Those who have borrowed to invest may be forced to sell assets to avoid defaulting, further depressing prices and wealth. Banks that have lent to investors or accepted shares as collateral will also suffer losses. That forces them to rein in their lending, harming the economy even more. In a paper for the Centre for Economic Policy Research, Markus Brunnermeier and Isabel Schnabel take an even longer view , examining years of asset-price bubbles. Be it tulips, land, housing, derivatives or shares, they find that the consequences of a bursting bubble depend less on the type of asset than on how it is financed.
High leverage is the telltale sign of trouble. What does this mean for central banks?
Activist sorts argued that the monetary guardians should lean against the wind by raising interest rates when asset bubbles grew. The opposing camp, exemplified by Mr Greenspan, countered that it was too difficult to spot bubbles in advance and too costly to tighten monetary policy erroneously, so it was best to wait for them to burst before cutting rates to help clean up the mess.
Shifting the focus to debt changes the terms of the debate. As Frederic Mishkin of Columbia University has written , policymakers must distinguish between bubbles inflated purely by exuberance and those pumped up by debt. The latter are also easier to identify: credit issuance is abnormally fast and underwriting standards slip. In such circumstances, regardless of the level of asset prices, the case for intervention is strong.
That still leaves the question of what central banks should do after a stockmarket bubble has burst. Those that come to the rescue of collapsing markets are stoking moral hazard. Investors, believing that the central bank will always provide a backstop, are more likely to take unwarranted risks, as American ones did in response to the Greenspan put.
Nevertheless, given that stockmarket bubbles accompanied by lots of debt, as in China, can cause severe economic damage, letting them burst without any succour is not a good option either. One option is to boost the broader economy through a spurt in government spending.
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Direct intervention to prevent the stockmarket from falling is more problematic, since it gums up price signals, preventing overvalued shares from returning to more reasonable levels. Halting stocks from trading, as seen recently with nearly half of listed Chinese companies, does not eliminate the problem but simply masks it. It was as if America had enacted a moratorium on selling homes after the subprime crisis.
Roger Farmer of UCLA has argued that central banks should buy stocks to keep falling markets at reasonable price-to-earnings PE ratios. The Chinese central bank did this by providing cash to a stock-buying fund. Crucially, Mr Farmer says that central banks should then sell their holdings when PE ratios climb too high. That sounds like wishful thinking. In China as in other countries, the central bank often seems more intent on laying a floor for stocks than erecting a ceiling.
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Disaster Is Inevitable When America's Stock Market Bubble Bursts
Subscribe to The Economist today. Media Audio edition Economist Films Podcasts. New to The Economist? Greed was again the cause. Well, greed as we saw in all the examples of financial bubbles. But there are causes beyond pure greed. Fools are always causing bad things to happen, and they contribute to economic bubbles too. The fools are those from the greater fools theory. When there are no greater fools, the bubble bursts. Bitcoin may be an example of the greater fool theory.
The demand has skyrocketed because the price is going up so quickly. Charles Kindleberger, a historian of financial bubbles perhaps explained the mad rush for Bitcoin when describing various bubbles,.
What happens when bubbles burst?
Extrapolation is projecting past data into the future on the same basis; if prices have risen at X rate in the past, prices will continue to rise at X rate forever. Extrapolation causes investors to overbid risky assets in an attempt to capture the same return rates. The overbidding will result in reduced rates of return, and then the price deflation starts. When investors are no longer making money by holding risky assets, they will begin demanding a higher return on their investments.
The housing crisis is an example of extrapolation. Herding is an aspect of behavioral finance. It is the tendency humans have to do what the rest of the herd is doing even if as an individual, they know what they are doing is irrational. The dot-com boom is an example of herding. But everyone else was doing it, and humans have FOMO.
So many investors went against their own better judgment and made what were pretty clearly bad investments. We knew we were wrong but tried to convince ourselves that we were right. Moral hazard means that if someone is protected from risk, they behave differently than if they were fully exposed to the risk. That our behaviors have consequences helps us to make rational decisions. A moral hazard occurs when the risk-return relationship is altered, usually because of some government interference. The National Flood Insurance Program is an example of moral hazard.
Recognize the Signs of an Asset Bubble
Insurance companies will sell policies to cover flood damage to homes in flood-prone areas because there is no risk in it for them. The government subsidizes the policies, so if a homeowner makes a claim, the government, not the insurer pays it out. These policies are nearly pure profit for the insurance company with no risk. Homeowners make a claim, and the company merely handles the paperwork. There are four distinct psychological phases of financial bubbles.
The stealth phase is the very early days of an asset when only relatively few people are aware of it and can see the value. The true believers. Now big money comes calling. Institutional investors take an interest.
Five Of The Largest Asset Bubbles In History
There is some selloff during the awareness phase by the initial true believers but not enough for anyone to notice. The true believers are starting to think the band is changing, trying to go mainstream to sell out. The media picks up on what is going on and shouts it far and wide. Average investors catch wind that something big is happening and they want in. The price starts to go up, and inexperienced investors think it will keep going up forever.
Your parents are now listening to the band. The blowoff phase is the bubble part. The selloff accelerates driven by fear. The fire sale plunges the price of the asset. There are now no greater fools. The band is currently doing a weekly show in Branson, Missouri. Is your idiotic brother in law who has filed for bankruptcy seven times and once tried to strike it rich panning for gold in the desert telling you to buy a particular stock?
What is an Economic Bubble?
William Bernstein laid out his criteria for spotting bubbles, and it has more to do with sociological factors than economic indicators. With all these signs , you think people would see financial bubbles coming a mile away. Some good does come from them. The housing bubble created a lot of new homes.
Before the bubble burst, the houses were unaffordable but after, they were much cheaper. People who thought they could never afford a home were now able to buy one. Infrastructure also sprung up around all these new homes, things like parks, schools, and improved local services. The housing bubble also created jobs and increased wages, temporarily anyway. Bubbles can drive innovation. Startups who do have a good product or service get an influx of cash that allows them to bring their idea to the market. For every one hundred Pets.