Pop goes the bubble
The lives of millions have been caught up in economic bubbles that seem beyond anyone’s power to control. Boom followed by bust – can anything be done to stop this vicious cycle? Perhaps not – and perhaps we shouldn’t even try.
In that magical world known only to a few economists, where resources are allocated efficiently and investors and consumers behave rationally, bubbles would always be unambiguously negative. They cause all sorts of distortions and silly, self-defeating behaviour. Exactly what triggers a speculative bubble remains mysterious, as do the mechanisms that inflate and ultimately burst it.
But to put it simply: bubbles start when dissatisfied people try to shake things up by taking risks with their money, their careers and even their lives. Since human beings are both imitative and inventive, other people find ways to jump on the bandwagon, which starts rolling faster and faster – until it crashes.
A physicist in the world of finance
Professor Didier Sornette, a physicist cum economist and chair of entrepreneurial risks at the Swiss Federal Institute of Technology in Zurich, as well as author of Why Stock Markets Crash (2004), is essentially trying to gain a better understanding of the dynamics of bubbles. He is alone – or one of very few – in three leading concurrent fields in the analysis of complex systems: pure physics, applied economics and econometrics, and market practitioners. Being a physicist in the world of finance automatically makes Professor Sornette an outsider. But then again, being alone versus being part of the herd is also a large part of Professor Sornette’s research.
Financial markets, unlike earthquakes or other natural phenomena, express what Professor Sornette refers to as reflexivity – or the expectations of others’ behaviour. Analysing price behaviour, which is a mere human perception of fundamental value, is something else entirely. But markets are endemically heterogeneous, according to Professor Sornette. And that makes them more predictable than “purer” homogeneous systems.
“What we are trying to do is examine evidence of precursory stress in the build-up to a crash. While it’s impossible to determine the crash itself, most complex systems show signs of stress as they become dislocated,” says Professor Sornette in an interview with the Financial Times. He gives the counter-example of a quartz crystal. A single pure quartz crystal does not show any foreshock as force is applied to it, it simply breaks when it can no longer withstand the pressure.
Didier Sornette’s method of fitting a dizzyingly broad array of phenomena into unifying mathematical frameworks has raised controversy. Yet two aspects of his thesis – that bubbles enable the risk-taking behaviour necessary for building future infrastructure and are an intrinsic feature of society – are worth pursuing.
The light and dark side of the bubble
In his 2007 book Pop! Why Bubbles are Great for the Economy, journalist Daniel Gross argues that in bubbles, investors’ money is used to build
“It is only during the reckless abandon of bubbles that individuals and companies take the foolhardy risks needed..."
infrastructure that can’t possibly repay its upfront costs, but ends up being beneficial for companies and consumers in the long run – particularly after more-efficient companies have picked up the pieces for pennies. To take a recent case, most investors in “dotcoms” lost their investment but their money built the software and infrastructure that runs today’s Internet. There are plenty of other historical precedents. For example, a bubble in the 1840s rendered shareholders in train companies penniless but left Britain equipped with the world’s best railway network.
The social economist Carlota Perez believes that bubbles inevitably precede each of the “techno-economic paradigm shifts” by which society advances. In a paper in the Journal of Economic Interaction and Coordination, Didier Sornette argues that it is only during the reckless abandon of bubbles that individuals and companies take the foolhardy risks needed to develop technologies with large social impacts but low financial returns.
Contrary to the above-mentioned examples, financial bubbles do not lead to the construction of useful infrastructures. The dotcom bubble meant that fibre optic cables were laid; the housing bubble involved the construction of houses. Yet what is left once a financial bubble pops? Not much, only the illusion of a never-ending supply of money and a world that tries to fulfil its own expectations. According to Sornette, this wouldn’t be a problem if the “virtual economy did not constantly intervene in the real economy. The branch of finance has to stop pretending to be the queen and should once again become the servant of industry.”
Tulipmania again and again
“Perhaps rather than pretending that we can do something about bubbles, we should surrender the illusion of control..."
How far should we go in allowing bubbles to run their course? Policymakers tend to be terrified of speculative bubbles, and with good reason. Bubbles by their nature represent a failure of control, which looks bad, and threatens the social order.
People who can no longer afford their houses or cars probably aren’t much in the mood to listen to theoretical economic arguments about future benefits: a politician convicted in the court of public opinion of presiding over economic boom and bust might as well start drafting his memoirs.
On the other hand, attempts to prevent bubbles seem to be largely fruitless anyway.
People have been trying to stop them since “tulipmania” took hold in the Netherlands in the 1630s, to little discernible effect. At the start of 2007, banking experts were talking about the end of the boom-and-bust cycle, but it seems only to have been deferred and exacerbated by their attempts to avoid it.
Perhaps rather than pretending that we can do something about bubbles, we should surrender the illusion of control – and concentrate our efforts on trying to make the best of the bust that follows the boom.
Article by Michael Afenzar
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