Popping Bubbles Isn't as Easy as You Would Think
The economic blogsphere has done a fair amount of discussing on financial bubbles. The primary argument is if the Federal Reserve had acted more quickly regarding the housing market then the current problems would have been avoided. However, there is one problem with this argument: what is the exact definition of a bubble? While it may seem easy, there are several problems with actually defining it. And it is this inability to adequately define a bubble that makes popping them that much harder.
First, here is a definition of an asset bubble from Investopedia.com:
A spike in asset values within a particular industry, commodity, or asset class. A speculative bubble is usually caused by exaggerated expectations of future growth, price appreciation, or other events that could cause an increase in asset values. This drives trading volumes higher, and as more investors rally around the heightened expectation, buyers outnumber sellers, pushing prices beyond what an objective analysis of intrinsic value would suggest.
There are two keys to this definition: price relative to some historical norm or benchmark and volume. Let's take this in the order presented.
Here is a simple question regarding asset prices: how do we determine an assets real value? If you ask different people, you'll probably get different answers. For example, two of the most common methods of valuing a stock are price to book value and price to earnings (PE). We already have a problem -- there are two popular methods of valuing a company, each with its pros and cons. In other words, there is no single generally agreed to valuation model. Let's take this one stop forward and assume that a single benchmark is accepted. What is the highest amount prices can stretch beyond that benchmark? For example, suppose we all agreed to use PE as the primary benchmark. How far could prices extend beyond that level before action was required? What if prices crossed a line one day just slightly? Would that warrant action? Or would prices have to extend beyond that level for a period of time? If so, how long? In other words, even if we create or accept a single method of valuation the relationship of prices to that valuation create further problems is identifying when prices are "out of sync."
The second part of the bubble definition implies volume, or the number of people participating in the market. There is a problem with this part of the definition as well: how do you identify the difference between a legitimate increase in the number of people who want to buy or sell a particular item and a speculative mania? For example, a central theme to the last expansion was commodities demand. Both China and India were growing at strong rates. As a result, a large number of people (over 2 billion) would start to demand more raw materials like copper for the production of goods and oil. So, over the last 10 years the number of people demanding these commodities increased greatly. As a result we saw a huge spike in the prices of natural resources. As the correction started these prices dropped hard, leading some to argue this drop proved there was a speculative bubble in commodities. But again, how do you prove the difference between a change in demand caused by more people legitimately demanding more of an item and "speculators" participating in a mania ?
By now the point should be clear. Identifying a bubble is nowhere near as easy as many people think. There are clear problems in identifying the proper valuation to be used in identifying a bubble along with when there is a legitimate market driven change in the number of people participating in the market as opposed to a speculative mania. In short, central bankers have an incredibly difficult task in dealing with this matter.
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Bonddad, great post! The lack of the government's and media's discussion of speculative bubbles has been scandalous. However, I think you focused too much on "identifying" a bubble vs. "what to do about it". As a layman, even I questioned for years "How can housing prices keep accelerating in an environment where wages are basically flat?". Of course, the easy answer was "It is a speculative bubble!" Ok, problem identified. The regulatory response should have been....?
The regulatory response should've been to reinstate the Glass-Stegall Act or something very similar. Also, taxes should've been kept at Clinton-era or higher rates to stem speculation.
When a goverment spends borrowed money property prices go up untill they crash.
Here's a way to identify when too many people are invested in a potential bubble: chart the historical number of investors (in established industries, that is. For new industries, use boot-strap estimates.). If the current number of investors exceeds the trendline by more than two (2) standard deviations, then it's probable that a bubble exists in that market.
what's the definition of a "bubble?" --- a bubble is Wall Street running a ponzi scheme --- the savings and loan bubble of the 80's, the energy and dot com bubble of the 90's and the mortgage and credit bubble of the 2000's --- all of these "bubbles," were based upon a false dichotomy that were ponzi schems writ large and legitimized by Wall Street snakes --- the inappropriate manner in which value was accessed to financial products and the marketing of derivatives as though they were financially sound instruments, lack of transparent accounting principles and, regulatory agencies that are either reluctant or refuse to enforce the spirit and letter of the law, the revolving door and collusion between regulators and the staff at the various trading markets, investment firms, banks and DC lawmakers -- there is nothing complicated about a "bubble," a bubble is simply an artificial paradigm contrived to decieve and rip off folks
The exact definition of an economic bubble?
That assumes that the Federal Reserve, a private corporation, didn't intentionally lie to the American taxpayer. To debate anything other than the malfeasance of the scam is to feed the Feds ability to lie.
Stop debating bubbles. They happen, no one with a brain cares.
Start debating the issue of debt, and talk about who benefits from it?
The system went bankrupt last year. Instead of the Rule of Law applying, our government violated laws to pay billions to favored companies ... that's called a fiat government.
Now that the emperor has no clothes, they are peeing on your leg and telling you "It's a bubble! It's a bubble!"
I'd be laughing if there weren't so many people who believed the lies.
Audit the Federal Reserve. Every penny since 1913, see where the money has gone and debating the bubbles can be left to academia ... I'm only concerned about my money, not your ridiculous waste of time on bubbles.
Bonddad, i think many of your long past articles pointed to a bubble. You pointed to data which clearly showed irrational and fearless behavior. You didn't play the prescient wizard and call it a bubble, yet you pointed to the data taking its place as outsized historic anomalies.
The problem wasn't that nobody had a trigger tipping point for a bubble, it was that a bubble is not something considered. It was, and apparently remains to be, a driving ideological construct that markets will take care of themselves. So there is nothing to watch, regulate, or draw concern. At some time everything returns to a decent representation of intrinsic value, as difficult as the number is to see in a crystal ball. Winners win, losers lose.
The financial industry might have been a red flag. The sector went from 6% of the S&P market cap, to 26% in 2006. Without outlandish P/Es, somebody might have wanted to look into on what their earnings were based, and those off-balance assets which swelled their balance sheets.
For me, the easiest way was to be aware of the most recent de-regulation on law which had garnered steady reasonable levels of growth for 50+ years. S&L de-regulation spawned the S&L fiasco. Capital application de-regulation gave us the LTC death. The end of Glass-Steagull, along with the cap on leverage ratios in 2004, paved the recent road to Hades.
You don't pop bubbles. You prevent them with regulation. We need to go back to the pre-Reaganomics days, and regulate the crap out of everything.
The mortgage market was massively regulated during the growth and popping of this bubble. Regulators couldn't even figure out that Bernie Maddoff made no actual investments for a couple decades, so much for regulators. Also BTW, more deregulation was done under Carter than Reagan.
Well, Bush put regulators in charge who were hostile to regulation. Bush would have fired regulators for actually doing their jobs. You are taking the conservative antipathy for regulation and the hiring of industry dupes in regulatory positions by conservatives as an excuse to say regulation does not work. Under Bush, regulation was designed to fail.
Subprime lending was not regulated in the least. Then subprime lenders could bundle all loans and sell them on the secondary markets without retaining any of them. Rating agencies would give them all AAA ratings. Then investment banks who bought them could pretend to hedge their bets with unregulated derivatives that had no monies set aside to cover losses the way insurance companies must. If that is your ide of massive regulation, I wonder what is your idea of free markets?
Rubbish! Everything you write flies in the face of reality.
I don't know what you think caused this Great Recession, but it most surely was not regulation.
It wasn't the defaulting borrowers who caused the crash, it was the reckless commercial hedge funds and investment banks who bid up securitized bundles of mortgages to 40X their "value". This is ridiculous leverage (no mortgage on earth is worth 40 times its face value at current value)
When people started defaulting on mortgages, we might have ended up with a mild recession. Instead, the damage was amplified forty times and the banks found themselves backing their deposits with a pure fantasy of assets.
AIG, which was idiotic enough to insure these bundles against losses, took a hell of a bath and ended up as a minor branch of the U.S. Government.
Under the table, everyone knew these securities were worthless. However, the Wall Street geniuses picked off a commission every time they passed through - so the securities got passed back and forth like a basketball at a high-speed game. With a few percent sticking each time.
It was a house of cards. These securities were completely unregulated. They were traded privately because there wasn't even an exchange to oversee an orderly market.
Deregulated, high-risk, ridiculously over-leveraged investments, being passed around from institution to institution, with no regard for their underlying asset valuation is what caused this recession.
No regulation let all the thieves out to do their worst.
The mortgage market was anything but "massively regulated." Just saying it doesn't make it so.
A bubble is simply overinvestment. Or call it malinvestment if you wish. Like when everyone and their uncle made video games in the early 80's until the video game crash of 1983. textbook example of too much money/product chasing too few cutomers/revenue - the market naturally corrected
http://en.wikipedia.org/wiki/Video_game_crash_of_1983
Sadly, when central bankers put interest rates at zero, this discourages savings and insults and injures the savers, and promotes mal or overinvestment. The central bankers are driving forces of the current bubbles, and this final 200+ (500?) year one is a doo-zy. A fifth grader could understand it.
Bubbles like the $ bubble? Since the shiny new world financial center is operational in asia, there is only one way for the money power to free themselves up to move from the US and to their new home and that is blow up the $ like a couple of big towers in New York. Parsing definitions and creating strawman arguments is like playing tiddly winks on railroad tracks while a bullet train is blowing its horn at 200 mph to get you to move off the tracks and save your financial life.
Jet Ski sales go through the roof.
Your argument does not appear to me to be well grounded. I knew a bubble was in progress when my town hired a firm to assess the property for taxes. All of a sudden my house was worth more than twice what it was the night before. I also noticed that someone I knew who was a alcoholic, with a part time job was able to buy a home that was way out of her league. I also noticed a lot more people riding around on ATV's and I was wondering where the heck they were getting their money? To make a long story short I tried to tell my friends that something was rotten in Denmark but they all laughed at me. I told them that soon the house of cards would fall. They looked at me like I was crazy. I decided to rearrange my investments at that time to conform to my suspicions. I am glad I did. The problem is not or was not the Fed; it was greed and stupidity. Oh, yes you can tell when a bubble is happening and you can more or less tell when it will burst. Your statistics are fun and interesting but a common lick of good horse sense will get your further any day.
"I also noticed that someone I knew who was a alcoholic, with a part time job was able to buy a home that was way out of her league."
That's because the mortgage originator was not the ultimate holder of the loan. The mortgage originator made the mortgage and then, with the assistance of the rating agencies bundled the mortgage into an "AAA" rated security that was then unloaded onto an investor who relied on the AAA rating and got defrauded. No mortgage originator would have made the loan if the originator was the ultimate holder of the mortgage.
The borrower should never have took the loan either if they knew they couldn't pay it back. Regarding investors who bought the bonds, they take a massive amount of fault in this as well as they dramatically under-estimated the risk involved in buying mortgages during the peak of a massive housing boom. I could have bought MBSs in 2005-2007 like many others did, but I didn't. That's similar to investors buying high yield junk bonds right now at these expensive levels, thinking that default levels are going to go back down to low levels. I'm not buying them at these prices. The reason is because there is way too much risk in owning them, at least in my opinion.
I think that criminality shouldn't be overlooked in the real estate bubble. We had rating agencies grading mortgage backed securities as "AAA", without examining and sampling the underlying portfolio. Therefore mortgage originators were making mortgages as fast as possible, because the mortgages could then be bundled into the mortgaged backed securities and sold for more than they were worth, defrauding the purchasers of those securities that relied on the rating of AAA.
I would have liked to seen a prosecution attempted on conspiracy to defraud investors in connection with the rating of the mortgage backed securities.
Without that rating, there would have been a lot less easy money chasing real estate, and the bubble would have then been less pronounced. Of course, the Fed had lowered interest rates, but that alone didn't mean lending to people who couldn't pay back. It was the mechanism of the mortgage backed security with its AAA rating that was a major contributor to the bubble because unloading the mortgage to 3rd party investors meant that originators could make loans to people who couldn't pay them back, resulting in more people chasing real estate.
Excellent point! Very true! It was fraud plain and simple. The whole rating system was a vast scam. There should either be rating agencies on the "buy" side that sell their ratings to the buyers of bonds and not only sellers or it should just be a crime to give out a less than honest rating. .
It is a crime. The problem is, that our government is so bought off that they are impotent against white collar crime, except the lowest hanging fruit. Maddow had to turn himself in to get charged.
To charge the rating agencies with misrepresenting the mortgage backed securities as worthy of the "AAA" rating it would have to be shown that "there was a false representation of a material fact with knowledge of the falsity for the purpose of inducing the investor to act, and that the investor relied upon the representation as true and acted upon it to his detriment."
I don't think that would be too hard, since, from what I heard, the rating agencies didn't subject these securities to the same scrutiny that other "AAA" securities are subjected to. The trouble here is in an administration whose President had as his largest corporate donor, Goldman Sachs, if you catch my drift.
"If the Fourteenth Amendment gives corporations rights like a person", then it must require duties in kind. This is the argument that future prudent justices of the Courts must use to bang away at the despicable 1880's ruling that a corporation is a person. In theory and practice it is impossible to delegate responsibility and authority to an organization, whether it be a corporation, company, religiigious group, university, school district, or regularly meeting committee. Right and duty can only be delegated together to the single individual, for example, the CEO or the Staff Director.. It is impossible to exact accountability from an oganization of two or two thousands members.
Any regulatory policy must be written always to hold individuals responsibility, Otherwise, the policy is unenforceable.
The big Bank presidents were responsible under the fiduciary responsibility clause of the banking regulations. Their actions should be investigated, indictments brought and trials be held to determine their guilt and punishment and restitution to the innocent borrowers and investors. Rewarding their criminality will bring ruin upon our government and country.
Additionally, the sagacious Olephart is right and informative as usual, indeed proving to be a prophet in his own time.
Hmmm....
1) Increased housing values allow people to take out home equity loans
2) The excess cash from the loans allows people to go on buying sprees
3) The people on buying sprees buy bigger and more expensive houses
4) Rising demand for bigger and better houses causes housing values to rise
5) Go back to 2)
Yup - couldn't have seen this one coming.
When the Federal funds rate is 0, bubbles are blowing and nobody should need a dictionary to see it.
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