's Cat.

[anne]

http://www.nytimes.com/2008/05/17/world/middleeast/17prexy.html

May 17, 2008

Bush Rebuffed on Oil Plea in Saudi Arabia
By SHERYL GAY STOLBERG

With the price of oil hitting record highs, President Bush used a visit with King Abdullah to try to persuade the Saudis to increase oil production and was rejected yet again.

[Now, for comedy.]

[anne]

"So bubbles actually lessen Income disparity."

Because only the wealthy can afford to lose, and lose they will. Nonsense.

[Spectator]

This article does a huge disservice to Hayek. The not so subtle suggestion that Keynes understood bubbles and Hayek did not is blatant misinformation.

The Austrian business cycle theory, and warnings of the dangers of huge distortions wrought by Fed credit, fully explain these bubbles. Keynes on the other hand provided the intellectual cover to blow these bubbles. Another attempt to cover the collective behinds of the Keynesian-deluded economics profession. The travesty continues.

[jamzo]

investors are speculators

speculators create bubbles

how well do economic models predict the behavior of speculators

investors speculate on the price of stocks of pharma companies betting on stock prices rising from market peculiarities like "patent protected" drug prices

investors speculate on the stocks of health insurance companies betting on stock prices rising from market peculiarities which enable them to ration care to maintain profits in both private and public insurance markets

in the digital era investors gained new tools that enabled them to speculate on stocks, bonds, commodities, and "virtual" assets like reits, and other innovative financial schemes

every news broadcast reports stock market indicators

protecting society from the tendency for speculators to screw thing up is an important job

[kthomas]

"protecting society from the tendency for speculators to screw thing up is an important job"

Well said, but our society rewards dishonesty. Look a President Bush.

[Jas Jain]

--
"Another attempt to cover the collective behinds of the Keynesian-deluded economics profession. The travesty continues."

What % of economists are deluded?

Jas

[macburger]

This article is linked right here on this blog under 'Things You Might Want To Read"

Fed and Bubbles: First, Heal Thyself?

http://blogs.wsj.com/economics/2008/05/16/fed-and-bubbles-first-heal-thyself/

Still, like most human beings Fed officials are reluctant to turn the spotlight on themselves too brightly when looking for blame. Fed Chairman Bernanke and vice-Chairman Donald Kohn have recently given speeches on the mistakes banks have made but devoted scant attention to any role the Fed and other bank regulators may have played in making those mistakes more likely. As former Fed Chairman Paul Volcker pointed out earlier this week, banks were allowed to accumulate significant assets in lightly regulated off-balance sheet vehicles.

Although it has been gotten little attention, this was made possible in part thanks to an explicit decision by federal bank regulators in 2003, then finalized in 2004 to exempt banks from holding full capital against such vehicles, which post-Enron accounting changes could potentially have required. (To be sure, regulators did require additional capital to be held against some entities to which banks had short-term funding commitments. And banks eventually found ways around the accounting standard anyway.)

Here is the FED regulation allowing regulated banks to follow Enron tactics

http://www.federalreserve.gov/boarddocs/press/bcreg/2003/20030912/default.htm

http://www.federalreserve.gov/boarddocs/press/bcreg/2004/20040720/default.htm

Still, the claim is that the Fed is for regulation.

It's like the old joke - Finance is the most regulated industry [small print - the financiers wrote all the regulations]

[Spectator]

Thanks macburger. That's a clear indictment of the Fed that identifies the primary culprit for the bubbles and the credit crisis. Could it be more obvious? For some reason, most economists refuse to see the obvious. They'll blame consumers in China or India, or greedy homeowners, or other tangential players, rather than the Fed that directly caused it.

Although I do appreciate our host's prominent link to this Fed expose.

[Bruce Wilder]

macburger, I think you are right on. All the talk of housing "bubbles" just seems like a determined effort focus attention on the mysterious, when there's nothing mysterious about theft and fraud.

I think of my native Michigan, where there was never a "bubble", but rates of foreclosure were driven up by predatory lending practices, which, in other places, did drive speculation and "bubbles".

There's nothing irrational about speculating with other people's money.

[mrrunangun]

No fire can burn without oxygen and no speculative excess can continue without cheap money available for speculation.
Take away the oxygen, the fire goes out. Take away the cheap money and the speculation dies. That is why the Fed has not and does not remove the cheap money. The Fed wants the speculation to continue.

[Masonik]

where the house skimmed their 15%.

Ever wonder why the folks living in the Hamptons are the stock BROKERS (or IBs) as opposed to the traders?

[Winslow R.]

Very simple.

Over leverage.

5x leverage 20% price decline no problem
10x leverage 10% price decline no problem
33x leverage 3% price decline no problem
infinite leverge 0% price decline no problem

Market sets price based on season, weather, world events and a million other variables. Don't see why we shoulc allow our financial system get anywhere close to 33x leverage.

'Finanical efficiency' must come from reducing margins but keeping leverage ratios the same. Instead we see reduced margins and increasing leverage.

[Lafayette]

What humans seek

lm: if the average middle class person is someone who spends all his/her income, what is that person supposed to do when the time comes to retire?

It is presumed that one has spent a lifetime putting 2.3 children through university, paying the mortgage off, having survived 4.6 layoffs and no debilitating illness ... so you're supposedly clear with no debt overhang. Then you live happily ever after since you have a roof over your head (that is yours) and because Medicare will cover whatever hospitalization expenses may occur. (Some people used to call this the American Dream.)

If this does not jibe with your actual situation, present or future -- you are living the wrong dream in the wrong country.

Life is a hazardous mind-field, like you're parents told you. (What did they know that we've forgot?) Still, we strive to take the risk out of life and to prepare our children to carry on, much as we have, in the perpetual search for well-being. Unfortunately, the paradigm changes right underneath our feet whilst searching.

Any society that believes only Market Solutions can assure that we make it through the life-cycle, home free to years of carefree retirement, in this day and age, is seriously misguided.

The Market Solution alone does (or did) provide a relatively high level of employment that should supposedly assure all that is described above. Unfortunately, since the early nineties it has been showing functional distress.

What we are faced with is an economy in which a select few (around 1% of the population) have found the key to practically unlimited riches and, by manipulating the right levers, they have become immensely rich all the while leaving others to bear the burden of their illicit shenanigans. (Yes, no doubt, there are the supposedly "honest ones" who see the error of their ways and try to give as much away as possible.)

A fairer economy would have none of this. Increased marginal taxation would take the temptation out of immense wealth. People should be allowed to get rich, but not hallucinatory rich.

A more fair economy would assure that the wealth generated by communal effort is shared more equitably. This can only be done by Social Expenditures (financed by taxation) that gives people that "level playing field", meaning a "real chance".

A life where the educational system guarantees a "chance" (not a ticket to an office at Goldman Sachs) to play the game, with a Health Care system that does not obliterate our savings in case of serious illness, with a safety net for those who, despite their efforts, do not make up to and into the Middle Class. No one should, literally, be left behind.

And no one should be strutting about cockily with a Forbes mention as amongst the "richest Americans". What sense does that make? That you've managed to be smarter or luckier than someone else as clever and dishonest as yourself?

If you are religious, consider this:

Matthew 16:26 For what is a man profited, if he shall gain the whole world, and lose his own soul?

And, if not, then consider the Income Distribution effects of Welfare Economics, here. The Austrian School aside, it assumes that the marginal utility of money for each of us is more or less the same and tends towards zero. I sense that such is true. There is only so much satisfaction that spending more money can bring us -- until its marginal utility (in terms of acquired satisfaction or social status) is zero.

And, that presumes that other factors are equal or constant. All that is needed, to upset the marginal utility of money applecart is, say, a serious illness. Whereupon the marginal utility of money (meaning its expenditure) drops like a rock to zero.

In the end, what humans seek is Well-Being. Some societies actually think it is brought about by having always more personal net worth.

Silly notion, that.

[Farrar]

I'm forever blowing bubbles,
Pretty bubbles in the air,
They fly so high,
Nearly reach the sky,
Then like my dreams
They fade and die.
Fortune's always hiding,
I've looked everywhere,
I'm forever blowing bubbles,
Pretty bubbles in the air.
When shadows creep,
When I'm asleep,
To lands of hope I stray!

I'm forever blowing bubbles,
Pretty bubbles in the air,
They fly so high,
Nearly reach the sky,
Then like my dreams
They fade and die.
Fortune's always hiding,
I've looked everywhere,
I'm forever blowing bubbles,
Pretty bubbles in the air.

[VG]

-- Andrew:
The onus of providing good Social security benefits and containing commodity prices is on the government. But not by investing the pension funds in risky markets.

And I was not referring to the US exactly, when I said, that only the rich invest in the markets. The Indian stock index ‘SENSEX’ has gone up from 4000 to 22000 in a span of 4 years. Due to the economic boom, the young employed Indians (Age: mid and late 20’s) in the high-end industries earn almost 10 times more than the average person. And all the excess money is either invested in the Stock markets or the Realty sector. And even though the government has increased the interest rates to 8.5%, there is still excess liquidity in the market. The SENSEX has fallen down to 15000 recently, due to the global uncertainties and the high Oil prices, but is bound to go up again as people have money to invest. So, only the ones who could invest are investing in the markets and even if they loose, that’s not the end of the world.

-- Lafayette:
What humans seek is Well-Being. Hats off :)

And Jas: I’m not an “Economics Geek”; I’m just a common man.

[Bruce Wilder]

Is it overleverage? Or, just a stupid shell game?

At the end of the day, banks engage in intermediation: borrowing short and lending long.

One theory of originate-to-distribute is that banks can escape the risks of borrowing short to lend long, by taking the long loans and selling them off as "securities", securities with which the banks have no connection, except as a trusted agent and servicer (for a modest fee, of course).

If the banks form an SIV to hold the long debt, they've made the long loan disappear from the balance sheet, but the bank is still on the hook. Investors and regulators are supposed to not notice the impairment of the bank's capital, though, because the SIV is not on the balance sheet. (It's lie. A fraud. SIVs are fraud. Can we just say it? Why do we have to call it overleverage?)

If the bank sells the long loan, properly packaged, to some group, to which the bank loans money to finance the purchase, how does this "overleverage" spread risk, exactly? Because of the tiny sliver of the group's equity? Are you kidding me?

[Masonik]

selling them off as "securities", securities with which the banks have no connection except as a trusted agent and servicer

Some banks trade the securities as well I believe. They have their own internal hedge funds ie UBS.

[Winslow R.]

"(It's lie. A fraud. SIVs are fraud. Can we just say it? Why do we have to call it overleverage?)"

The 'fraud' only becomes apparent once prices adjust downwards sufficiently to wipe out any equity, hence my chart.

Theoretically, any intermediation can be considered 'fraud' as the government/Fed can wipe out the equity on any loan.

Are loans created at the beginning of an asset price upswing any less fraudulent than loans made at the start of the down-slide?

Given the government/Fed determine the moves up and down in asset prices through the monetary and fiscal control system, I'd say the government/Fed help create fraud by allowing intermediation.

If the swing in asset prices exceeds previously allowed leverage you are going to have a crash.