This is a synopsis of a series of reports that my firm (UBS) recent published on the history, causes, and implications of economic bubbles (did you think this post was about Pallys??). I thought it an interesting summary, so I post here:

Why Bubbles Can't Be Avoided

Economic history shows that in an increasingly stable and reliable environment, individual market participants will take on more risk. This behavior creates favorable conditions for bubbles. A series of research reports from Wealth Management Research (WMR) takes a closer look at this phenomenon.

Economic history is handsomely populated with bubbles over the past 400 years [1]. The most recent ones were related to the US housing market and technology, but Holland's tulip mania in the 1600s is often cited as a forbearer of modern asset bubbles. Feverish demand sent prices for tulip bulbs soaring to levels several times the average yearly income of a skilled craftsman until demand finally collapsed in 1637.

Two UBS economists, Yves Longchamp and Veronica Weisser, both of WMR, examine the bubble phenomenon in a series of reports, called "Bubble-ology." One of the main conclusions of their study is that bubbles cannot be avoided because they are part of the functioning of the economic system.

As they point out, there are a few prerequisites for bubbles, as observed in the recent crisis in the US housing market. The first one is the expansion of liquidity in the economic system. Additional liquidity, combined with the illusion of wealth among market participants, can trigger a simple economic mechanism: more buyers bid for the assets, demand exceeds supply, and prices go up. If optimism continues, initial rises in price generate expectations for further rises and create a bubble. Price increases will continue until market participants realize that their expectations are not sustainable and sell their assets, resulting in a reverse movement and a downturn in the economy.

Liquidity broadly speaking

The two UBS economists point out that the definition of liquidity needs to be broad enough to include the different ways in which liquidity can be generated: not just through cash, but also through what they call "shadow money," or liquidity driven by financial market instruments (e.g. the lending activity based on asset collateral). In fact, the expansion of liquidity behind the 2008/2009 financial crisis was driven, in particular, by low interest rates and an expansion of shadow money.

The American economist, Hyman Minsky (1919 – 1996), argued that economic stability in itself engenders crises. He explained that in an increasingly stable and reliable environment, – the 'Great Moderation,' [2] for example – individual market participants, be they individuals or companies, will take on more risk. This results in additional borrowing through credit financing (leverage) and typically increases returns in stable times. According to Minsky, this type of credit growth first leads to strong economic expansion, then to euphoria and ultimately to bubbles.

Another prerequisite is a willingness to bail out. The US Fed has a long tradition of successfully bailing out the economy. This tends to induce the perception that the risk-taker will bear little or no consequence of his risk-taking activity, leading to a diminished risk perception.

The role of central banks

Can central banks counteract bubbles by preventing an expansion of liquidity in the system? Central banks can influence money supply. However, so far, their mandate has been to control consumer price inflation (CPI), not asset price inflation. Factors, such as lower production costs due to relocation of production to emerging markets, have kept consumer price inflation under control in recent decades, and central banks have been able to reach their CPI target and keep interest rates low. However, a loose monetary policy created additional liquidity in the economy, which flowed into asset markets, thereby producing favorable conditions for a bubble.

Whether central banks should also target a certain level of asset price inflation remains open. In any case, this would not be an easy task. First, even if they were given the authority to control asset price inflation, central banks would only have an indirect impact on asset price levels. They can directly influence interest rates, but the impact of their action on asset prices can be limited or delayed.

Longchamp notes the implications of determining an accurate level of asset price inflation in the long term. For example, one of the most widely accepted methods to value a stock, the dividend discount model (DDM), values the share price of a corporation based on the discounted value of its expected future dividends. "This is valid in the short term, but in the long term it is of limited accuracy because of the assumptions it makes on the level of interest rates. Determining a target for asset price inflation in a few years' time requires making assumptions."

Weisser adds that it is also a societal issue: "Setting a target for asset price inflation means limiting increases in investors' wealth. On the other hand, allowing asset price inflation distorts the distribution of wealth, as it enables an increase in wealth only for those who already hold the assets."

What then needs to be changed in the economic system to avoid excessive rises in asset prices? Mainly two things, according to the UBS economists: liquidity expansion would have to be limited, and the rules of the game would have to become more transparent so that risk perception is improved among market participants. Longchamp concludes: "Risk takers need to be aware that if they incur losses, the price to pay can be very high, and there is not always a way out."

The next bubble will show whether participants in the economic system have really learned from past experiences.

[1] One prominent "bubble-ologist", Charles Kindleberger, records 46 important financial bubbles from the early 1600s to 2000 in his study, Manias, Panics, and Crashes: A History of Financial Crises.

[2] The Great Moderation was a phrase used by Ben Bernanke in a 2004 speech referring to a substantial decline in macroeconomic volatility over the past twenty years.

Forgot to post this after I got back home from the guild meet up.  Saw this picture at the Rogue Brewery in Astoria and had to take a picture of it. ALL FOR SALMON AND SALMON FOR ALL!