We have a love-hate relationship with asset price bubbles. After each one bursts, from tulip bulbs to credit default swaps, we are wounded but wiser. Or are we? Not only do we mourn the passing of steroid-stoked markets, we set off in search of the next one. And if somebody tries to let the air out of a nascent bubble, as we see today in several emerging economies, we cry foul.
Given what investors have been through over the past two decades or so, it is unsurprising that they worry a lot about bubbles and their consequences. Thus, one question I am often asked by clients is: “Do you think that such-and-such is in a bubble?” You can take you pick for “such-and-such” from a list that includes gold and commodities more generally, specific real estate markets like Switzerland’s, emerging market equities or government bonds. It seems that there are plenty of assets to worry about.
Let’s look at what makes an asset bubble. In his classic and still rewarding 1978 study, "Manias, Panics, and Crashes – A History of Financial Crisis," the economic historian Charles P. Kindleberger developed an elaborated model of financial bubbles. In this task, he drew heavily on a rather unorthodox economist, Hyman Minsky, who has enjoyed renewed interest in the wake of our latest financial crisis.
The Kindleberger-Minsky model requires the presence of three essential ingredients to declare a bubble has formed: excessive price increases, extreme levels of liquidity and credit activity to fuel the price increases, and, finally, a narrative, a story that inspires investors to throw money at assets that are based more on fantasy than on facts.
Wherever the three elements assemble, a bubble may well be in the making. Since the bottom of the markets, back in March 2009, many assets have enjoyed robust price increase, which in some case would point a developing effervescence, a bubbly formation. But let’s remember this run started from deeply depressed levels after the 2008 crash.
Liquidity certainly has been ballooned lately, as governments mint new money to support their still besieged economies, so this element of the Kindleberger-Minsky model is emphatically oh hand. But here, too, context is key. Credit activity in most developed economies continues to struggle against the outgoing tide of deleveraging. In many emerging markets, though, as well as in the European economies that have recovered faster—Switzerland, Germany, the Benelux and the Scandinavians, for example—credit indicators need a careful and fresh reassessment.
The narratives that have fed bubble over the centuries often look nakedly naïve in the rear-view mirror of history. While many financial and even non-financial assets and markets have experienced bubbles, from the infamous tulip bulbs in 17th century Holland to the soaring dot.com(edy) stocks at the beginning of this century, bubble narratives combine two basic threads: supply-phobia, or fear of shortages, and unfettered fantasies about potential profits. “If every mouse-click on our website leads to a USD 10 purchase….”
The first story line, shortages, usually relates to commodities: “What if the Chinese were to buy the entire world’s gold?” and to real estate: “What if all US retirees buy Miami condos?” The second is either related to a new, yet-to-mature technology—in the past hundred years, railways, cars, electronics, the Internet—or to the potential riches of exotic markets like those promoted by the Dutch East India Company, the British South Sea Company, the French Mississippi Company in the 18th century. Or, just fifteen years ago, the Southeast Asian Tigers before their crisis.
Today, those tigers want to change their stripes. They have learned the nasty lesson of burst bubbles: when they collapse, everyone gets soaked. No wonder, then, that many emerging markets, having been touted as hot investments, are now trying to cool the frenzy by restricting the domestic credit activity.
Yet some observers regard this commendable foresight an act of economic betrayal that will damage emerging economies. We wonder why they disparage such sober policies. Many of us, it seems, still have to learn that healthy, sustainable economic growth is not fed by bubbles.
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