Bubble, burst, repeat

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This article was published 26/09/2020 (2084 days ago), so information in it may no longer be current.

Just what makes a market bubble? A new book by a couple of academics aims to answer that question.

Curiously, it’s one of the few thorough examinations in the last two centuries of the subject despite market bubbles — in particular, stock markets — often having an outsized impact on societies beyond investor losses.

“We thought it was time for another book to be written,” say William Quinn, a lecturer in economics at Queen’s University Belfast, who co-authored with John D. Turner, a professor of financial history at the same university, Boom and Bust: A global history of financial bubbles.

Indeed, previous to its release last month, only two books had focused on bubbles and their inevitable bursts.

“One of them is from the 1850s — Charles Mackay’s Extraordinary Popular Delusions and the Madness of Crowds, and the other one is from the 1970s, which is Charles Kindleberger’s Manias, Panics, and Crashes,” says Quinn in a recent interview with the Free Press.

“And these pre-date a lot of the more interesting bubbles.”

Much has happened in the last 50 years. There have been the Dot-Com bubble in the early 2000s, and the Japanese bubble in real estate and stocks that burst in the early 90s, from which global economic powerhouse has yet to fully recover.

And then, of course, there was the Great Recession, sparked by a bubble in U.S. housing in the 2000s that infected the banking system. Its fallout nearly incinerated the financial system. It also wiped out homeowners’ equity, investors’ portfolios and the retirement dreams of millions.

“So we thought it was way beyond time someone wrote another history of financial bubbles that incorporates all this recent stuff.”

Indeed, Boom and Bust does just that, endeavouring to explain the commonalities in asset bubbles — whether it’s real estate, stocks or anything else that drives investor dreams of striking it rich.

Central to its premise is a model used to describe the key elements needed to start a fire.

“We based it off the fire triangle in chemistry: oxygen, heat and fuel,” Quinn explains.

“All you need is a spark, and then you have a fire.”

With respect to financial bubbles, fuel is easy access to credit and money. Low interest rates are a key source of fuel for bubbles. So are investors flush with money to put into markets. For example, prior to the 1929 crash, a decade of prosperity in the U.S. brought new money into the stock market.

In the 2000s, low interest rates fuelled housing that led to its crash and subsequent bank failures.

Interestingly, no bubbles formed between the 1930s and 1980s because over that period interest rates were higher — there was no easy money (unless you were earning interest).

Besides fuel, fire needs oxygen. When it comes to bubbles, the ability to buy and sell assets — quickly and easily — serves as oxygen.

Quinn adds that was the case during the Dot-com bubble when online brokerages emerged.

And slack lending rules in the U.S. and elsewhere were the oxygen for the subprime housing bubble a few years later.

“Now we see it with technologies like Robinhood — trading apps that make it much easier to buy and sell stocks,” Quinn says.

The third component to fire — heat — is akin to speculation in the financial world.

As Quinn puts it, “People start buying and selling stocks for momentum reasons, thinking the stock market will keep rising and their investment will too.”

The cryptocurrency bubble of the mid- to late-2010s, which has since burst, is a recent example of this phenomenon, he adds.

But isn’t buying low and selling high the point of investing in the first place?

Actually no, Quinn says.

Investing in stocks predominantly has been a game of patience for most of its history: buy, hold and earn dividends.

“Then periodically, it becomes something people do for fun, buying and selling stocks with the hope that they buy low and sell high,” he says.

“So if you have a lot of money around; assets are very easy to trade, and a lot of people are following speculative investment strategies, all this raises the possibility of a bubble.”

But you still need the spark. That’s often new technology — like the internet. Or in the case of the ‘Bicycle Mania’ in the UK in the late 1800s, when bike companies’ stock prices ballooned and popped, it was the pneumatic tire.

In other cases government policy is the spark. Quinn points to politicians in the U.S, UK, Ireland and Spain, whose policies in the late 1990s and early 2000s helped spawn the housing bubble. Their policies expanded lending to would-be homeowners, but they didn’t make housing more affordable. Consequently, prices rose unsustainably leading to a bubble that blew up spectacularly.

After reading all this, you may be thinking, ‘a bubble is forming today.’

All sides of the triangle are there: easy credit, increased access to trading stocks, and widespread speculation.

As well, government policy — especially in the U.S. — is propping up the stock market, which is increasingly divorced from the economic reality.

So are we looking at another bubble?

We might be. The problem, however, is asset bubbles can inflate for a long time, Quinn adds.

Back in 1997, many thought the tech bubble was ready to burst. But it didn’t happen for four years, so those who jumped out early, lost out on a lot of market gains.

The point here, he says, is bubbles are easy to see in retrospect, but harder to spot in real-time.

But spotting them early will become more useful as bubbles — and their ensuing burst — are likely to be more common in the future because the ingredients are more plentiful than ever.

“The most important lesson … is bubbles aren’t necessarily destructive,” Quinn adds. They are often caused by, and even a catalyst for, rapid technological change and innovation that improve lives.

But they cause major problems when government policies, or lack thereof (deregulation), expose key parts of the economy, like banks. Then those “Wile E. Coyote” moments occur: The bubble bursts and everyone collectively looks down to see there are no profits below to hold up the market. Subsequently, asset prices plummet as fear takes hold, and the pain is not just felt by investors. Everyone gets burned.

“So the important thing isn’t whether there is a bubble or not,” Quinn says.

What’s important is asking who might it hurt, besides investors.

And that’s a question many are likely asking today.