December 26, 2009
The Iron Law of BubblesBy Henry Oliner
In A Short History of Financial Euphoria (1993), J. K. Galbraith takes a brief look at financial bubbles and draws conclusion about the similarities among them. The most remarkable of the early manias was not in stocks, but in tulip bulbs. The value of mere tulips grew to the modern equivalent of $25,000 to as much as $50,000 during the Tulip Mania that swept the Netherlands in the 1630s.
Ninety years later, in 1720, The Mississippi Company, formed by John Law to speculate on the as yet undiscovered gold resources in the New World, collapsed. The revenues from the discovery of gold were supposed to support notes issued by the Banque Royale to pay off French government debt, but the stock proceeds ended up going directly to debt reduction. During this same time period, the British created a similar joint stock enterprise called the South Sea Company to seek wealth from trade routes in order to retire British government debt. Also in 1720, it met the same fate as the other manias.
All of these bubbles came to a ruinous end. Promoters that were hailed as geniuses became villains. Economies were set back years, and confidence in financial institutions was damaged for decades.
The American adventure had numerous bubbles culminating in the stock crash of 1929. The crash of 1987, the dotcom bubble of the 1990s, and the current mortgage fiasco seem to raise the question: In spite of the lessons of history and the superiority of modern regulatory agencies (the Fed, FDIC, SEC, etc.), why do we keep committing the same disasters? (I distinguish bubbles, which are real markets bid up excessively by irrational demand, from frauds such as Vesco and Bernie Maddoff.)
Galbraith notes some similarities. In the aftermath, the government tends to fault the instruments of speculation rather than the individual psychology. While new laws are passed to avert the last bubble, the human psychological need to speculate simply seeks a different avenue to quench its thirst.
Almost all of the financial bubbles have involved excessive debt to one degree or another. People forget that debt is a double-edged sword, and the very leverage that led to rapid growth leads to even steeper declines.
But the most striking common attribute is the human element. In almost every case, there is this infatuation with wealth as a sign of intelligence. Galbraith notes that there is "the impression that intelligence, one's own and that of others, marches in close step with the possession of money."
"No one wishes to believe that this is fortuitous or undeserved; all wish to think that it is the result of their own superior insight or intuition. The very increase in values thus captured the thoughts and minds of those being rewarded. Speculation buys up in a very practical way the intelligence of the involved."
Long Term Capital was a major fiasco in the late 1990s. With two Nobel-Prize-Winning economists on the board, the hedge fund made bets on small moves that were heavily leveraged, yielding remarkable gains...for a while. But when excessive debt meets excessive intelligence, the inevitable consequences of debt will eventually rule.
Our culture is enamored of talent, but the clear and measurable physical skills of an athlete do not transfer to the boardroom or the trading floor. There is too much uncertainty and randomness to either credit or blame talent alone for the result.
As Nassim Taleb noted and in the very title of his book, we are Fooled by Randomness. We do not pay an executive millions of dollars because he has talent; we assume he has talent because he makes millions of dollars.
But this same infatuation with talent can be attached to more than money; it can be attached to power as well. With capitalism struggling to recover from yet another smack-down bubble, we seem inclined to believe that academics in political power will yield better results. The same uncertainty that plagues the financial markets also plagues the political environment. The biggest difference is that a financial bubble will be brought down much more quickly. Bad political solutions become institutionalized and linger for decades. In many ways, the current financial mess was born from political solutions imposed in response to our previous bubbles.
The market doesn't analyze and hold hearings. It is swift and brutal. In fact the financial bubbles are the result of the public facing the reality of their previous foolishness and going cold turkey. The best solution is to let the bubble play out and to clear the rubble.
Our inability to withstand short-term pain tends to lead to longer-term, often far more severe pain. It is as foolish to associate political power with intelligence as it is foolish to associate wealth with intelligence. I would rather have a growing economy with occasional bubbles than government policies seeking to remove all our financial pain, thereby slowing our economic engine to a crawl. Many of the more recent examples of bubbles, such as the savings and loan bubble in the late 1980s and the current real estate and mortgage market bubble, were largely fed by a combination of political goals and a politically accommodating Fed. Oversight agencies were often restrained from their duty by political pressure and lobbyists.
Our political discourse is largely about the balance between the need to smartly regulate a very efficient but imperfect market and the desire to merely replace financial power with political power. It often means the balance between individual rights and the interests of the collective. While the economic self-interest of capitalism is suspect after the bubble is burst, we often suffer more from the political self-interest that seeks to correct it. Our most oppressive laws are often the ones designed to protect us from our own stupidity.
Galbraith says that our collective financial memory seems to be about twenty years. By that time, we forget the lessons of the past and repeat them. Recently, that period seems closer to eight years. But while our memory may be short, these financial bubbles do burst, and we do recover.
Political bubbles, however, are made of iron, and they are much more difficult to deflate.
Henry Oliner blogs at rebelyid.com.