Sunday, 11 January 2015

What are Economic Bubbles?

We reflected earlier in a previous article on whether we, as humans, were rational actors- to be rational is to be objective and well reasoned in all decision-making (it’s an unclear concept, one could say there’s no real definition for it).

Anyway, the main conclusion arose that we are not rational actors as individuals- though perhaps as a large population irrationalities may balance each other out, even still we are humans- subject to emotion (we often get excited easily, and make silly decisions as a result), and often a basic lack of knowledge of the effects of what we are doing- sometimes we are at fault for this, sometimes not. 

Now let’s explore something that perhaps exemplifies human irrationality best in the field of economics- bubbles.
No, not the soapy ones, but economic bubbles are certainly similar in nature (hence the name)- in essence, an economic bubble is a massive economic boom that has grown so quickly and expansively that it is, like a soap bubble, in danger of being popped in an instant. An economic expansion, followed by a prompt plunge- that’s pretty much the basic structure of an economic bubble.

The South Sea Bubble caused spectacular devastation.
Bubbles aren’t some abstract theoretical idea, they have occurred numerous times throughout history- the earliest formally recorded bubble is believed to be from the early 18th century. The bursting of the South Sea Bubble of 1720 was the result of wildly heightened expectations of the South Sea Company, which had taken responsibility of the entire British national debt in exchange for total control of all trade in the South Sea. In January 1720, SSC stocks were priced at £128. February 1720, £175. April 1720, £330. By June, a whopping £1050- almost 10 times what it had been just 6 months ago. 
But this was the peak. The bubble had grown too much. 
By September, just 3 months after South Sea Company stocks had reached a record price, it was almost back to square one- stock price shrunk to just £175. 
This had devastated numerous investors- who were caught up in the initial hype of this company ambitiously taking on all of Britain’s debt in promise of finding profit. But in truth, the South Sea Company had little chance at all. They were a massive failure; partly during to their own mismanagement, partly due to the crippling debt they had just taken on and partly due to the huge reduction in South Sea trade after the Treaty of Utrecht was signed in 1713. Whatever/whoever was responsible, the bubble had burst and proven all the hype, all the investment, all the trust, to be false.

The California Gold Rush, the ‘dotcom' bubble of the 1990s and early 200s, the 2008 financial crisis- all examples of bubbles and/or their catastrophic burstings. 
Take the most recent financial crisis of 2008. Now there’s much to talk about when it comes to the causes of the crash, but simply put, it was caused by a massive housing bubble that had developed not just in the US (although perhaps most seriously here), but throughout the world. 
Like all bubbles, the housing market in the USA had initially seen a massive boom- caused by radically low interest rates (which had been at an all time low of 1% in 2004), irresponsible lending from financial institutions and the power given to banks to be able to conduct such activity.

Low interest rates made purchasing housing a very attractive option- a rate of 1%, set by the Federal Reserve with the aim of boosting spending after the 2002 post-dotcom recession, was almost a free loan, and therefore many Americans went on to grab the opportunity and buy their own houses.
For the financial institutions (the banks), this 1% provided an issue- it meant their profit margins would be far lower than before, when the rate was closer to 5%. In seeking increased profits, they took on more loan requests. The regular system of financial discretion was almost abandoned, and banks began lending to more and more risky individuals, many of whom ended up being unable to pay their loan and thus homeless.
The banks had such a huge pot to lend from because every bank has customers- people who deposit their money, in the trust that the bank will keep it available for them whenever they need it. But gradual recession of the Glass-Steagall Act, which initially prevented the lending side of banks to use the customers’ deposits, meant that banks eventually were able to use money deposited by customers to fund lending and other investment activity. This gave them a huge amount of money- and thus the banks could afford to be more reckless and risky with their money management. 

Wall St.- responsible for the 2008 financial crisis?
This increase in house buying caused a surge in house prices- causing even more people to jump onto the bandwagon, presenting what seemed to be a great investment in an asset that appeared to be endlessly growing in value. The bubble was pumped up more and more- house prices peaked in 2006, then the big burst came in 2008- the burst that cost the USA an estimated $648 billion lost in economic growth between September 2008-December 2009, roughly $5,800 in lost income for every US household, and is still haunting the global economy.
The bubble had popped, and the liquid stains are going to take a long time to rub off. 

The problem with bubbles is that their usual steps of boom then bust are very tricky to work out. The initial boom is by no means a promise of an oncoming burst; indeed an economic boom is often good, providing employment, wealth that can potentially itself prevent a bubble from arising.  
Economist Hyman Minsky is famous for calling out symptoms of an oncoming bubble- yet mystery still hovers over which booms of today are going to become the popped bubbles of tomorrow. Will it be the housing market again? The technology industry, again? Another industry altogether, or none of them?

Only time will tell.
Mohammad Lone Editor