How can we spot bubbles before they burst?
I had high hopes for this book. The first 5 chapters lived up to my expectations. The remaining chapters, though interesting in spots, are a bit vapid. However, those first 5 chapters are worth the price of admission.
The book starts with a discussion of the difference between:
- a puzzle
- a mystery
A puzzle is something to which there is a definite answer — an answer that can be found given enough effort.
A mystery is more complex. There may not be a real answer, and the ground may shift.
The book references Malcolm Gladwell’s article on Enron. That is a part of item 9 of my ideas for World Statistics Day.
Part I of the book discusses the five “lenses” through which the author thinks it is profitable to look at the bubble problem. Multiple perspectives can better elucidate the mystery. The five lenses are:
Traditional economics assumes that supply and demand move the market to an equilibrium. The book spends a lot of the chapter discussing the theory of reflexivity of George Soros. There are times when an increase in supply can cause even more supply to be created (we’ll see an instance later), and times when an increase in demand can cause even more demand (momentum in assets, for instance).
The book shows an excerpt of testimony that Soros gave to the U.S. Congress in 2008. An excerpt from that excerpt is:
Usually markets correct their own mistakes, but occasionally there is a misconception or misperception that finds a way to reinforce a trend that is already present in reality and by doing so reinforces itself. Such self-reinforcing processes may carry markets into far-from-equilibrium territory.
As with a lot of things, Shakespeare was there a few centuries earlier:
Methought I was enamoured of an ass.
One topic of this chapter is Hyman Minsky’s Instability Hypothesis. Minsky divides borrowers into three classes:
The first category can afford to pay back interest and principal. The second can afford to pay back the interest. The last needs to borrow to pay the interest. That is the static part of his explanation.
Here are the dynamics: when the economy is stable, then profits are small. This encourages leverage (which at that point is safe). Leverage continues to grow until instability is achieved. The formerly “hedge” borrowers become “speculative”, “speculative” become “ponzi”, “ponzi” disappear.
Another topic of the chapter is Austrian Business Cycle Theory. This holds that booms and busts are caused by excessive credit growth. The excessive credit growth is caused by government intervention in their view. The implied solution (in this book at least) is to have a market mechanism to decide on interest rates.
Hmmm. Isn’t there a problem here? You want the market to keep the market from doing bad things.
This chapter is about behavioral finance.
This chapter discusses such things as property rights, and the distortions of government-imposed price floors and ceilings.
This chapter covers some of the same territory as Smart Swarm. Smart Swarm talks about how a swarm of bees selects a new home. But it doesn’t say how the whole swarm gets to the new home even though only a few have been there.
You might expect, as I did, that the ones that knew where they were going would be in front leading. Wrong. The whole swarm takes off in a basically random direction. The few that know where they are going go slightly faster and in the right direction. The staying-together rule of the swarm means that those few can steer the whole group to the right place.
The lesson is that markets might be driven in the same sort of manner.
The chapter also presents a boom as an epidemic. The bust is likely to come once there are few additional people left to be infected.
Part II of the book is a set of case studies of booms and busts. They are (in chronological order):
- The Great Depression
- Japan boom and bust
- The Asian financial crisis
- The U.S. housing boom
The historical parts of these chapters are quite interesting and educational. However, the promise of applying the five lenses to the situations is executed in a generally anemic manner.
The final part of the book looks to the future, first in general and then at a particular case.
Here is one of the best actionable sentences of the book:
When the primary criteria for extending credit switches from income-based affordability to collateral value, watch out.
The author looks at China as a possibility of being in a boom that will crash. He presents a lot of seemingly compelling evidence for the case. One particular statistic (which is admittedly hard to quantify exactly) is that it is estimated that about 20% of the steel produced in China is used to build new steel plants.
When the tulip mania hit, Holland was experiencing a dramatic bout of the plague. Hardly seems like a time for irrational exuberance.
The Japanese have a reputation for being long-term and collectivist oriented.
The author tries to find ways for these to contribute to their respective booms. I’m more pessimistic. I think these might be telling us that booms can take root even when some of the circumstances are decidedly anti-boom.
A role for slackers
One factor that the author doesn’t explicitly identify as a contributor to booms is the urge to outperform.
Leverage is one thing that people do who want to outperform. But the “hot money” that flooded in and out of Asia in the 90′s was also a result of the desire to outperform.
Being a slacker is not all bad.
She said “I got a plan
Listen, Sam, how’d ya like to make some easy money ? ”
He say, “yes! oh yes!
from “Easy Money” by Rickie Lee Jones