2011
Understanding
Economic Bubbles
Author: Álvaro Jiménez Jiménez
Tutor: Jordi Caballé Vilella1
Programa Universitat-Empresa
Index
Page
ABSTRACT……………………………………………………………….….
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INTRODUCTION………………………………...…………………
SECTION 1: A SUMMARY OF THE HISTORY OF BUBBLES…….….
1.1 A brief chronology of bubbles…………………………………….......….
1.1.1 Early1600s-1637, Holland: The Tulip Mania……………………………...
1.1.2 1720-1721, Britain: The South Sea Company…………………….…….…
1.1.3 1840s, Britain: The Railway Mania……………………………………….….
1.1.4 1920s, United States: Stock Market Bubble…………………………………
1.1.5 1980s, Japan: Asset price bubble (Heisei boom)……………………………
1.1.6 1997, Asia: The Asian Crisis…………………………………………………...
1.1.7 Mid 1990s-2000, Western economies: The .com bubble……………………
1.1.8 2003-2008, Western economies: The Securitization Bubble…………….…
1.2 First observations after the bubbes’ descriptions………………………..
1.3 A snapshot on bubbles’ price trends…………………………………...…
1.4 Concluding Remarks on Section 1………………………………………..
SECTION 2: THE BASIC BUBBLE MECHANISM………………..……...
SECTION 3: BUBBLE THEORIES………………………………...……….
3.1 Psychological theories………………………………………………..…….
3.1.1 The Greater Fool theory…………………………………………………..……..
3.1.2 Herding theory…………………………………………………………..………...
3.1.3 Extrapolation theory………………………………………………………..…….
3.1.4 Moral Hazard theory………………………………………………….……….....
3.2 Investors’ behavior…………………………………………………………
3.3 The Logistic Functions Methodology……………………………………..
3.4 Different theoretical setups for bubbles detection……………………….
3.4.1Market manipulation and bubbles in the presence of
informational monopoly………………………………………………………..…….….
3.4.2 When bubble creation is a rational government policy………………. ……
3.5 The conspiracy happened: The .com bubble and the
securitization bubble schemes………………………………………..……….
3.5.1 The Government role……………………………………………………………..
3.5.2 The Set Up……………………………………………………………….…………
3.5.3 The Elites’ Role……………………………………………………………………
3.5.4 Consequences……………………………………………………….……………...
SECTION 4: BUBBLE EFFECTS ON ECONOMIC WELFARE
AND POLICY RECOMMENDATION………………………………..…....
4.1 Desirable bubbles…………………………………………………..…...….
4.2 Negative Bubble Impacts……………………………………………….…
4.3 Policy recommendation………………………………….……………..….
CONCLUSIONS……………………………………………………………….
BIBLIOGRAPHY……………………………………………………………..
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ABSTRACT
Globalized economies have experienced two of the biggest economic bubbles in history
in this last two decades: the .com bubble and the securitization bubble. The “burst” of
every bubble generates its subsequent effects on the real economy; for instance, the
current western economic crisis. All the economic agents are currently facing the
impacts, but there are still many controversies remaining on the air regarding the bubble
phenomenon. Some arguments point on the direction that bubbles cannot be predicted,
while others maintain that with certain kinds of bubbles both the incubation and the
burst can accurately be detected. Controversy also arises regarding whether bubbles are
desirable or not, whether economic policies should take place to attempt to control a
bubble or not, or even if these last point can feasibly be implemented. Furthermore,
there is literature arguing against the existence of bubbles. And of course, a significant
number of different bubble-formation theories are also in place.
This paper analyzes the existence of bubbles, provides a historic overview on different
bubbles, analyzes different bubble theories and its effects on economic welfare,
develops and provides evidence for the “conspiracy theory”, and provides detectionprevention-recommendation policies.
Keywords: Economic Bubbles, theories, effects, policies.
1
INTRODUCTION
The first conceptual economic framework established for a bubble was a situation where
the price of a product or an asset increased, within a specific market, above its “usual”
price; on a current basis and at dramatic scales. This phenomenon was called a mania
on its origins, rather than a bubble as we denote it today. 1
The first so-called mania emerged in Holland 1637 in the tulip market. Some of those
tulips ended up at the peak time being worth the same as a house. The concept of a
mania reflected the fact of individuals purchasing a tulip at an extremely high price being aware that the price could be potentially unrealistic- with the expectation of
selling that tulip at an even higher price to another individual or agent who had even
higher expectations on the future evolution of the price. The word mania takes into
account facts like individuals or agents jumping into the exaltation of the market, selling
partially or totally their assets in order to purchase more tulips and be able to cash extra
profits in what today we would call a speculative process. That mania ended when some
individuals or agents sold their tulips realizing that price levels could difficultly keep
that upward path, and then the common exuberance finished suddenly with its
subsequent price collapse. There have been many other bubbles along history, which
will be described in the next section.
The concept of mania illustrates the first economic theories that tried to explain the
phenomenon. Some illustrative examples of such theories could be the greater fool
theory, the extrapolation theory, or the herding theory. All of them which are based
upon what John Maynard Keynes (1935) called Animal Spirits. The mentioned
economic explanations are denoted as Psychological theories of bubbles and are based
on human social factors, behaviors and expectations.
But there are other kinds of explanations which are based on completely different
approaches such as technological and economic development, or market structure with
subsequent manipulation and running elite‟s set-ups. The logistic growth models for
bubble formations (Girdzijauskas et al. 2009) or theories based on market manipulation
in the presence of informal monopoly, informational oligopolies, rational government
induced policy, imminent-revolution, and ruling elites manipulation (Thompson and
Hickson, 2006) illustrate these points.
The common partial assumptions for bubble formations are a weak financial policy and
excessive monetary liquidity in the financial system (Topol, 1991), which intrinsically
implies low interest rates and excessive leverage. This is related with an excess of
currency in circulation ending invested in a limited number of assets, causing their
prices to appreciate beyond their fundamentals until prices reach unsustainable levels. 2
While these factors might be necessary, or might induce partially to the bubble boost,
they are still not sufficient factors by themselves to explain a bubble creation. Different
institutions and economic context play an important role here, as it will be seen in this
paper.
A bubble can manifest in multivariate different contexts. A bubble can appear virtually
anywhere – there have been bubbles in China, the United States, Argentina, Holland,
Spain, Australia, Japan, Romania, Ireland, Zimbabwe, and many other regions-. It can
also be reflected in the price of a great variety of commodities and assets – bubbles have
1
Later on, as the economic science developed within the field of bubbles in order to refer to “usual price”
the new term used was fundamental value.
2
Without taking into account the quality of those assets. That is whether they are good assets or bad
assets.
2
appeared in tulips, companies‟ non-traded shares, stocks, real estate, uranium, rhodium,
wheat, ostrich eggs, and others -. And bubbles emerge both in recession, depression, or
expansion cycles; adopting different characteristics.
The effects of a bubble can also vary depending on different factors. And the outcome
of the bubble might be distinct as well for every single agent. However, there is
empirical clear evidence that every single bubble generates a redistribution of wealth,
directly or indirectly, among the various agents in the economy. It is clear that a bubble
can harm an economy, but it may simply generate a strong temporary deviation from a
price tendency, or it could even benefit the economy. The last mentioned point is the
one which causes more controversy. But as it will be shown, clear examples to illustrate
it are: the expansion and proliferation of the Internet during the .com bubble, or the
bubble during the 1920s in United States which permitted the elimination of utility
companies‟ barriers that eased the vast implementation of electricity around the country.
But there is yet to mention the most positive bubble effect on history, the intrinsic value
of money (Samuelson, 1958).
This paper is structured in four sections, each one illustrating different bubble related
aspects. In Section 1, a history of the main economic bubbles will be presented in order
to illustrate the general picture of what bubbles are and how everything develops in their
set ups. In Section 2, the bubble component will be mathematically illustrated through
the basic bubble mechanism. In Section 3, the main bubble theories will be discussed
through a variety of different approaches, and an exemplification of the conspiracy
theory will be given through the .com and securitization cases. In Section 4, bubble
effects on economic welfare will be analyzed, and policy recommendation discussed.
SECTION 1: A SUMMARY OF THE HISTORY OF BUBBLES
In this section, I am going to present a brief chronology of the most relevant economic
bubbles that have happened in history.3 The objective of this part is to gain a global
overview of what bubbles have been, the shape they took, and the impacts, effects, and
transformations that generated on their respective times and economies.
1.1 A brief chronology of bubbles.
1.1.1 Early1600s-1637, Holland: The Tulip Mania. Tulips were imported to Holland
around 1593 and became an expensive, yet accessible good, before the mania. The
tulips started to become a fashion, and there was a virus know as mosaic that produced a
change in colors on the tulip making it looking like flames; it was then when tulips
became more than a fashion. Slowly, the tulip mania took place. At the beginning it was
just merchants who speculated on the future price of tulips, buying huge amounts in
advance for the next season. But as the rise in price went on, everybody started to
speculate on tulips. The mechanism of options helped that speculation to grow, since
those options reduced the amount of money needed to put down while increased the
profit –due to leverage-.4 In the peak price of tulips, in January of 1637, the price of
tulips increased twenty fold. A price of a tulip could be purchased for 6,000 Florins,
3
4
For the ones that there are accurate records.
Similar to the financial products that we have today
3
while the average yearly salary in Holland was 150 Florins.5 In February 1637, the first
significant sales of tulips started, panic spread, and massive sells began. The
government tried to stop the sells through positive propaganda and some re-purchases,
but it was worthless. A tulip ended up being worth the same as an onion, and with just 1
Florin you could then purchase various tulips.
1.1.2 1720-1721, Britain: The South Sea Company
The South Sea Company was one of the “hot issues” of those times in Britain. Owning
stocks was considered sort of a privilege, and so The South Sea Company was projected
to fill an existing need. It bought £10Milion of government debt, and in exchange it was
given the monopoly over all trade to the South Seas. Its business based on trade
however, were not significant and even poor. But the company always managed to have
great positive propaganda, and its trade prospects became better when Britain ended the
war with Spain, and Mexico “was willing” to exchange gold and silver for cotton and
woolen goods. The company had distinct favor from the government, and both investors
and normal people believed there were potential riches to be made on such trade. In
1720, the directors decided to increase their reputation by offering to fund the entire
national debt, amounting to 31 million pounds. This fact initiated the speculation on the
stock price. On April 7, when a bill was introduced in Parliament, the stock promptly
rose from ￡130 to ￡300. Five days after, there was a new issue of stock at ￡300. The
issue could be bought ￡60 down and the rest in eight easy payments. Important public
figures such as the king also bought stock. There was and excess demand, and the price
increased even more reaching ￡340 within a few days. The company announced
another new issue at ￡400, and there was still an excess demand among the public.
Within a month the stock was ￡550, and still going up. Eventually, the price rose nearly
￡1,000. At that point, the price of the shares had no logical realtion with the real
context of the company, and directors and officers decided to sell their participations
during the summer. The news arrived to the crowd, the stock fell, panic set in, and the
price eventually collapsed.
A very similar story like the South Sea Company happened in the same period of time
in France, with The Mississippi Company. During this period of time there were
massive similar cases of companies starting new issues promising big rewards.
Sometimes they were scams, and the owners left with the money. In some other cases it
was just a curious enterprise like the Puckle Machine Company which was supposed to
revolutionize the concept of war with a new machine.
1.1.3 1840s, Britain: The Railway Mania.
Together with the Industrial Revolution came the need of a vast transportation system
both for the industry and for the population; the railway seemed an imperious necessity
and a prominent enterprise to get in. Hundreds of Acts went to Parliament to be passed,
and about 272 were approved. Taking into account all the railway companies and their
projects, there was an overall proposal of 15,300 km to be constructed. On the other
hand, there was a growing middle class together with a large literate part of the
population with accumulated savings and willing to invest. In addition, the Bank of
England lowered interest rates. And furthermore, the government promoted heavily the
5
The equivalent in today‟s USD prices would be an annual salary of $45,000 and a tulip being worth
$1.8Milion
4
railways projects as a foolproof venture.6 Thousands of people became investors buying
a large number of shares while only being mandate to pay a deposit.7 The Railway
Mania became a self-promoting cycle.
In the mid-run, by 1845, the infeasibility of many projects and many companies became
clear. The railways projects were realized not to be as lucrative and easy to conduct as it
was previously thought. In addition, the Bank of England raised the interest rates by the
end of 1845. The direction of investments switched to government bonds and
subsequently money flow out from the railways. Many companies were left with no
funding, and the prospects of return on the investments disappeared. By the early 1850s
there were just few main big railway companies that survived.8
However, in this case there was a clear net effect after the bubble burst as some authors
point out (Wolmar, 2007). The British Railway System was vastly expanded during the
investment euphoria period. The speculative frenzy attracted huge amounts of private
capital that were necessary for the railway construction, more than what the banks were
ready to lend. A total of 10,000 Km were constructed as a result of projects authorized
between 1844 and 1846. It is interesting to compare that number with the modern
railway network of United Kingdom, which is about 18,000 Km. This fact gives us an
idea of how expansive and important the undertaken construction of the railway system
was in such a short period of time.
1.1.4 1920s, United States: Stock Market Bubble
The most common accepted explanation for what happened in the stock market during
this decade is that the bubble was formed during the rapid growth of the 1920s together
with an irrational element – the mania- and an expansion of credit in the form of
broker‟s loans that leveraged investors (Galbraith, 1954). However, there are other
studies which manifest the fact that no bubble was in place during the period and that
stock prices reflected fundamental values, according with econometric studies
(Hamilton, 1986). A revised and comprehensive study points to a combination of factors
generating the bubble, factors that were not simply the ones mentioned by Galbraith and
factors that could not be detected with econometric data due to the short time period in
place (White, 1990). This paper is going to stick to this last explanation in order to
describe the overall picture.
From 1922 to 1929, GNP grew at an annual rate of 4.7 percent and unemployment
averaged 3.7 percent.9 Great economic conditions were in place hand in hand with the
emergence of large-scale commercial and industrial enterprises, economies of scale, and
modern management. Both new and old corporations issued equities to finance new
plants and equipment. Commercial banks moved to investment banking creating
affiliates. The number of affiliates grew from 10 to 114 between 1922 and 1931 (Peach,
1941). A great number of investment trusts also emerged, and grew from about 40 to
750 (Carosso, 1970) between the same period stated before. Many of the new investors
who participated in the stock market through these institutions or by themselves lacked
experience completely, thus easing a bubble context. The stock market responded, with
6
However, the Bubble Act had been repealed, and again there was a completely laissez-faire on
investments. Importantly enough as well is the fact that many Members of Parliament were personally
involved in the railways investments.
7
About a 10% of the total value. The company had the right to demand the rest of the amount at any time.
8
Many companies were bought by big competitors, some others went bankrupt, and there were also some
scams in between the boost and burst.
9
U.S Department of Commerce, 1975, Vol I, p135 and 226
5
a special focus on utilities companies. Between March 3, 1928 and September 3, 1929
the percentage increases in the major securities traded on Wall Street ranged from 87
percent up to 434.5 percent (Malkiel, 1973). However, at the peak of the market in
August 1929 Charles Amos Dice of Ohio University argued that prices were the product
of economic fundamentals, and even after the crash Irving Fisher of Yale University
justified the same proposition. These mentioned doctors hold their theories on the fact
that there was an economic growth accompanying the stock‟s price trend and that it
would have continued if it was not because of policy blunders by the Federal Reserve
and Congress. However, due to the existence of business cycles an expansion cannot
last continuously, plus investors might not extrapolate past growth rates.
From 1922 to 1927 the trend between stock prices and dividends was shared, but
between 1928 and 1929 stock prices raised much more above dividends (White, 1990
and Pierce, 1986). This fact is no sufficient to claim in favor of a bubble; however it
remarks an existing investor‟s exuberance. Unrealized dividends and negative
manager‟s statements did not slow down the dramatic upward price trend. While the
fundamentals in the economy might have helped the upward trend to start, they clearly
did not sustain it. A crucial factor here, was easy credit in the system. However this
credit was not cheap (White, 1990). If buying stock through loans was not cheap;
earnings and dividends did not play a crucial role; but there was a clear investors‟
exuberance, a plausible explanation is a bubble. Bubbles are likely to appear when
fundamentals are difficult to assess (Blanchard and Watson, 1982), and during the
1920s they were due to major changes in the industry.
Yet there is the bubble burst to be explained. The reason was a chance in the business
cycle. A recession was potentially plausible. The Federal Reserve‟s index of industrial
production might be a good indicator, and its first decline was registered in July 1929.
In August and September, some other indices of the Federal Reserve began to drop as
well. These data arrived to the market while there was a rise in real interest rates both in
the U.S and European countries. These factors together forced stockholders to
dramatically change their expectations. Sells began, and the collapse took place.
1.1.5 1980s, Japan: Asset price bubble (Heisei boom)
During the 1980s Japan entered a period of prolonged long-lasting economic growth
and stable inflation. However, the bubble is commonly located between 1987 and 1990;
as it was then when fundamentals completely lost relation with stock prices, land prices,
and real estate prices. Professor Malkiel, Burton G. provides these data:10 “By 1990, the
total value of all Japanese property was estimated at nearly $20 trillion- equal to more
than 20 percent of the entire world‟s wealth and about double the total value of the
world‟s stock markets […] Japan‟s property was appraised to be worth five times as
much as all American property. […] At their peak in December 1989, Japanese stocks
had a total market value of about $4 trillion, almost 1.5 times the values of all U.S
equities and close to 45 percent of the world‟s equity-market capitalization.”
There is a certain parallelism between this bubble and the above described 1920s U.S
bubble regarding the reasons for the boom and burst –excluding the real estate factor-.
The following causes are identified as interconnected factors that increased the bullish
expectations on the economy and triggered the bubble formation (Shiratsuka, 2003):
aggressive behavior of financial institutions; progress of financial deregulation;
inadequate risk management on the part of financial institutions; introduction of the
10
On his book “A Random Walk Down Wall Street”
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Capital Accord; protracted monetary easing; taxation and regulations biased towards
accelerating the rise in prices; overconfidence; euphoria; overconcentration of economic
functions in Tokyo, and Tokyo becoming an international financial centre. Interest rates
remained low in spite of the economic expansion of the period as well, contribution to
easy and cheap credit that leveraged agents.
As in other cases, it was a declining in profitability and a –slowly at the beginning- turn
in the cycle that made agents revise their expectations. Both the stock market and the
real estate market collapsed.
1.1.6 1997, Asia: The Asian Crisis
As this is a relatively contemporary event, there are still different points of discussion
about the causes of the Asian Crisis. The first view relies on psychological theory based
on a shift on the expectations, as well as regional contagion (Radelet and Sachs, 1998;
Marshall, 1998; Chang and Velasco, 1999). These authors sustain that rather than
fundamentals deterioration, what happened was that panic emerged among domestic
and international investors. The second approach on the other hand, is based on
fundamentals imbalances: structural distortions, wrong government policies, and a
herding overreacted effect (Corsetti, Pesenti, and Roubini,1998; Dooley, 1999).
However, in this paper these two approaches are considered for this description,
together with a third vision based on enormous rapid capital inflows that switched
severely rapid as well into devastating capital outflows (Rajan, 2001), combined with
negative effects of pegs to a single foreign currency (Bustelo, 2004). Mixing these
theories all together, this paper supports the idea of too much money going to few
assets, therefore inflating them over their fundamental values; within non yet prepared
deficiently structural economies, which could not mange such highly severe inflows and
outflows.
During the late 1980s and 1990s interest rates in developed economies were relatively
low compared with interest rates in Asian developing economies. This fact generated a
large inflow of money that boosted those Asian regional economies. The so-called
Asian Dragons achieved GDP growth rates of 8% to 12%. However this growth was
almost purely based on capital increase (Krugman, 1994). The Asian economies
maintained high deficits on their current accounts, which translated into external
borrowing and leveraged economies, while being jeopardized by currency exchange
risks.11 In addition, some studies point out that the capital flows did not pursued
efficiency criteria and were allocated according to centers of power, seeking quick
profit (Blustein, 2009).
During the same decade, the U.S recovered from an early recession and started to raise
interest rates making the U.S investments more attractive and appreciating the U.S
dollar, what increased pressure among Asian pegged currencies. Capitals started to flow
out, and speculation turned bearish on Asian currencies. The whole process of collapse
is described as a bank panic -when all the customers run to pull their money out of their
accounts-.South Korea, Malaysia, Thailand, Indonesia, Singapore, and Philippines were
the most affected countries both during the boom and during the adjustment shock.
11
Due to pegged exchange rates with the U.S dollar.
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1.1.7 Mid 1990s-2000, Western economies: The .com bubble
The period was clearly market by the expansive implementation of the internet in
society. The internet was a completely revolutionary technology that opened new
horizons. It enabled completely new business possibilities; it offered a way of sharing
and transmitting information never thought before; and new ways of purchasing goods
and services. It was called, and it is still called “The New Economy”. The prospects
were limitless, and as it was a new concept the boundaries were still unclear. Positive
feedback loops started, and the media played an incredibly boost through all kinds of
propaganda. Soon, the internet related issues became the only topic in everyday life.
Venture capitalists were major players in the start of the boom. As a dot-com company
became public, the stock price automatically skyrocketed. Thus, venture capitalists
changed their usual strategy, and instead of focusing on the viability of the project they
soon financed any kind of dot-com enterprise in order to make it public and cash a big
quick profit. In the first quarter of 2000, 916 venture capital firms invested $15.7 billion
in 1009 startup internet companies. 159 initial public offerings had been completed in
the previous quarter (Malkiel, 2007). Any technological related public company raised
in price without stop. The traditional criteria for companies‟ valuation changed.
Fundamentals, price-earnings ratios, sales, or profits were no longer important; the
important factors became how many visits did the website attracted, how many time did
the visitors spent on the site, or simply which prospects did the company had for market
expansion.
The NASDAQ Index more than tripled from late 1998 to March 2000. Speculation
increased dramatically as well; the average holding period for a typical stock was days
or hours. Trading became a popular occupation, and there were 10 million internet day
traders. Online trading was also another boom that helped boosting the bubble.
There were also fraudulent scandals during the time, like Enron.
Over 1999 and early 2000, the U.S. Federal Reserve increased interest rates six times,
and the economy began to lose speed. On the other hand, many internet based
companies reported vast net losses. Two sufficient factors to make investors reinterpret
their expectations.
When the bubble exploited, over $8 trillion of market value evaporated. Even the
leading stocks collapsed. Amazon.com, Cisco Systems, Corning, JDS Uniphase, Nortel
Networks, Priceline.com, Yahoo.com among others, lost between a 90 percent in share
price and a 99.7 percent.
1.1.8 2003-2008, Western economies: The Securitization Bubble.
This bubble is usually referred as the Real Estate Bubble, the Sub-prime Bubble, or the
Credit Bubble among other names. However, in this paper those labels are going to be
considered wrong since the bubble might have materialized in Real Estate, but it also
materialized in other sectors. And the bubble‟s creation, contagion, mechanism, burst,
and effects were all based on a securitization process. Hence, this paper refers to this
bubble as the Securitization Bubble.
This bubble perfectly fits in what could be defined as the ruling elite‟s set up
(Thompson and Hickson, 2006); a theory that will be developed in Section 3. Since this
is a quite recent and extremely important bubble, this paper will dedicate an entire
subsection to it, Section 3.
8
1.2 First observations after the bubbes’ descriptions
As anticipated in the introduction, it is clear that a bubble can manifest in many
different contexts and within different asset classes. It has also been shown that a bubble
might lead to a positive net effect like in the Railway Bubble, a simple redistribution
like the Tulip Mania, or a negative net effect like Japan‟s Bubble.
However, there are different factors worth to be stressed that take place commonly
among them.
To start with, even if it might be clear, the first factor is a supreme rise in prices. That is
the most noticeable characteristic of a bubble; prices rising usually at double digit in a
really short period of time, loosing correlation with fundamental values and maybe
reaching ridiculously high prices. A boom on the asset or assets that might prolong but
eventually will have a strong correction, if not a complete crash.
The second elemental, yet crucial aspect is massive investment/speculation. In every
single bubble sawn there is always great deal amounts of money flowing in, and
eventually flowing out. There has to be concurrence of money flows towards one focus
in order to generate the bubble.
The third factor or characteristic worth to be stressed is that the economic bubbles
described in this section all share a common context in their formation: a prominent
venture, which is supposedly dared to excel, but surrounded of uncertainty. To illustrate
this point, the clearest example might be the .com bubble. The technological-internetrelated companies were supposed to establish a new horizon for businesses,
communications, information, and so on. However, there was a clear uncertainty about
the profitability of those companies, their business strategy, their markets‟ capacity, etc.
The same happened with the Railway, which was thought to revolutionize transportation
both for trade and human mobility. But at the same time, there was uncertainty
regarding the projects to be undertaken, the feasibility of those, their profitability, and
even their future demand. In the case of the Asian economies there were great prospects
on their growth as well, but again at the same time uncertainty existed as far as their
macroeconomic equilibriums were concerned. And we could illustrate the same idea for
each of the fore mentioned bubbles. There is always a promising venture that comes
together with uncertainty about what surrounds it.
The fourth factor is that there is a common denominator in all the above described
bubbles: leverage. The tulips craze had options to leverage investors; the South Sea
company accepted down payments during the issues and the rest to be paid in
installments; with the Railway just a deposit was needed in order to own the shares; in
1920s stock bubble, there was abundant credit and much of the stock was purchased in
debt; in Japan there was abundance of cheap and easy credit as well; in the Asian case,
it was foreign plus national credit that over flown in the economies, which overtook too
much debt; and during the .com bubble many derivatives emerged and were used,
together with abundance of credit as well. Hence, either through margin purchases,
simple down payments, derivatives, or abundance of credit and debt, leverage is found
among agents participating in the bubble process.12 Although it would be premature to
identify leverage as a must-factor for a bubble, it should be taken into consideration and
further research might have to point toward this direction.
There is a fifth factor as well, which accounts for government role. In almost each
bubble respective governments took part in various stages of the bubble. In the case of
the tulips it was trying to avoid the bubble burst; in the case of the South Sea generating
a clearly privileged monopoly supported by the government; during the Railway the
12
Margin purchases: buying the entire asset just paying a fraction of it
9
government and Members of Parliament even took part in the projects both legislating
and investing; when the 1920s bubble arrived to a peak, The FED and Congress were
accused of taking wrong policies that induced to a depression; in Japan, the government
deregulated and promoted fiscal incentives towards the bubble together with monetary
easing; in Asia the governments also played a key aspect all along the bubble process;
etc. Subsequently, it could be argued that governments usually take part directly or
indirectly at a certain stage of a bubble process, being it at the incubation, the formation,
the proliferation, or the burst –if not at every stage-.
Hence, in order to summarize, it could be said that a bubble presumably occurs under
prominent prospects together with uncertainty surrounding it; leverage is usually found
on bubble formations; governments usually intervene in some sort of way at a certain or
all stages of a bubble; massive money flows are found on bubbles; and prices skyrocket
up to eventually have a big correction as well.
Although these are just observations, some could emerge as patterns for bubble
detection with further research. This paper will point towards these research directions
all along the next sections.
1.3 A snapshot on bubbles’ price trends
Even if the price evolutions of the described bubbles on this section have been
explained, it is significant to illustrate them through graphs in order to understand and
gain the image of how bubble prices behave, and which trends do they draw.
Consequently, below I show the respective bubble price graphs from Figure 1.1 to
Figure 1.8.
Figure 1.1. The tulip Mania Bubble.
10
Figure 1.2. The South-Sea Bubble.
Figure 1.3. The UK Railway Mania.
11
Figure 1.4. The 1920s Stock Market Bubble.
Figure 1.5. Japan‟s Land Bubble.
12
Figure 1.6. The Asian Crisis.
Figure 1.7. The .com Bubble.
13
Figure 1.8. The Securitization Bubble.
It can be observed that regardless of which kind of bubble or graph we look at, the price
evolution in terms of patterns is quite similar. The main stages of a bubble, can be
established as follows (Rodrigue):
1) Stealth. Few specialized investors realize new fundamentals that provide a great
potential for substantial appreciation, even if accompanied with a considerable risk
since the assumptions are yet to be tested. This is called the “smart money”, which takes
positions into the market with caution and without letting the other participants notice it.
This kind of market participants might have better and quicker information, as well as
the tools and knowledge to understand what is going on. Asset prices will increase
gradually and slowly, but without the participation of massive investors. The smart
money will increase their positions gradually, as they see how the fundamentals work
well and how the assets are likely to significantly increase in price in the future.
2) Awareness. The price trend is detected by other investors who put more money into
the assets and subsequently push prices higher. New investors might cash in their first
profits, thus generating a short-lived sell off phase, which will be used at the same time
by the smart money in order to further increase their exposition. By the end of this
stage, the media starts to get involved and as a result “unsophisticated” investors start to
jump into the train.
3) Mania. The price trend is clearly upward and the general public decides to invest in
the “investment opportunity of a lifetime”. “The expectation of future appreciation
becomes a "no brainer" and a linear inference mentality sets in; future prices are a
"guaranteed" extrapolation of past price appreciation, which of course goes against any
14
conventional wisdom.” This phase is run by emotions, not rationality. Huge amounts of
capital flow in, thus generating even higher expectations and making prices skyrocket.
This trend is self reinforcing and as prices climb, more capitals flow in. However, the
smart money together with institutional investors are quietly starting to close positions
on their portfolios, selling the overvalued assets to the general public. As far as the
media and opinions are concerned, there are no arguments against fundamental values
since many players are heavily involved in the bubble and everybody wants to keep the
music playing and prices appreciating. Euphoria and greed set in as fortunes are made
on the venture.
During the madness everybody tries to participate, without any king of understanding of
the situation and without preparation. Leverage and debt play their roles increasing the
bids and pushing prices higher. When credit is cheap, this phase lasts much longer than
expected. Eventually, the media and the crowd will claim that new fundamentals have
been achieved, and that there is a “permanent high plateau”, in order to justify
vertiginous prices. The bubble is approaching its burst.
4) Blow-off. “A moment of epiphany (a trigger) arrives and everyone roughly at the
same time realize that the situation has changed (like the Road Runner Coyote realizing
he is about to fall after walking on air for a few seconds).” The crude reality emerges,
and confidence and expectations are lost. There is a denial stage where many trapped
investors try to convince everyone that the setback is just temporary and that everyone
saying anything different is the fool. There is a little revival due to some who believe it
is just a setback, but it does not last for any long. Declines start, each one more
dramatic, and everyone expect further declines. The collapse sets in, and the general
public is left with the overvalued assets while the smart money had left the scenario a
long time ago. The burst is much quicker than the inflation was. Many agents under
great leverages go bankrupt, thus forcing new waves of additional sales. Prices might
decline as much as undershooting the long term equilibrium trend, giving a new
opportunity to buy, this time undervalued assets. However, the crowd by this time
considers these assets the last evil on the world, and this is when the smart money
acquires bargains at bottom prices. The above mentioned stages can be illustrated in a
graph as follows:
15
Figure 1.9. Bubble Phases.
It is interesting to notice that the firsts to get in -the so called smart money- might be
information monopolies as will be explained in Section 3. And institutional investors
being the second ones to take positions right before the boom also seems quite
suspicious, since it is after the media attention enters in game that the mania starts. We
stress this suspicious fact as part of a conspiracy theory that will be explained in Section
3 and exemplified through the securitization bubble.
Another remarkable aspect is that the Real Estate Bubbles have very similar stages to
the ones shown in Figure 1.9, and follow almost exact same price patterns. But even
more interesting is the fact that the bubbles that have happened most times in history in
many different places are precisely those, the Real Estate Bubbles. This is a brief
summary of the latest modern Real Estate Bubbles that have happened during the last
two decades:
16
1.4 Concluding Remarks on Section 1.
A general idea of different bubbles, their effects, their formation, their impacts and so
on has been gained through the descriptions of the main bubbles in history. It has been
observed that a bubble might lead to an overall positive effect, a negative effect, or a
mere redistribution of income. Some characteristics or potential factors that usually take
place in bubbles have been determined:
a supreme rise in prices; massive
investment/speculation; a context of a prominent venture but surrounded of uncertainty;
leverage; and government roles. It has also been pointed out that bubbles follow a
typical price pattern with four different stages. And there is empirical evidence to
conclude that the most repeated bubble in history is the Real Estate Bubble.
SECTION 2: THE BASIC BUBBLE MECHANISM
Since there is a minority of authors within the bubbles‟ literature that argue against the
existence of bubbles, it might be worth to illustrate the basic bubble mechanism through
a not too complex mathematical applied process. In this way, it offers a first yet simple
insight on the existence of bubbles, and at the same time illustrates the relationship
between fundamental price and the bubble price component. The demonstration comes
from (Blanchard, 1978), and the process illustrated in this paper comes from an
adaptation (Caballé, 2010):
In equilibrium, the price of an asset pt at a given moment of time t needs to satisfy the
following equation:
(2.1)
This equation reflects the fact that today‟s marginal costs, which appear on the left hand
side of equation (2.1), need to be equal to tomorrow‟s expected discounted marginal
profits, which appear on the right hand side of (2.1). Then, isolating the price value we
obtain:
,
(2.2)
is the time discount factor,
the mathematic expectation subject to all the
available information at , and
is the dividend associated with the asset.
where
In order to make the process easier, the following considerations are assumed:
-
Risk neutrality, which implies to be constant.
No uncertainty is taken under consideration.
.
where
is the interest rate that we will also assume to be
constant.
When these assumptions are applied to equation (2.2), we obtain the following
simplified formula for the asset price:
17
.
And for the time
(2.3)
:
.
(2.4)
Combining equations (2.3) and (2.4) we obtain:
.
And repeating the same process for
following valuation formula:
(2.5)
, and successively infinite times, we obtain the
.
We will denote
(2.6)
as .
In equation (2.6),
is the bubble, because if it was equal to 0, then the
asset‟s price will correspond to its fundamental value:
.
(2.7)
The bubble appears whenever there are expectations on returns that are not based on
future dividends.
In order to mathematically prove this last statement, and taking into account the above
process obtained, we deep into the following stage:
We re-order equation (2.3) in differentials:
.
(2.8)
And its solution should be expressed as follows:
,
Where
(2.9)
is a constant at is the solution to
,
(2.10)
18
And isolating
we obtain:
.
(2.11)
Hence, being the fundamental value as seen in equation (2.7). So now, we just need to
solve for , which is a constant and a solution to the following “characteristic
polynomial” of the differential equation:
.
(2.12)
And this implies
Up to this stage, the only factor missing to solve for is A, but A is a random constant.
Therefore, the complete solution to the differential equation (7) is:
.
(2.13)
If we compare equation (2.13) with equation (2.6)13, we observe that
is the bubble.
Hence, we could equal
to the other bubble expression in equation (2.6) and have:
.
And isolating
(2.14)
we obtain:
.
(2.15)
However, in these dynamic systems based on future expectations and completely
flexible prices, there is no way do determine the constant .
If prices were supposed to grow at a rate less than , then would be equal to 0 and
there will be no bubble.
Even though, for any non-negative value for , we obtain a solution for the asset‟s
price. Having
the asset‟s price will have a bubble component that will imply a
price different than the asset‟s fundamentals.
As closing remarks for this section it is emphasized that bubbles exist and the bubble
element is characterized for being a price element added to the asset‟s fundamental
value. This bubble element cannot be quantified in our basic mathematical setting. For
further discussion on mathematical approaches to bubbles, it is worth to see (Evans,
1991).
13
Bearing in mind that we denote
as r
19
SECTION 3: BUBBLE THEORIES
This section will present some of the most important existing bubble theories. It is
possible to subdivide these theories among three different groups: Social and
psychological theories; Logistic functions based theories; and governmentally created
bubbles. The main exponents for each group that are going to be taken into
consideration in this section are: Kenneth L. Fisher and Meir Statman; Girdzijauskas, S.
et al; and Earl Thompson and Charles Hickson, respectively for each theory group. It is
important to remark that because these are theories none of them are empirically
proven; but they do provide important indicators, aspects to consider when looking for
bubbles, and methodologies.
3.1 Psychological theories
It could be argued that these psychological based theories have their base on what John
Maynard Keynes named “animal spirits” on his magnum opus The General Theory of
Employment, Interest and Money, which was published in 1936. Therefore, it is worth
to start with a look at first glance to this base.
Keynes talked about animal spirits in Chapter 12 “The Stage of Long-Term
Expectation.” The entire chapter argues against the fact of mathematical calculations
being able to predict or measure the expected value of asset prices. The general crowd is
supposed to be too ignorant to form reliable estimates of present values. “Their
ignorance leads to short-term trading, “speculation”, rather than long-term trading,
“enterprise.” And this short-run perspective often makes for instability.” (Koppl, 1991).
Keynes specifically adds: “These tendencies are a scarcely avoidable outcome of our
having successfully organized liquid investment markets” (VII, p. 159). Animal spirits
are taken as a source of instability and a cause for action. Keynes defines animal spirits
as “a spontaneous urge to action rather than inaction” (VII, p. 161). He believed that
actions induced by animal spirits were absolutely irrational.
All in all, Keynes brings the idea that economic agents may act under irrationality
causing distorted asset prices, and therefore, instability.
Having this as a base, the next sub-theories are built:
3.1.1 The Greater Fool theory. According to this theory, over-optimistic market agents
(fools) buy overvalued assets –being aware that the price does not reflect the
fundamental value- with the intention of selling them at an even higher price to other
market agents, (the greater fools) who have even higher or over-optimistic expectations
on the assets prices and are willing to speculate with them. The cycle goes on, with
fools buying and selling at a higher price to other fools until the bubble bursts when
there are no more fools willing to buy at the peak price.
3.1.2 Herding theory. This theory claims that individuals mimic the actions (rational or
irrational) of a larger group. That is, the investors‟ crowd buying and selling in the
direction of the market. Technical Analysis is usually based upon this concept, since its
overall goal is to detect market trends in order to follow them, what contributes itself to
reinforce the herd behavior. But this fact is not only found on individual basis,
institutional investors like mutual funds also classify for it. Investment managers are
usually evaluated relative to their competitors, and if some funds or firms enter into a
bubble the incentive for an outsider investment manager is to enter as well since his
performance and the fund‟s performance are going to be evaluated relative to others‟.
Hence, in front of a mid-term or long-term bubble institutional investors might
20
rationally participate since the costs of not doing so are greater than the benefits of
remaining out of the bubble.
3.1.3 Extrapolation theory. The key aspect of extrapolation is projecting historical data
into the future into the same basis, believing that what has happened under certain
conditions is going to repeat in a future under the same context. In the bubbles‟ case this
relates to price extrapolation, believing that prices will continue their past trend in the
future. The support for this argument comes from the fact that investors tend to
associate past returns on certain assets with future returns, with the consequence of
overbidding some risky assets in order to try to maintain and achieve the same past rates
of return. But this process leads eventually to a point where returns are no longer
positive when considering all costs involved in the overbid, and then is when investors
do not feel compensated for their risk, and the bubble bursts.
This concept in particular, is going to be perfectly illustrated when explaining a part of
Kenneth L. Fisher and Meir Statman work.
3.1.4 Moral Hazard theory. According to this theory, whenever the risk return
relationship is altered, or agency problems emerge, moral hazard might appear as a
result. This happens when an agent has some sort of immunity or bailout if his
investments decisions produce a fatal situation, then, this agent might have an incentive
to undertake a level of risk above his control or not in accordance with his rational if he
were to be fully personally exposed to the risk. Subsequently, these agents might act
above their equilibrium risk levels generating instability in the system, and bubbles
could emerge as a consequence. This specific case usually happens due to government
policy, as it will be seen later on in this same paper.
3.2 Investors’ behavior
All this psychology factors play a certain role on bubbles. A clear example is well
analyzed in (Fisher and Statman, 2002) when studying the psychological factors and the
forecasts of both institutional and individual investors in the .com bubble case. They use
the Gallup survey in order to infer about investor‟s optimism. This paper is going to
focus on certain graphs, specific figures, and some data both from the Gallup survey and
the Blowing Bubbles work in order to provide evidence of the Extrapolation theory and
show through the .com case how investors‟ exuberance takes place during bubbles and
even after the burst –surprisingly enough- . A starting point is to take a look to the
following graphs:
21
Figure 3.1.
Figure 3.1 is interesting mainly because of two facts. The first is that is shows how
investors extrapolate past results and translate them into future expectations, since there
is a clear correlation between what happened in the twelve preceding months and what
they thought was going to happen during the next twelve months. And the second
remarkable fact is that even at the burst –on April 01- investors remain relatively
optimistic since even if there was a 21% loss on the preceding months. Hence, investors
remained overall optimistic during the peak and at the burst.
Figure 3.2
Figure 3.2 further supports the stated conclusions, and adds the information that
investors were concerned that overvaluation existed and knew there was a bubble, but
despite that fact, around almost 60% thought it was a good time to invest –probably
because they also expected the bubble to continue inflating-. This is absolutely
consistent with the mania behavior explained on previous pages. But even at the burst,
there were still a 40% of investors thinking it was a good time to invest, and 30%
thinking that the stock market was overvalued.
22
Figure 3.3
Figure 3.3 points out that short term return expectations of investors were shaken during
the burst, but remained quite optimistic –about a 7.5% annual return-. However, long
term returns expectations were almost absolutely unchanged. Kenneth L. Fisher and
Meir Statman conclude in their work that “investors are often wrong, the victims of
cognitive biases. Individual investors think that high past returns portend high future
returns, but they are wrong. Institutional investors think that high past returns portend
low future returns, but they are equally wrong. […] Investors are unrealistically
overconfident in our setting, expecting, on average, higher than average returns. They
are unrealistically optimistic in other settings as well.”
3.3 The Logistic Functions Methodology
Another interesting and technically based approach to tackle bubbles is through Logistic
Functions. This paper will summarize the methodology exposed in (Girdzijauskas et al.
2009). The starting point on their model is that growth is limited. And from it, it raises
the point that capital growth is also limited to an investment capacity. Invested capital
fills a part of this capacity and it is named “investment coverage”. The rest of the
investment capacity is for capital growth and it is denoted as “resources of growth”..
Since investment capacity is limited, as investment coverage grows the resources of
growth need to diminish. Investment capacity then, limits the growth of investments as
it can be illustrated in their picture:
Hence we have:
.
23
This is the initial setup. The bubble is supposed to form and expand as investment
coverage squeezes resources of growth within the limited investment capacity. And
when investment coverage is near the capacity limit, the bubble is supposed to burst.
The indicator used in order to detect the bubble effect –following the exposed
reasoning- is to notice when the logistic internal rate of return or the efficiency of the
investment increases very sharply. The creation of the bubble implies an inflationary
process as well.
In order to mitigate or even prevent the bubble effects, the solution in this setup is to
enlarge the capacity of capital, extending the investment capacity through globalization,
entering new markets, or implementing innovations and technological progress. An
example to illustrate this, is the EU expanding to 27 countries when its GDP
continuously decreased indicating that resources of growth were being exhausted.
Entering in the mechanics of the method, the growth of capital is derived through the
logistic function of growth as follows:
,
(3.1)
where K0 is the present capital value; r is the accumulation rate coefficient; and t is the
time expressed in the same units as the time estimated in the interest rate of growth.
And K0 is calculated as follows:
,
(3.2)
which is the present logistic value, and the expression is the formula of logistic
discount.
By differentiating equation (1) we find the expression of the capital growth rate, which
reflects a suitable explanation for the mechanism causing diminishing limit products,
and hence reflecting the limit to capital growth:
,
(3.3)
where S0 is the saturation coefficient. This equation denotes that capital growth rate –
which is not constant- increases, reaches a maximum, and then decreases tending to
zero. This trend is a good representation of business reality and markets, and it is
supported by empirical evidence.
“Logistic model demonstrates the economic growth under constraints. The pressure of
constraints start after reaching the peak of the growth rate and going down what shows
the slowing down rate of economic growth and approaching an economic crisis.” The
only escape to this situation is to increase the investment capacity as explained before.
In order to calculate the typical IRR for investment projects, the LIRR (Logistic Internal
Rate of Return) is used. The LIRR depends in the size of capital resources. It is
calculated for each particular limited capital based on the equation: (Girdzijauskas
2008):
.
(3.4)
24
The dependence of the LIRR on the quantity of limited capital is represented on the
following figure:
The decrease of the limited capital represents the growth of the system‟s saturation.
“The diagram shows that, when saturation is low (i.e. the limiting capital is
approximately 10 times higher than the largest member of the flow), the logistic internal
rate of return will exceed an ordinary internal rate of return no more than by 10%. With
the growth of saturation, the LIRR increases. The growth is especially intensive, when
saturation approaches the limit of 50% (i.e. when the largest member has outgrown
twice). When the limit is exceeded, the logistic internal rate of return increases several
times. The increase of the internal rate of return is the prediction of the bubble
forming.”
“Based on this formula, we can identify that when the internal rate of return
approximates to the margin of growing resource, the rate of increase of internal rate of
return is very high. Such a high rate of increase of return was the main characteristic of
stock price bubbles manifested in 1920 and 1990”
Through these statements and process, the authors conclude that price bubbles can be
predicted and mitigated by applying analysis based on logistic growth models. They key
fat to detect, is the resources‟ limits. A new stage of technological progress or new
markets, are necessary to overcome diminishing returns, and consequently necessary to
avoid the bubble.
All in all, using Logistic growth models, and taking into special account equations 1 and
2, bubbles can be predicted -according with the author‟s criteria- looking to the
following events:
1- High and increasing growth rates in the economy. This fact could be identified
through GDP measures and really high financial company indicators.
2- Low interest rates and high debt measures.
3- Complete usage of growth factors understood as lack of innovations and
technological progress, and stagnation in financial expansion.
4- Psychological pressures on demand and limited supply.
25
As it has been summarized here, Logistic growth models are an interesting technical
approach in order to try to detect bubbles; since the formation, inflation, and burst can theoretically at least- be approximated. For further knowledge on this method, it is
strongly recommended to carefully read the full author‟s article.
3.4 Different theoretical setups for bubbles detection
Different series of theoretical setups are presented in (Thompson. and Hickson, 2006).
Their paper classifies bubbles between short-term informational monopoly bubbles, and
long-term government involved bubbles. The firsts are considered “mini-bubbles”, and
the second ones are the historically important ones. The main difference between them –
and really interesting to keep in mind- is that short-lived bubbles are accompanied by no
expansion in asset supply whereas long-lived bubbles are accompanied by substantial
supply increases.
3.4.1Market manipulation and bubbles in the presence of informational monopoly
These kinds of bubbles are generated through market manipulation by an agent who has
certain kind of long anticipated information about an specific asset. This agent, who
could be represented via specialized traders, needs to be well financed in order to carry
out the speculative process, and have time in advance to manipulate the market before
the event for which he has privileged information occurs. The setup works like this: the
trader buys without signaling his excess demand, trying not to substantially modify
transaction prices. He generates price fluctuations pretending that he follows normal
news and thereby deterring some outsiders in front of such price fluctuations. “Sharp
increases in price volatility and volume followed by decreasing price volatility relative
to volume indicate that an informational monopolist is preparing the market and prices
are about to either jump or dive.” Once the market has been prepared, the informational
monopoly trader buys successive units at successive higher prices, but each price being
insignificantly higher than the previous one in order to not reveal a trend, and to be able
to cash profits without generating a spread on the price.
These kinds of bubbles are not predictable since they do not contain any kind of hype
element. In addition, the duration of those are no more than few weeks since otherwise,
it would be necessary for the trader to accumulate such amount of purchases in order to
sustain a jump in price that he will not be able to completely liquidate his position in the
burst. Hence, there is no significant supply asset increase either as stated on the
section‟s introduction.
3.4.2 When bubble creation is a rational government policy
These bubbles can be formed under two different kinds of governmental actions
(Thompson and Hickson, 2006):
“1) a sequence of positive governmental announcements widely considered to be true
because of the rarity with which they are deceptive
2) legal „reforms‟ reducing the legal penalties of deceptive private announcements,
„reforms‟ the public only understands through bitter experience.
Corresponding to each type of legislative deception, there is a distinct disequilibrating
shock.”
26
This paper is not going to describe the first kind of bubble since it is quite rare, but a
brief summary could be as follows: A government without central bank is facing an
opposition‟s running elite imminent revolution. There has to be no central bank because
of monetary implications in this setup. What the government in charge does, is to
generate some kind of very attractive government backed investment. For instance, the
government might generate positive shocks on a company, and give it government
privileges such as national debt holding, advantageous legislation or even subsidies.
This induces outsiders, including revels, to invest in the created bubble; and therefore,
the revolution is delayed. Eventually the bubble is bursted and the rebels lose their
investment.
Now the focus is going to be in the second kind of bubbles; the ones that imply
government legal reforms and are the big long-term bubbles that we usually observe on
our markets. The basic setup here consists in preparing a “jump on the train” situation
where ruling elites are aware of the process and know when to effectively leave the train
before it crashes. What the government does is to elaborate legislation in favor of the
running-elite that permits the diminished middle class to borrow and participate in the
asset boom, but legislation that at the same time “decreases the legal punishment that
ruling-class promoters face for various offences against ordinary people.” There also
might be a tax increase for the middle class, accompanied with decreasing wage rates.
Since the redistribution of wealth cannot be done through capital or land directly taken
out from the middle class, stock market bubbles and real estate bubbles might be a
feasible alternative. The legal measures usually facilitate the hype and euphoria among
the crowd as well.
Furthermore a flat spot at the peak time might be observed, enabling the insiders‟
ruling-class to liquidate positions. “The cumulative result would be an immense shakeout, leaving most assets in ruling-class hands.”
This setup has been applied in current western democracies through the .com bubble,
then a small time to recover, and following a real estate bubble. Meanwhile, big rulingelites institutions were well informed and protected all before, during, and after the
bubbles as we have seen.
3.5 The conspiracy happened: The .com bubble and the securitization bubble
schemes
This subsection aims to support the theory previously explained, where governments
together with the ruling-elites set a bubble scheme through which they generate a
redistribution of wealth in society towards ruling-elites. In order to illustrate it, some
facts and figures that happened from 1981 up to 2009 are going to be classified in four
groups: The Government role, The Set Up, The Elites role, and Consequences. Facts
and figures will be given for each group that clearly shows the framework where all
happened. All four groups and facts are interrelated among them. This section has been
elaborated from very different sources, but mainly The Federal Reserve Bank of St.
Louis, Thompson Reuters, Economic Policy Institute, and Inside Job Documentary
among others.
3.5.1 The Government role
 Deregulation was the first step. It started under President Ronald Reagan in
1981, having Donald Reagan, former executive of Merrill Lynch as Secretary of
the Treasury. During Bill Clinton‟s period, deregulation continued with Alan
Greenspan, Robert Rubin, who was former CEO of Goldman Sachs, as Treasury
Secretary, and Larry Summers, a Harvard Economics Professor.
27







In 1999 the Gramm-Leach-Bliley Act permitted a merger between Citicorp and
Travelers to generate Citygroup. While the Act was to be passed, Citygroup was
given a one year exemption from the government. The Act cleared the way for
future mergers.
JP Morgan was accused during the .com bubble to bribe government officials.
Derivatives were key for the investment banks financial strategies and profits,
and by the end of 1990s were unregulated products moving about $50Trillion. In
1998 Brooksley Born, who was in charge of the Commodity futures Trading
Commission under Clinton‟s Administration, tried to regulate the derivatives
market and issued a proposal in May 1998. The Treasury Department declined
the proposal as Larry Summers had the visit of thirteen bankers‟ representatives
before making his decision. Right after that fact, Alan Greenspan Chairman of
the FED, Robert Rubin Secretary of the Treasury, and Arthur Levitt Chairman of
the SEC, issued a joint statement in May 7, 1998, recommending legislation to
keep derivatives unregulated. In June 21, 2000, Senator Phil Gramm, and
Chairman of the Senate Banking Committee presented a bill for derivatives
unregulation. After leaving the Senate, he became Vice-Chairman of UBS. In
December 2009, Congress passed a Commodities Futures Modernization Act
(H.R. 5660) that banned the regulation of derivatives.
In 2001 George Bush entered to office. Former Wall Street people had positions
on his government as well, and Alan Greenspan –who had been in charge of the
FED under Reagan‟s and Clinton‟s Administrations- continued in his position.
Wall Street starts to capture the political system.
In March 16, 2008 Bear Stearns collapsed, and was acquired for $2 a share by
J.PMorgan Chase & Co. The deal was backed by $30Billion in guarantees from
the FED. The same happened after for Merrill Lynch which was acquired by
Bank of America.
In September 18, 2008, AIG is taken over by the government, and one day later
the FED asks Congress for $700Billion to bail out the banks. AIG was forbidden
to sue banks that owned CDSs against AIG.
In September 29, 2008, Obama points to Wall Street‟s greed and regulation
failures as needs for change in the U.S. After taking office, nothing was
proposed; and Wall Street senior people got deeper into government positions:
Timothy Geithner as Treasury Secretary; William C. Dudley, former Chief
Economist of Goldman Sachs who supported derivatives in his publications, is
appointed as Chief of the NY FED; Mark Patterson, former Lobbyist for
Goldman Sachs, is appointed as Chief of Staff for the Treasury; Lewis Sachs,
who was head of Tricadia and betted against CDOs, was appointed Senior
Treasury Advisor; Gary Gensler, former Goldman Executive who helped ban the
regulation on derivatives, is appointed as Head of the SEC; Mary Schapiro,
former CEO of the Financial Industry Regulatory Authority, the securities
industry self-regulatory organization for broker-dealers and exchanges in the
United States, was appointed Chairperson of the SEC; Rahm Emanuel‟s, from
the Freddie Mac‟s board, is appointed as Chief of Staff for the SEC; Larry
Summers, is elected as Chief Economic Advisor; and Ben Bernanke gets reelected.
3.5.2 The Set Up
 During the .com bubble, a federal investigation revealed that U.S banks had
promoted investments in companies they knew would fail, but the Securities and
Exchange Commission had done nothing to avoid it. In December 2002, ten
28


investment banks were fined for a total amount of merely $1.4Bilion, which is
about $114Milion each.
Between 1998-2003 Freddie Mac and Fannie Mae were fined $125Milion and
$400Milion respectively for accounting fraud.
In 2001 the securitization bubble is being prepared. And a securitization food
chain system is developed as follows:
Home buyers Lenders Investment Banks that issue Collateral Debt
Obligations (CDOs) with all kinds of debt mixed together. This Investment
Banks pay Rating Agencies to evaluate those CDOs, and most of them are rated
AAA14 since those Rating Agencies had no liabilities if their ratings proved
wrong. CDOs are sold to Investors.
Figure 3.4 Source: Inside Job documentary
Figure 3.5 Source: Inside Job documentary



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Hundreds of Billions of dollars flown through the securitization chain between
2001 and 2007. Subprime lending increased from $30Billion per year in funding
to over $600Billion per year within ten years. Subprime loans were preferred by
banks because they carried higher interest rates, and predatory lending emerged
as a result, as it can be appreciated in Figure 3.4 and Figure 3.5.
Money was created through this system; it went to firms books and translated
into profits. Then defaults began and was all gone. The parallelism is clear with
a typical scam setup.
Through the Home Ownership and Equity Protection Act of 1994, the FED had
authority to regulate the mortgage industry. However, it did nothing. The SEC
conducted no major investigations during the securitization bubble. In fact, the
Safer as government securities
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SEC‟s Office of Risk Management reduced its staff members to just one single
person.
Figure 3.6 Source: Inside Job documentary




Henry Paulson , in 2004, was CEO of Goldman Sachs, and lobbied the SEC to
release limits on banks‟ leverage. On April 28, 2004, the SEC met to consider
lifting leverage limits on investment banks, and it did; as it can be illustrated
with its effects in Figure 3.6.
During 2001-2007 AIG was selling CDS –about $500Million of CDS just in
London- which incremented the exposition to CDOs.
Goldman Sachs sold at least $3.1Trillion of junk CDOs, which were rated AAA,
just in the first half of 2006; while Henry Paulson was the CEO of the firm.
In 2006 and 2007, Goldman Sachs was betting against the same CDOs it was
selling, through $22Billion CDSs from AIG. The same did Morgan Stanley, the
hedge funds Tricadia and Magnetar, Merrill Lynch, J.PMorgan, and Lehman
Brothers.
Figure 3.7 Source: Inside Job documentary
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Figure 3.8 Source: Inside Job documentary




At the same time, rating agencies did rate everything AAA without any kind of
legal responsibility: Bear Stearns was rated 2A one month before its bankruptcy;
Lehman Brothers was rated 2A within previous days to its collapse; AIG was
rated AA right before its bankruptcy as well; and Freddie Mac and Fannie Mae
which also went bankrupt were rated AAA. The profits for these rating agencies
skyrocketed at the same time. Both facts are respectively illustrated in Figure 3.7
and Figure 3.8.
The market for CDOs collapsed in 2007.
Interest rates have remained in historical low values during the past two decades,
easing the bubbles emerge, and enabling middle classes to get into deep dept.
After the bubble burst, nothing happened to financial executives, or to financial
firms. There was no federal prosecution, nothing.
3.5.3 The Elites’ Role
 Robert Rubin made $126Million as Vice Chairman of Citygroup after leaving
Clinton‟s Administration.
 Franklin Range, who was Budget Director under Clinton‟s Administration,
received later on $52Milion in bonuses in the financial industry while being a
CEO.
 Larry Summers made $20Million as a consultant to a derivatives hedge fund.
 Lehman Brothers CEO Richard Fuld made $485Million during 2001-2007.
 40% of S&P500 firms‟ profits between 2001-2007 was made solely by financial
institutions.
 Joseph Casano, CEO of AIG made $315Million. After AIG collapsed, he passed
from being CEO to become a consultant for the firm, earning $1Million per
month.
 In May 30, 2006, Henry Paulson enters as Secretary of Treasury, avoiding
$50Million is taxes when selling his stocks of Goldman Sachs.
 When AIG collapsed, Goldman Sachs made $60Billion through the CDSs it
owned against AIG.
 Countrywide‟s CEO Angelo Mozilo made $470Million between 2003-2008.
And $140Million of those, came from selling his stock in Countrywide before it
collapsed.
 Stan O‟neal, CEO of Merrill Lynch, made $90Million in 2006-2007. When he
was forced to resign, he got paid $61Million in severance. His successor was
paid $87Million in 2007 alone.
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


The Financial Sector in the U.S employs 3,000 lobbyists –more than 5 for each
member of Congress-.
Between 1998 and 2008 the Financial Sector spent over $5Billion on lobbying
and campaign contributions. And after the crises, it spent even more money.
The same three U.S major private investment banks financed both Obama‟s
campaign and McCain‟s campign.
Figure 3.9 Source: Inside Job documentary

As it can be seen in Figure 3.9, the income of some ruling elites skyrocketed
during the securitization scheme period.
3.5.4 Consequences
 The U.S National Debt has more than doubled post-crisis, and there are more
than thirty million people unemployed.
 The .com bubble cost $5Trillion just in investment losses.
 AIG‟s bailout cost $160Billion from taxpayers. Banks bail out $700Billion.
 Unemployment rises to 10% average in U.S and Europe.
 In December 2008 General Motors and Chrysler face bankruptcy, firing
thousands of employees.
 Foreclosures in U.S reached 6Million by early 2010 and were predicted to end
up with 9Million more foreclosures.
 Concentration of the financial industry in fewer but bigger banks.
Figure 3.10 Source: Inside Job documentary
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Figure 3.11 Source: Inside Job documentary
Figure 3.12 Source: Inside Job documentary

There was indeed an income redistribution towards the ruling-elites, and the
middle class indeed got further into debt. In Figure 3.10, it is seen how the
middle class got trapped into debt. The income redistribution towards the rulingelites is clearly shown in Figure 3.11. And another important impact on the
middle class are the number of foreclosures, as it can be appreciated in Figure
3.12.
SECTION 4: BUBBLE EFFECTS ON ECONOMIC WELFARE AND POLICY
RECOMMENDATION
The main purpose of this section is to discuss whether bubbles have positive effects or
negative effects on the overall economic welfare, and take a close look to the aftermath.
To carry on this objective, positive and negative effects will be discussed separately.
Therefore, it can be anticipated as mentioned that not all bubbles are necessarily bad
since certain specific kinds of bubbles are needed in our monetary system, for instance,
while some other might lead to economic sector expansions that otherwise would have
never taken place. Parallel to the desirability or undesirability of bubbles, an outlook is
also going to be undertaken regarding economic policies in front of bubbles; whether it
is better to act when signs of bubbles are clear –during the bubble-, even without clear
signs –before the bubble-, or after the burst.
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4.1 Desirable bubbles
The biggest, largest, and probably most importantly positive bubble that has existed –
and still exists- is fiat money. Fiat money, as it could be analyzed with model presented
on section 2 –the basic bubble mechanism- has zero fundamental value, and all its value
is intrinsic in the bubble component. When the convertibility of the gold standard was
abandoned in 1971 by President Richard Nixon, paper money lost all its relation to the
precious metal gold. X dollars were no longer convertible into X ounces of gold, and
paper money adopted value by itself. What then could arbitrarily assign value to
money? If after all, since there was no longer any kind of convertibility, paper money
was a mere “bunch of pieces of paper”. The answer is confidence, and convenience.
Confidence since money is a specific kind of contract that enables agents to exchange
goods and services, under the guarantee of the Central Bank as it can be read on any
paper bill. And convenience, since fiat money serves as a medium of exchange, which is
by itself an efficient clearing arrangement. Money also serves to pay taxes, which grants
it value; and money is a vehicle for savings. For further theory on money, it is worth to
read (Samuelson, 1958).
As explained in section 1, there are also theories in favor of bubbles as a mean of rapid
economic sectors‟ expansion. It is remarkable to bring the figures again of the Railway
Mania: a total of 10,000 Km were constructed as a result of projects authorized between
1844 and 1846. It is interesting to compare that number with the modern railway
network of United Kingdom, which is about 18,000 Km. The two other most praised
bubbles are the utilities‟ bubble, that permitted electricity to arrive virtually everywhere;
and the .com bubble, since it expanded the telecommunications all around and brought
the internet to virtually all the territories as well.
It could be arguable that such expansions would have happened anyways in the longrun, but the question is if the necessary capital to undertake such ventures would have
been accumulated without a bubble, and whether it is better to achieve such global
targets like electricity, railway and internet in the long-run or in the short-run.
4.2 Negative Bubble Impacts
Tirole (1985) is one of the first authors who test the impact of economic bubbles on
modeled economies. Later on, Grossman and Yanagawa (1992) expanded Tirole‟s
model to include economies that grow in the long run at an endogenous rate. The
conclusions in these kinds of settings are that “bubbles retard the growth of the
economy, perhaps even in the long run, and reduce the welfare of all generations born
after the bubble appears.” The main reasoning supporting these theories is that bubbles
attract capitals, that otherwise would have been allocated in more productive assets.
Furthermore, in these models, bubbles can only exist on nonaccumulable useless assets.
And the impact of both the emergence and the burst of the bubble, although might be
beneficiary for the current generation, have serious retards on economic growth for
future generations.
Bubbles might lead to economic distortions as well as financial and real economy
instability, and have effects on current output growth, aggregate spending and expected
inflation (Roubini, 2005).
We have also seen empirical evidence in section 4 of the negative impacts the .com and
the securitization bubble had, especially on the middle class. It generated a clear
redistribution of wealth from the middle class –which ended increasing its debts by
almost 50% on average- towards the ruling-elites, generated an almost immediate
unemployment of 10% on average, implied a bailout of more than $800Billions just in
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the U.S, more than doubled the national debt, and plunged world western economies
into severe recessions that today still last.
4.3 Policy recommendation
When economic policy faces a bubble, it is important to distinguish an ex-ante the burst
scenario, and an ex-post the burst scenario. Before the burst occurs, when it is the
moment to try to control the bubble, just monetary policy is mainly relevant. However,
after the bubble bursts fiscal policy becomes relevant as well. There are two
mainstreams of thought about bubble policies: the first one argues against any kind of
intervention, and the other sustains that bubbles should be targeted since the very
beginning.
The main advocates about non-intervention are the current FED‟s Chairman Ben
Bernanke, and the former predecessor Alan Greenspan, together with some other
authors that are going to be mentioned next as well. The main view from the FED then,
is that monetary policy should take place after the bubble bursts, whenever there is an
evidence of financial damage. This attitude has been described as “mopping up after”,
but the point is that this kind of policy is the same as with any other economic shock. It
does not distinguish whether there is a bubble or what is the cause, it is just answering
to a negative impact on the economy. Since bubbles most of the times cause a negative
impact on their burst, this policy approach implies an asymmetric response: no reaction
while the bubble is inflating –since there is no negative consequence meanwhile on the
economy- but strong monetary easing in order to prevent collateral damage when
bubbles burst. The first main argument highlighted by these pro-non-intervention
authors is that in most of the cases, there is uncertainty about a bubble‟s existence, and
so it might be dangerous to react monetarily if the authorities are not even sure of the
existence of one (Greenspan (2004), Bernanke (2002,2004), Kohn (2004)). Such a
monetary policy reaction in front of a wrong analysis could lead to a severe recession or
even depression. Greenspan (2004) and Bernanke (2002) have argued that in order to
prevent or smoothly burst a bubble, a very sharp increase in interest rates would be
needed, thus generating such a big negative repercussion on the economy that the
potential damage would be greater than the bubble problem. Greenspan expresses such
concern as follows: “The notion that a well-timed incremental tightening could have
been calibrated to prevent the late 1990s bubble while preserving economic stability is
almost surely an illusion.” And Bernanke (2002) expresses the same concern similarly:
“bubbles can normally be arrested only by an increase in interest rates sharp enough to
materially slow the whole economy. In short, we cannot practice „safe popping‟, at least
not with the blunt tool of monetary policy. The problem of safe popping applies with
double force to the aggressive bubble-popping strategy. A truly vigorous attempt by a
central bank to rein in a supposed speculative bubble may well succeed but only at the
risk of throttling a legitimate economic boom or, worse, throwing the whole economy
into depression.” Bernanke exposes the 1929 crash as a critic to bubble pricking, and
also argues that past monetary contractions did not prevent asset bubbles to emerge
right afterwards.
Parallel to these arguments Blinder and Reies (2005) express the idea that during a
rising bubble, investor‟s returns expectations are so high that a modest increase in
interest rates by 100 or 200 basis points would have slight or no impact at all on
investors‟ rational, therefore monetary policy being useless.
An extreme point of view (Garber, 2000) is to expose that changes in asset prices are
strictly driven by fundamentals, hence denying the whole existence of bubbles, and
therefore concluding that no policy should be taken because it would go against
35
economic rational. Similar –but less intense- arguments point towards bubbles having
no economic impact on real or financial variables such as growth, inflation or deflation,
sustaining that bubbles cause no lasting nor serious damage (Posen (2003,2004)), and
therefore policy reaction would be non-sense. The same author expresses the idea from
a different point of view, adding that monetary policy is not sufficient neither necessary
to generate bubbles. Posen observes in his study that only in 17 out of 48 –less than a
third- cases of sustained monetary easing have lead to property or equity booms.
Asymmetrically, the above arguments can be counter-argued since there are elaborated
reasons as well in favor of bubble control and intervention. Nouriel Roubini (2006)
states “monetary policy should react to asset prices and should try to “prick” or “burst”
asset bubbles. Bubbles that are growing excessively large lead to economic and
investment distortions that are dangerous and likely to eventually trigger bubble bursts
whose real and financial consequences are severe. Thus, optimal monetary policy
should preemptively deal with asset bubbles rather than just mop up the mess that they
cause after they burst.” Roubini advocates that “asset prices should enter directly in the
reaction function of the optimizing monetary authority, above and beyond the direct
effects that such asset prices have on expected inflation and current growth.” Filardo
(2001, 2004) theoretically demonstrates that even under uncertainty, optimal monetary
policy should react to asset prices. React to the overall asset price, regardless if there is
uncertainty about a bubble component or not. Even in the limit, a timid response would
be more optimal than no response at all, hence non-reacting being non-optimal nor
rational. These mainstream thoughts sustain that bubbles clearly negatively impact the
economy, although the magnitude of the impact might be uncertain ex-ante. Roubini
rebates Posen‟s argument that bubbles have no economic impact exposing that if
bubble‟s impact is not severe is precisely because policy has reacted after the burst,
otherwise the impact would be intense. Furthermore, there is plenty of literature
providing studies in favor of asset price booms and bursts having negative impacts on
the economy (Bordo and Jeanne (2002), Borio and Lowe (2002), Helbling and Bayouni
(2003)). As regarding controlled bubble bursts – or prickles- it seems to be empirical
evidence supporting monetary policy tightening deterring bubbles while not causing any
financial or economic crash. The examples are U.K, Australia and New Zealand; being
Australia the clearest and smoothest example. By 2002, a housing bubble was clearly on
track, with Sydney‟s house prices increasing as much as 50% in H2:2002, and monetary
authorities reacted in 2003 with a tightening policy. By the spring of 2005 short term
interest rates were at a four-year high. Due to this policy, the housing bubble stopped
without great negative impacts on the economy. Actually, asset prices were benefited of
a housing collapse prevention, and the local stock market celebrated it with a 10%
increase in the summer relative to that year‟s starting level. “The soft landing of the
economy was so successful that Australia has recently been referred to as a “nirvana” or
“goldilocks” economy” (Pesek, 2005). However, the growth rate slowed down although
it remained at a decent rate after fourteen years of continued expansion.
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CONCLUSIONS
I have tried to show both trough mathematical procedures as well as through empirical
evidence that bubbles are a not so rare economic phenomenon. Bubbles are an
observable economic phenomenon that manifests mainly in three different ways: 1)
Naturally, such as the bubble component on fiat money that appears due to confidence
and convenience throughout agents transactions; 2) Due to Informational monopolies,
like when some big institutional traders have privileged information about an specific
company, and they manipulate the market creating an specific company‟s stock price
boom; 3) Through the coalition of governments plus running elites, who together
prepare and generate economic events that involve a major part of society. All the
historical mentioned bubbles are clear examples of this third cause. The first and the
third cases are usually long term bubbles, while the seconds are always by their
structure short term defined. Bubbles appear in different kinds of assets, but in our
current modern context historical bubbles are likely to emerge predominantly in the
stock market and Real Estate market, since it is easier to use these market structures in
order to canalize the capital flows and generate redistributions of wealth. However, for a
bubble to emerge, the participation of “the crowd” is needed. The core of this crowd
tends to be formed by investors who are unprepared, less informed, and with a relatively
unfavorable context. Prominent investment ventures are the gimmick to attract the
multitude, and the mass media the instrument necessary to persuade them. The bubble is
perfectly smoothed under great prospects, and investors show overconfidence at almost
all stages. Hence, the nature of human psychology eases the bubble process.
Bubbles usually share a similar price pattern, and different stages can be clearly
identified. Bearing in mind the explained price pattern, two different approaches might
serve as tools in front of a rise in price which is difficult to distinguish whether it is due
to fundamental values or not. The first and more technical tool is the logistic functions
model; while the second and theoretical approach is identifying the ruling elites plus
government set ups. When using the technical proposed tool it is important to look for
the dramatic increase in the internal rate of return, whereas if using the theoretical
approach it is remarkable to identify deregulations in certain markets, regulations in
favor of certain groups or sectors, legal immunity for some market participants, and
basically government support to specific economic agents. Economic factors that
facilitate and impulse bubbles are: cheap credit, capital mobility, leverage instruments,
and fiscal pressure on the middle class.
Bubbles can clearly have positive, negative, or zero sum effects. Nevertheless, in any
case bubbles generate a redistribution of wealth, not only among the participant agents,
but also among the agents that potentially receive the externalities and collateral
impacts. The bubble negative effects can be mitigated through expansionary monetary
and fiscal policies, being the first one the most efficient and effective under a bubble
burst scenario. However, as regards to intervening the bubble formation there is
empirical evidence that Real Estate bubbles can be effectively controlled during their
formation, ex-ante its burst, via appropriate increases in interest rates. But in spite of
this fact, there is still controversy and lack of empirical evidence concerning
intervention with the rest of bubble types.
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