Blowing Economic Bubbles

The formation of asset bubbles in the economy – and the eventual devastating pop that follows – has become ubiquitous in the free markets of the West.

Bubbles are characterized by a sharp, rapid, and sustained increase in price of an asset such as a stock, bond, real estate, or currency. The price skyrockets into the stratosphere, reaching highs that are not justified by the underlying fundamentals. Once the buying frenzy tapers off, the price of the asset goes into free fall, erasing the gains of high-spirited investors and speculators. Sometimes the bursting of an asset bubble is so severe that the broader economy is affected; a recession is a very real possibility.

Because asset bubbles are capable of wreaking havoc in thefinancial markets and overall economy, we must all be cognizant of them and be better prepared by building robust systems to mitigate the negative effects.

But wouldn’t it be far more effective to prevent them in the first place?

While I don’t believe it can be done, completely eliminating the conditions that precipitate bubbles in the first place would be ideal. Once they are identified through the application of objective metrics, the appropriate monetary and fiscal policies would be enacted to diffuse them, just as they are beginning to form.

This would only work in theory, however.

In reality, our modern-day economy actually depends on the formation of bubbles from time to time. This is because bubbles help produce what economist call the wealth effect.

The wealth effect is a change in the spending habits of individuals that follow when the perceived wealth of their assets increase. As people become aware of the rising values of their assets, they respond by spending more money on consumer goods, with the justification that they are growing richer.

In today’s modern economy, consumer spending accounts for a large portion of GDP. So large in fact, that a significant slowdown could cripple the economy, sending it down a deflationary spiral.

The last thing that politicians, corporations, and central bankers want is for consumer confidence to turn sour, so they do everything they can to prevent a recession from occurring. Politicians, in particular, always fear that an asset bubble may burst during their term, with the result that they may take the blame. No politician wants to preside over an economic downturn that costs voters their jobs and evaporates their savings accounts. Thus, their is an incentive to keep bubbles going for a long as possible – and to grow new ones after they burst. But in doing so, they only prolong the inevitable.

Despite what the “experts” say, our economy is dependent on people perceiving that they are more wealthy than they are. But it is an illusion. You can only realize the gains in your portfolio by selling the securities (the same thing goes for you personal residence). Perception counts for nothing; you only realize your wealth by converting it into cash.

Once the bubble bursts, the phantom valuations that looked so appealing on paper vanish. All that remains is the debt that was accumulated to finance the spending and speculation.

This brings me to my next point: we have an economy that relies very heavily on debt.

As consumers exhaust their disposable income, they must rely on debt (such as utilizing a line of credit or borrowing against the equity in their home) to keep purchasing more goods and services. Keeping the economy growing at a  sustainable pace that people have grown accustomed to requires ever increasing levels of debt.

The process looks like a virtuous cycle – until asset prices drop and a vicious cycle ensues, inflicting financial carnage on the economy. Businesses shut down, workers get laid off, and consumers abruptly halt their discretionary spending.

However, once businesses and individuals deleverage their balance sheets and jobs start coming back, a new cycle begins. The bubbles never stop emerging.

But what happens when debt levels get too high and the acquisition of financial and real assets by individuals becomes economically unfeasible?

Banks and other credit institutions may be forced to lower their standards and lend to people who would not normally qualify; this creates more demand and sends asset prices even higher.

Immigration may be increased in order to bring in fresh “clients” that can help boost the economy. Financial institutions can sell them mortgages, student loans, auto loans, and tax-deferred investment vehicles such as RRSPs. Inevitably, this means that standards must be lowered when it comes to admitting new immigrants, with the result that they may become a net liability rather than a net asset to the country.

When bubbles form, they absorb capital and labour in excessive quantities not justified by the fundamentals (these are called malinvestments). Once reality sets in, the market realizes its cluster of mistakes and begins liquidating the malinvestments, resulting in massive layoffs in the sector that spawned the bubble. The market then begins the process of allocating the misused resources to sectors where they are needed. And with a substantial portion of the economy driven by consumer spending, it is not possible to address this correction without causing a recession.

Instead of allowing the economy to reorient itself after the bursting of a bubble, central banks “aid” in the recovery process by lowering interest rates and governments initiate round after round of fiscal stimulus packages. While this may help the economy recover in the short run, it may only serve to create a new bubble in another segment of the market.

After the demise of the Dotcom bubble in the United States in 2000, interest rates were brought to historic lows and a new bubble formed in the housing market, bursting in 2008. What followed was even more record low interest rates, with the economy being deluged by money left and right. What bubbles are being formed now underneath the surface? And what will happen when they burst with interest rates at already historic lows (not to mention high levels of debt and stagnant wages)?

With interest rates at historic lows for many years now, more money will continue to flow into housing, stocks, and other speculative investments, thereby precipitating the formation of bubbles. There is simply no more value in investing in relatively safe investments such as GICs and bonds. We are now forced to become speculators in order to not only grow our wealth for retirement, but simply to prevent the value of our money from being eroded by inflation.

We must ask ourselves if relying on bubbles, the wealth effect, and ever escalating levels of debt, is the best way to grow and sustain an economy.

Can market bubbles be stopped? I don’t believe so; our debt based monetary system, coupled with the element of fractional-reserve banking, is a system that is precisely suited for bubbles. In addition, they are driven by psychological factors due to the fact that market decisions are made by humans – and humans do not act rationally most of the time. Even if politicians and central bankers act in a completely rational manner and employ the appropriate monetary and fiscal response, we are still not going to completely eliminate bubbles from forming.

At the very least, we should not help fuel bubbles to absurd levels by getting the market hooked on easy credit. It is far better for bubbles to burst when they are smaller, as this implies a recession much shorter in duration will follow. Propping up the stock market, housing market, or any other area where prices are soaring to unsustainable and unwarranted highs, is counterproductive and will only result in a greater crash in the future. The less resources that are poured into the bubble through rampant speculation the better.

The choice is as follows:

  1. Small bubbles and recessions that occur more frequently but cause minimal damage to the economy
  2. Giant bubbles and recessions that occur rarely but cause massive damage to the economy.

To prevent a large forest fire, it may be helpful to let the small ones burn, or even start one yourself.

To prevent a large market crash, it may be helpful to let small bubbles burst, or even start one yourself (ask the short sellers with deep pockets for help)

Okay, ignore that last part about crashing the market because you think it’s a tad too high………just wait for the bubbles to pop on their own.

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