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Recent economic events have brought the concept of financial bubbles from academic
texts to the forefront of economic and commercial thought. Whereas economies used
to be slow laborious creatures, the globalisation of capital markets, and growth of
technology within them, has increased the ‘speed’ of economies to a pace never seen
before.
The Financial Times define a bubble as existing “….When the prices of securities or
other assets rise so sharply and at such a sustained rate that they exceed valuations
justified by fundamentals, making a sudden collapse likely (at which point the bubble
"bursts").”
1) The underlying asset class on which the bubble is formed (be it real-estate,
currencies, or other)
Definitions:
Real Assets: The perceived value of real-assets in the economy such as the
underlying value of commodities, cash, equities, real-estate and so forth.
Stage 3 – “Irrational Optimism” – By this stage, the ‘real asset’ bubble has
grown to encompass the entire size of the economy at ‘stage 2’. Economic
leverage is still available, but around this, as the economy globalises and
becomes more ‘sophisticated’ a new bubble forms. This bubble, the
‘secondary leverage’ bubble is created where already-levered assets and debt
structures (such as mortgages, debt driven corporate transactions, overvalued
equities etc) are used to create further new money (mortgage derivatives,
credit derivatives, and so forth). This second bubble can grow immensely
fast, and invariably creates the sharpest increase in the price of the underlying
asset. Eventually, you will reach a stage where the availability and ratio of
counterparties who are interested in acquiring/disposing of assets changes
(fewer counterparties, those who exist usually wish to dispose not acquire) and
the availability of liquidity (cash) to finance those transactions decreases (as
the system is so stretched that no more new money can, in good faith, be
created). In our new economy THIS is when the bubble bursts. The massive
momentum built invariably creates a steeper and more precipitous collapse of
prices across asset classes, meaning that non-commercial-actors in the market
(central banks) have to create new money to slow the contraction of the
bubble, and hopefully revive optimism.
This macro-model of bubbles can exist for whole economies (as we have seen
recently) but can also be seen on individual asset classes. Currently we see similar
bubbles to the above forming in US Treasuries, energy commodities, precious metals
and even some BRIC equities.
Classic economic theory simply will not allow governments and regulatory bodies to
deal with bubbles effectively, as they will grow to tremendous sizes immensely fast,
meaning that the amount of support needed when they burst vastly exceeds the value
of most economies. For example, in December 2007, Listed credit derivatives
(secondary leverage) stood at USD 548 trillion (to put that in context, The GDP of the
entire world is USD 50 trillion). On top of the listed credit derivatives, there was also
an OTC (Over-The-Counter) derivatives bubble which had a notional (face) value of
USD 596 trillion.
Regulating capital structures (with accords such as Basel) doesn’t prevent these
bubbles, it simply encourages participants to find alternative methods to create ‘new
money’ and alternatives ways to trade. The numbers involved also mean that these
measures are very unlikely to prevent a catastrophic failure of the economy when it
gets to “stage 3” (in our model above). Regulating the products themselves, however,
can prevent the dangerous expansion of economies. Cynics may argue that this would
hamper economic growth, but the truth is that it is the sinusoidal movement of
economies between “stage 1” and “stage 2” which contributes to growth, while the
participants in “stage 3” very rarely contribute to any ‘real economic growth’ as their
entire theatre is virtual, and comprises a few powerful participants (investment banks)
rather than the wider environment.
We can only hope, therefore, that regulators and political actors begin to realise that
our highly global and rapid economic environment requires a very different approach
to regulation to control bubble formation.