Anatomy of a Bubble

The Joint Economic Committee is a standing committee of the US Congress is charged with reporting on US economic conditions. Needless to say, the Committee is making a close study of the financial turmoil triggered by the collapse in US house prices and rising delinquency rates among “sub-prime” borrowers. Recently Alex J. Pollock gave testimony to the Committee entitled “Regulatory Implications of the Housing and Mortgage Bubble and Bust”. Pollock’s brief paper makes interesting reading and he provides the following succinct explanation of the factors that can conspire to inflate financial asset bubbles:

The belief in the ever-rising price of the favored asset seems to be confirmed on all sides as the bubble expands. As long as the underlying price, of houses in our current case, keeps rising, everybody wins—borrowers and lenders, brokers and investors, speculators and flippers, home builders and home buyers, rating agencies and bond salesmen, realtors and municipalities, and many others. Bubbles are notoriously hard to control because so many people are making money from them while they last.

A staple of business courses is the notion of the product life-cycle, which progresses from introduction to growth, maturity and, ultimately, decline. Although during the introduction stage, new entrants can help incumbents by expanding market awareness of the product, for most products new entrants during the growth stage simply result in increased competition for existing participants.

Product Life Cycle

The situation is very different for financial assets. As new investors pour in during the growth phase, they push up prices which enhances the returns for existing investors and further encourages new entrants. This distinctive feature of financial assets makes them particularly prone to the formation of bubbles as prices rise too fast and too far during the growth stage. When this happens, prices can collapse sharply at the end of the growth phase. In some cases prices will then recover slowly through the maturity stage, in other cases (and sub-prime securities are likely to be an example) the market will jump straight to the decline phase.

One point Pollock makes is that a bubble can only be definitively identified after it bursts. Before the burst, explanations will abound as to why high prices can be maintained. In the case of the tech bubble, pundits pointed to the “new paradigm” that technology had created for business. Before the credit crunch, some analysts felt that the “weight of money” being invested by pension funds, sovereign wealth funds and central bank currency reserves could keep credit spreads low indefinitely. While some doubted these explanations, it was only the bursting of the bubbles that would prove them wrong.

So now the question is, are rising oil prices due to the approach of peak oil, do soaring food prices represent a new structural reality for the world, or are rising commodity prices simply the inflation phase of the latest bubble? In his article “Whither the Price of Oil”, John Mauldin discusses the views for (futures speculation is pushing up prices) and against (commodities are not pure financial assets and so not subject to bubble behaviour). Which view is right? Only time will tell.


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