2008-The Great Crash: The Trouble With Bubbles

My wise friend TB repeatedly reminds me of the basics and why they are so important.  Take this pearl as example “If your outgo is greater than your income then your downfall will be your upkeep”

We know, however, that hope, greed and fear tend to overwhelm rationality especially when the prospect of increasing our wealth is concerned and as the old sales pitch goes ‘this time is different’ becomes especially enticing when markets {housing and stock] are on their way up and our PM assures us interest rates will remain low.  By the way, famed investor Sir John Templeton referred to the aforementioned sales pitch as ‘the four most expensive words in the English language’.

And why are those words so expensive?  Well, it’s because of the spell these words tend to have on the masses in times of great optimism and growing prosperity.  But for every bubble these words help create there’s a pin. That’s what we’re learning right now.

In short, the collapse in confidence we are seeing, in my opinion, comes back to the excesses generated by easy money, namely debt, and the rampant  speculation that it helped generate on a very large scale [global level] for far too long [starting back in the 1980’s] .. In short, we’ve experienced a prolonged period of prosperity and monetary ease [credit expansion] and the financial innovation of more than a few dubious financial instruments that has led more than a few to truly believe that ‘this time is really different’.

The late Hyman Minsky knew that there was nothing new under the sun. If he were alive today, he would have understood exactly the dilemmas raised by the explosive growth in real estate prices, for example. Minsky developed a simple universal framework for understanding all bubbles. The circumstances of each bubble may differ, but each one goes through seven stages.

Stage One – Displacement

Every financial crisis starts with a disturbance. It might be the invention of a new technology, such as the internet. It could be a shift in economic policy. For example, interest rates might be reduced unexpectedly. Whatever it is, the world changes for one sector of the economy. People see the sector differently.

Stage Two – Prices start to increase

Following the displacement, prices in the displaced sector start to rise. Initially, the price increase is barely noticed. Usually, these higher prices reflect some underlying improvement in fundamentals. As the price increases gain momentum, people start to notice.

Stage three – Easy Credit

Increasing prices are not enough for a bubble. Every financial crisis needs rocket fuel and there is only one thing that this rocket burns – cheap credit. Without it, there can be no speculation. Without it, the consequences of the displacement peter out and the sector returns to normal.When a bubble starts, the market is invaded by outsiders. Without cheap credit, the outsiders can’t join in.

Cheap credit is the entrance ticket for outsiders. For example, petrol prices have risen sharply in recent years. However, banks aren’t giving out loans so that people can store gas in their garages in the hope that the price will double in three months. The banks, however, are prepared to give loans to people with poor credit to hold condos in the hope that they can be quickly flipped.

The rise in easy credit is also often associated with financial innovation. Often, a new type of financial instrument is developed that miss-prices risk. Indeed, easy credit and financial innovation is a dangerous cocktail. The South-Sea Bubble started life as new-fangled legal innovation called the limited liability joint stock company. In 1929, stock prices were propelled into the stratosphere with the help of margin calls. Housing prices today accelerated as interest-only mortgages emerged as a viable means for financing overpriced real estate purchases.

Stage Four – Over-trading

As the effects of easy credit kicks in, the market starts to overtrade. Overtrading stimulates volumes and shortages emerge. Prices start to accelerate, and easy profits are made. More outsiders are attracted, and prices run out of control. Accelerating prices attract the foolish, greedy and the desperate to enter the market. As a fire needs more fuel, a bubble needs more outsiders.

Stage five – Euphoria

The bubble now enters its most tragic stage. Some wise voices will stand up and say that the bubble can no longer continue. They put together convincing arguments based upon long run fundamentals and sound economic logic. However, these arguments evaporate in the heat of the one over-riding fact – the price is still rising. The wise are shouted down by charlatans, who justify insane prices by the euphoric claim that the world is different and this new world means higher prices.

Of course, the “new world” claim is true; the world is different every day, but that doesn’t mean that prices run out of control. The charlatan wins the day and unjustified optimism takes over. At this point, the charlatans bolster their optimism with the cruelest of all lies; when prices finally reach their new long run level, there will be a “soft landing”. The idea of a gentle deceleration of prices calms the nerves.The outsiders are trapped in knowing denial. They know that prices can’t keep rising forever, but they rarely act on that knowledge. Everything is safe so long as they quit one day before the bubble bursts.Those that did not enter the market are stuck in a terrible dilemma. They can not enter but neither can they stay out. They know that they have missed the beginning of the bubble. They are bombarded daily with stories of easy riches and friends making massive profits. The strong stay out and reconcile themselves to the missed opportunity. The weak enter the fire and are damned.

Stage Six – Insider profit taking

Everyone wants to believe in a new brighter future but a bubble takes that desire and turns it upside down. A bubble demands that everyone believes in a brighter future, and so long as this euphoria continues, the bubble is sustained.However, as madness takes hold of the outsiders, the insiders remember the old world. They lose their faith and start to panic. They understand their market, and they know that it has all gone too far. Insiders start to cash out. Typically, the insiders try to sneak away unnoticed, and sometimes they get away with it. Other times, the outsiders see them as they leave. Whether the outsiders see them leave or not, insider profit taking signals the beginning of the end.

Stage seven – Revulsion

Sometimes, panic of the insiders infects the outsiders. Other times, it is the end of cheap credit or some unanticipated piece of news. But whatever may be, euphoria is replaced with revulsion. The building is on fire and everyone starts to run for the door. Outsiders start to sell, but there are no buyers. Panic sets in; prices start to tumble downwards, credit dries up, and losses start to accumulate.

Here is the paradox of all bubbles – everyone knows how the fatal combination of easy credit, overtrading and euphoria will affect prices. Minsky didn’t need to write down a thing about the madness of speculation.  American investors have a lifetime of experience. Within the space of five years, America moved from the tech stock bubble into the real estate bubble. Housing prices became grossly overvalued. Everyone knew at some stage the prices would collapse.  One thing, however is certain, the longer it takes for a bubble to burst, the more painful it will be.



24 Responses

  1. Time for a Global denomination, JMc?

    That’d knock half the speculators out and bring a bit of stability to the world…oops! Instability is how “smart people” (read @rseholes) make money…

    How anyone could need more than a couple of million in the bank (I wish!) is beyond me…

  2. Hi TB,

    I could never get into this greed thing…I suspect my family turned me off it…the soul-less bastards.

    I reckon St Vinnies and the Salvos are going to be stretched to the limit in coming months and the government would be advised to look after the pensioners instead of giving tax cuts or they will get a rude shock come next election.

    I smell bacon…then I’ve got to go to do a few quotes, then invoicing and more paperwork!!!

    Then after that, reply to my email, then write more letters…not much time for myself or the family but they understand.

  3. Did you hear Bush’s speech?

    Basically he said that all nations should work together on this crisis and bail each other out as “no one nation should drag down all the others”.

    What the fuck has America been doing for the last 8 years if not exactly that?

  4. Adrian, I thought exactly the same things (re Bush). 8 years of unilateral action that has ruined so many lives, and now he is worried about countries acting by themselves.


  5. So what are the rules here in relation to swearing???

  6. scaper… | October 12, 2008 at 8:13 am

    I reckon St Vinnies and the Salvos are going to be stretched to the limit in coming months and the government would be advised to look after the pensioners instead of giving tax cuts or they will get a rude shock come next election.

    As the States are going broke in the US they are asking the US Fed to spend two trillion plus to fund them, the first thing being cut is their services to the needy. Montana has stopped funding all it’s handicapped workshops that employed disabled people leaving these people with no money and potentially many out on the streets, and that is only the tip of the iceberg from what I’m reading at the moment.

    So whilst the governments bail out the wealthy who caused this crisis, as usual it is the most vulnerable and the ordinary citizens who will wear the long term pain and suffer the most. Why can’t a system be bought in where the greedy wealthy suffer as much as those they cause suffering to?

  7. Scaper – I guess the only rule on this blog is that outright abuse will not be tolerated.

  8. Sorry scaper I rarely swear but that utterly disingenuous speech by Bush really got my goat up. As joni said, for eight years he behaved unilaterally on everything, basically telling the rest of the world to stuff off and either fall in line behind the US or get out of the way. Now his policies have totally screwed his country and the lives of many others around the world, he is begging the rest of the world not to go it alone and leave the US out in the cold.

    But of course according the wingnuts it’s not Bush’s fault or that of his neocon policies but all the cause of the liberals who either voted with his policies or against them.

  9. Fair enough joni…I just hope that the site does not degenerate into the use of the C word.

  10. Adrian,

    No need for an apology, I was just enquiring…that’s all.

  11. Absolutely not…. we will never use the term “conservative” on here.

    But seriously – that sort of abuse will not be tolerated.

  12. Not keen on outright swearing (not personal, Adrian) and I think it should be controlled before it does degenerate, Joni. (PS Can’t publish – need to offer something other than JMc :-D)

    My grandkids (and others) sometimes read this blog – I too am guilty (re comment 1) .

    As for your comments, Adrian – ma-ate, you’re starting to sound like me! Not the swearing, the sentiment! 🙂

    Time for the Insiders (another single word oxymoron!)

  13. TB

    You are now an author, and I just published your post on knives.

  14. You would not be happy with The Insiders this morning TB, apart from continually praising Turnbull as being ahead of the game and Rudd being a dudd, they basically stated that pensioners were not that bad off as they had a steady indexed income but self funded retirees were in deep poo and needed urgent government assistance.

    Inside Business is really having a go at Bush’s terrible bail out plan and the revelations Bush made the plan with the very people he was going to bail out, which is a blatant conflict of interest. So it now appears it was exactly what everyone said it was, a direct taxpayer funded bailout of the wealthy people who had caused the problem so they would not be personally out of pocket, which is why you had things like AIG executives partying at an exclusive resort after they heard they were being bailed out by taxpayers.

    Bush was apparently bought to heal when Europe and especially England bought in policies that did not mean direct equity funding into the failed financial systems and were having more success than the US.

  15. Further to my last, Inside Business has stated that the Bush bailout failed as it was discovered it was flawed from the start and would never work, which is why the markets completely collapsed and now collateral around the world is collapsing.

    Bush should have followed the European model and nationalised most or parts of their financial systems whilst at the same time putting into place punitive actions against those that caused the problem through their greed.

    Of course Bush (or any US conservative government) could never do this as it admits the tenets they base their entire ideology on are flawed and wrong, and the very people who fund them and are their best mates would have to be punished.

    So now you have the stupid situation where the Bush administration is using a trillion+ to give to the very people who caused the loss of confidence in their ideology, whilst many in it are saying the problem is flawed and too much government regulation along with liberal oppositions allowing flawed policies or tabling flawed amendments to sound conservative free market economic policies. The argument now is that the conservatives are the regulators and the liberals the deregulators, whilst at the same time they say the problem is too much regulation or flawed government regulation.

    And you believe they might learn a lesson from this. Not as long as this type of thinking is alive and well in the US, which it will be unless there is a total shake out of their entire system.

  16. Thanks for the compliments – keep them cards and letters comin’

    I reckon the first time (for anything) is usually the hardest …

  17. That last on the wrong thread oh! well.

    Adrian, I missed the self funded retiree comments (probably fell asleep!). … and I am one – no pension here…but in principle why are the old and the weak STILL picked on in our enlightened age!

    Government by the people for the people – BS – have we all become too bloody complacent?

    My kids worry that someone will take a swing at me when I stand up for issues in public…why – ’cause society has not been controlled for years not just the banks and business.

    I was an RTO and was audited regularly by 20 somethings out of college who had never conducted a training course and never run a small business – clueless – I’d guess the banks and business run rings around their auditors.

  18. Adrian

    “And you believe they might learn a lesson from this. Not as long as this type of thinking is alive and well in the US, which it will be unless there is a total shake out of their entire [global] system.”

    Frankly, I believe the US will no longer be to control and influence world’s financial markets to the degree it has been allowed in the past.

    I was wondering whether you saw the demonstrations of anger in London just recently? I think you’ll find that this crisis has placed the whole system under scrutiny, which features the US front and centre, and will no doubt involve further demonstrations by the huddled masses.

    This crisis runs very deep and and collapse of confidence in the entire system that we are now seeing will essentially drive essential change and that process will no doubt involved much trial and error, unfortunately. I guess what I’m trying to say is that ‘smoke and mirrors won’t cut it anymore, in my opinion.

  19. “I guess what I’m trying to say is that ’smoke and mirrors won’t cut it anymore, in my opinion”

    I’m not so confident John. Once the carcasses have been cleared, and today’s crisis a distant memory, we will all go back to believing the hype and of course – desire to accumulate those things that we cannot afford, but simply must have – through credit, IMHO at any rate..

  20. John,

    The way I see it is that this madness that had became the norm should not be allowed to perpetuate!

    I sense that this propping up of a failed system will lead to nought and believe that a total detruction is required in order to rebuild a new, fairer sysem to take us well into the future.

    We have for far too long expected that life will carry on as normal and all will be hunky dory, but that is not the reality…to effect change there has to be a shock to wake us up and history is full of such examples.

    The focus now should be on the lessons that will be learnt and emerge through all this a better and stronger nation.

  21. Reb and Scaper

    I have to agree that this crisis and the inevitable fallout, not only financially but socially, will challenge many of us to review what we really value in our lives.

    This, from my viewpoint, also represents a great opportunity to test and improve our system of democracy and our social welfare policies etc like never before.

    Like you say Scaper, “The focus now should be on the lessons that will be learnt and emerge through all this a better and stronger nation.”

  22. Sorry to burst ya bubbles but we have supported the Pope and every spin off for nigh on 2000 years – people WANT to believe – that’s why they are constatntly exploited

    From the “house cynic”

    BTW Rudd did well to guarantee all deposits and overseas bank loans.

    Surprised at the quality of the 7 News Special (doesn’t mean I agree with all the subject matter)

  23. Shock! Horror! Another bubble due to burst

    ‘AUSTRALIA’S big banks ignored the sub-prime crisis in the US and actively took greater risks in the home mortgage market to see off a challenge from rival lenders.

    The banks not only relaxed their lending standards in recent years – ultimately luring many customers into financial distress – but held off tightening their terms of credit to build a better market position.

    Reserve Bank documents, obtained by The Australian using Freedom of Information laws, show the change in lending standards was driven by competition and the housing boom.

    In the last six months of last year, banks informed the Reserve Bank that the proportion of new mortgages described as non-standard – such as low-document loans and those with high loan-to-valuation ratios – was increasing.

    That was despite the sub-prime crisis, rising interest rates and evidence that more of their existing mortgage customers were unable to make repayments. “

  24. TB

    I was suprised at the quality of the 7 news special too despite David Koche who was once a very mediocre financial planner with a fledgling business in Sydney before recreating himself into the goofy, gawky, geeky TV presenter he is today. A complete moron really.

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