Tag Archives: Bubbles

Bitcoin bubble?

Here is a video from PBS News with Paul Solman – he looks into cryptocurrencies  and tries to explain what they are and how to buy them. Also is bitcoin a bubble?

Professor, author and hedge fund manager Vikram Mansharamani states:

You do need some more stability in the value of it before it gets truly adopted as a currency, not as an instrument of speculation. Today it’s de facto an instrument of speculation or a means through which to fund illicit activities off the grid. Bitcoins and sort of other cryptocurrencies live outside of the traditional banking network. And in fact are intended to do so by design.

 

Crash Course Economics – YouTube channel

Here is a useful YouTube channel called Crash Course Economics. The presenters are Jacob Clifford (you may remember him from the Star Wars clips) and Adriene Hill. There are currently 11 videos on a range of topics – economic systems, budget deficits, money and finance etc. Most are around 10 minutes long but well structured. Below is a very good presentation on Inflation and Bubbles and Tulips.

A Bubble – what is it?

bubble2Yale University economist and Nobel Laureate Robert Shiller describes a bubble as a “psycho-economic phenomenon. It’s like a mental illness. It is marked on excessive enthusiasm, participation of the news media and feelings of regret among people who weren’t in the bubble”

Others have suggested that bubbles are an increase in the price of an assets of no more than two standard deviations above the trend taking inflation into account. Bubbles have been a lot more prevalent since the 1960’s and this reflects the liberalising of financial markets and the end of the Bretton Woods system of fixed exchange rates in the 1970’s. Many economists have struggled to understand bubbles as in a rational and perfectly informed market assets that are overpriced should be sold. However the frenzy of the market can last much longer than investors think and the bursting of the bubble will be a gradual and slow process or a sudden drop in prices.

Housing bubbles tended to be supported by the banking industry.

* As most people take out a mortgage from a bank, rising house prices encourage banks to lend out more money as there is more security for them. However this greater availability of credit allows borrowers to afford higher prices.

* In contrast when the banks become reluctant to lend money and house prices can drop greatly. According to The Economist’s house price- indicators property in New Zealand (or should that be Auckland), Australia and Canada is overvalued. However could higher prices just reflect the level of income inequality that is clearly visible in most developed economies and conspicuous consumption. Thorstein Veblen wrote about this in his book The Theory of the Leisure Class (1899).

Dow Jones record high but is it a bubble?

Another video by Paul Solman in which he discusses how the NYSE record high doesn’t reflect the fundamentals of the US economy. With interest rates at virtually 0% the US Federal Reserve is trying to lower unemployment by stimulating the economy. But, by doing so there has been a tendency for it to overstimulating the stock market in the process. And also lending to stock investors, whose margin debt to buy shares on credit has been hitting record highs. Last week the Dow ended above 16000, another record for the headline index of 30 major companies.

The last record was set in 2007, a few months before the Dow’s previous high watermark.But for all the talk of the Fed’s role there’s an alternative way to understand a record Dow and higher profits: a shift of power from workers to owners. The stock market would actually be much higher if the unemployment was much lower. I think the economy is still really fundamentally weak, and that slack that’s in the economy right now, with all the unemployed people, all the unemployed businesses, would actually bring up the stock market even further.

Causes of Bubbles

This is something that I have been covering with my Behavioural Economics students.

Behvaioural economists pay special attention to the causes of financial bubbles. Many explanations are offered, but key among them are herding, relative positioning and overconfidence. These psychological factors are sometimes referred to ‘Animal Spirits’ (from economist John Maynard Keynes) or ‘Irrational Exuberance’ (Alan Greenspan former US Fed Chairman) not only create bubbles but also greater volatility in the booms and busts.

1. Following the herd: Decision making in a world of uncertainty

Wall St - herdingPeople tend to follow the herd, especially information is uncertain, incomplete, and asymmetric (some people are more informed than others). Basically, in a world of bounded rationality (the limits of the human brain in processing and understanding information), herding makes sense to most people. Herding is a fast and frugal heuristic (short-cut) that has been used by both human and non-human animals across the millennia. Some behavioural economists see herding as irrational because people aren’t basing their decisions on objective criteria. If herding is seen as rational it can result in price cascades leading to excessive booms and busts in the prices of financial assets.

2. The role of relative positioning in investor behaviour.

Another cause of financial bubbles is relative positioning, which is a concern people have regrading their own economic and social status relative to other people. Any deterioration is a person’s relative positioning should reduce a person’s well-being. Many people will invest more as share prices increase for fear that otherwise their economic status will fall relative to those who are currently investing and making a lot of money, at least on paper (shares that they own). This fuels further increases in share values, but not on the basis of changes in the fundamental values of the assets. Relative positioning is similar to herding, but people aren’t following the leader. Instead they’re trying to protect their relative economic and social status by keeping up with others in their reference group who are already investing.

3. Overconfidence and underconfidence

Overconfidence is a belief, fed by emotions, that you can predict movements better than you actually can. When you’re overconfident, you’re not as smart as you think you are. Overconfidence tends to lead to great investment in financial assets that you would otherwise. Some economists argue that people invest in assets that they wouldn’t invest in if they considered more objective criteria and weren’t ruled by emotions.

Underconfidence is also emotionally driven. It’s a belief that you have a less capacity to understand and predict asset prices than you actually have. It tends to lead in panic-driven selling of financial assets, causing many people to dump assets they should keep, based on objective criteria.

Confidence is affected by the behaviour of others. Their confidence is often reinforced when people know that other people, including experts, and the rich and famous, are doing the same. In a world of bounded rationality, such behaviour may make sense – even though it can result in errors in decision making.

4. Institutional failure

Credit Rating AgenciesAfter the recent Global Financial Crisis (started in 2007) economists have emphasised the role of institutions in affecting decision making. Investment decisions that can be bad for society but good for the individual can be a product of the institutional environment. If decision makers face little or no downside risk when making very risky decisions, they’ll take those risks. The recent GFC showed that eventhough corporate decision makers and brokers often bear little or no cost for potentially bad financial decisions or for providing poor financial advice, they still earn significant salaries/bonuses. Why not engage in these behaviours if you come out with a lot of cash. Some people will refrain from behaving this way for moral reasons. But history has shown that plenty of people will make decisions that harm society if those decisions benefit them personally.

This is a classic moral hazard problem where the individual or institution doesn’t bear the costs of the decision. Nothing irrational is happening here, but such behaviour can fuel bubbles and busts and can cause bankruptcies and liquidity crises. Also, if regulations are not well designed, rational decision makers can provide misleading information to clients. Credit rating agencies (Moody’s, Standard & Poor’s, Fitch) were giving AAA ratings (very safe) to financial assets when they were more like BB (junk status). The quality of regulation and its enforcement play an important role in influencing investment behaviour therefore it is imperative that there is more accurate information about investments.