Why Bubbles Matter

Most people have heard of the Tulip Mania (Holland, 1630s), the South Sea Bubble (London, 1720), and the Wall Street Crash (the US, 1929). Less well known are the emerging market mining mania (London and South America, 1820s) and the railway mania (UK 1840s), and there were many more in the eighteenth and nineteenth centuries. These were all bubbles: a huge rise in prices followed by a crash.

In the middle decades of the twentieth century there was a lull, when bubbles were few and far between. But in the last 20–30 years bubbles have returned in a big way. In the last quarter of a century we have had the Japanese bubble (1980s), the UK and Scandinavian housing bubbles (late 1980s), the Asian Tigers bubble (mid-1990s), and the technology mania (late 1990s). Not only are they giving investors a roller-coaster ride, they are also having a major impact on the economy.

In each case the story begins with a rise in prices in the market in question, often for a good reason, which then continues on upward to an extraordinary level of valuation, before crashing back. On the way up the rise in price encourages a high level of business investment, boosting economic growth and prosperity and often creating a sense of euphoria. Following the crash the economy is hit by a combination of reduced wealth, financial caution, and uncertainty. At best this brings only an economic slowdown or a mild recession. At worst it can create a major depression, as in the US in the 1930s or Japan in the 1990s.

That such patterns repeat is a source of wonder to many. Does this mean people have short memories? Does it mean they are irrational? Is there a flaw in the financial system that encourages speculation? Kindleberger, in his classic 1978 book on the subject, was forced to argue at some length why contemporary commentators, who argued that the world had changed and bubbles had become less likely, would be proved wrong. He was writing in a period when the world had been relatively free of major manias and crashes for a while. Now, with the collapse of the 1990s stock market bubble still reverberating and amid signs that housing bubbles are emerging, the old patterns have returned with a vengeance.

Earlier systems of economic organisation, such as feudalism, nineteenth-century capitalism, or socialism, involved a sharp concentration of economic wealth and power in the hands of a few landowners, a small group of capitalists, or an elite group of bureaucrats.

Today, ownership of assets is much more widespread. Even 50 years ago only a very small proportion of the population held any assets other than small-scale deposits. Now more than 75% of the population in developed countries own stocks, mutual funds, houses, or pensions. It is also much easier to trade assets than before. The immediate transparency of prices on electronic quotation systems is now accessible to all through the internet, whereas just a few years ago it was available only to the big financial institutions. Even the purchase of property, still a relatively illiquid asset, has become easier, with the internet reducing search costs and mortgages more readily available.

The new asset-backed economy creates a far wider dispersion of wealth and represents a genuine democratisation. But it also brings volatility, which can be very damaging to the economy as well as creating crippling losses for investors.

Twentieth-century bubbles

The most disastrous bubble ever seen was the 1920s US stock bubble. After it burst in the Wall Street Crash of 1929, the effects of the asset price collapse, combined with central bank and government policy mistakes in 1931–2, plunged the world into a severe depression. The resulting political turmoil, particularly in Germany and Japan, combined with trade protectionism to lead ultimately to the Second World War.

The worst episode in recent times has been in Japan following the collapse of its stock and property bubbles. From the peak in 1991, land prices fell more than 90% while stock prices slumped 80%.

The 1990s was a "lost decade" for Japan, with economic growth averaging less than 1% a year and unemployment rising sharply. Interest rates were cut too slowly to kick-start the economy and attempts to use active fiscal policy led to an explosion of government debt. And, though the government has avoided a banking crisis, it has yet to deal fully with the overhang of bad debt left from the bubble years. Hopes are high that the economy is at last making a genuine recovery, although it has been a very long time coming.

In 1997–8 the Asian Tigers suffered a similar crisis, after asset price bubbles collapsed. While the trigger was a currency collapse, it was the massive rise and subsequent fall of property and stock prices that made the aftermath so painful. Only a few years earlier, as the bubbles inflated, these countries had been enjoying what was widely regarded as the "Asian miracle."

Today we are living with the aftermath of the 1990s stock bubble, fostered by technology and growth stocks. In the late 1990s US policy makers, led by Federal Reserve Chairman Alan Greenspan, sat back and watched as the US stock market went into a bubble strikingly similar to the 1920s experience. They argued that it was not necessarily a bubble and that, even if it were, it would be dangerous to deflate and much better to wait and be ready to deal with any bust after the event.

Whether allowing a bubble to inflate unchecked is really the best approach remains a controversial question. What is clear, though, is that having learned the lessons from the 1930s and also the 1990s Japan experience, the US authorities have been determined to prevent the asset price bust leading to a major economic slump and deflation. So far at least they have succeeded, with the help of rapid and deep cuts in interest rates and a huge fiscal stimulus. The US did suffer a recession in 2001 but it was only comparatively mild. And the economic recovery picked up steam in 2003–4, so that fears of deflation have receded.

Nevertheless, reactive policy is creating new difficulties for the future.

Budget deficits

The budget stimulus instigated by President Bush, including major tax cuts and increased military spending, was the largest fiscal stimulus in American history. But the legacy is a budget deficit of more than 5% of GDP, a level that creates problems of its own for the long term. European countries have also used active fiscal policy in recent years, particularly the UK but to a lesser extent Germany and France as well, and deficits are now running in the 3–4% of GDP range, again too high.

High deficits drag on economic growth, by reducing the resources available to the private sector and raising real interest rates. They also threaten rising government debt ratios, which can eventually make debt unsustainable. Japan already faces this problem with its debt ratio at over 160% of GDP. The US and Europe still have ratios closer to 60% (the UK at only 40%), so their problem is less urgent. However, this is not the whole story because governments have additional liabilities that are not included in official debt data, the most important being pensions and health care.

So far the US has avoided the drag from its budget deficit with the help of a matching current account deficit. In effect, foreigners are financing the budget deficit by sending the money gained from their trade surpluses with the US straight back into the US economy. During 2003–4 Asian central banks were the main sources of finance, buying US dollars to prevent their currencies appreciating too much so that they could maintain their own economic expansion.

Nevertheless, this large current account deficit also has long-term consequences for the US, in the build-up of foreign liabilities. At some point the current account deficit will need to be corrected and this will imply a prolonged period of dollar weakness. A weak dollar will help the US economy if the problem then is maintaining growth, but is a threat if inflation should start to pick up again. This will depend on whether or not the US has spare resources in the economy at the time.

High budget deficits have another important consequence. If we face a new economic slump, governments will have used up their fiscal ammunition. Japan reached this point in the mid-1990s, five years after he bust began, but the US and Europe got there in just two years. In the US the authorities used up virtually all their monetary policy ammunition too, taking interest rates down to 1%. Provided that the current economic recovery continues, rates will rise in the next few years but, in a world of low inflation, will remain relatively low. There are other monetary measures that can be taken if rates hit the zero limit, but these are untried and untested.

The US stimulus succeeded in averting an economic disaster in 2002–3 partly because of its sheer size and speed of implementation, but also because of a crucial difference between the 1990s bubble and Japan’s experience. Japan’s bubble was not only in stocks but in property too. When property prices fell in the 1990s the effect was to undermine Japanese companies’ balance sheets and leave banks with huge losses.

In contrast, property prices in the US and Europe held up fairly well after the stock market bust. Commercial property prices were relatively restrained in the 1990s and when economic growth slowed in 2001 there was only a limited overhang of supply, so rents and prices were only moderately affected. But—and this is critical—residential house prices not only have not fallen but, most unusually during an economic downturn, have risen sharply.

By cutting interest rates so dramatically, there is a danger that central banks have shifted the bubble from stocks to residential property. I shall argue that, with valuations at historically high levels, we face housing bubbles now in the UK, Australia, Spain, and the Netherlands.

Worryingly for everyone, a bubble may be emerging in the US as well. If these bubbles give way to busts there is a risk that the next recession will be severe, especially since the evidence suggests that property price declines have more impact on the economy than stock price falls. Moreover, with inflation so low, there is a danger that a new recession in the next few years could see more countries following Japan into a deflationary scenario. While deflation is not always bad news, it is something to fear if asset prices are falling too and debt is high. With household debt at record levels in all these countries, the potential for serious problems is considerable.

When any bubble goes bust, some people lose. Experienced speculators can be caught out, though they sometimes recognise the end of a bubble and cut their positions in time. Most importantly, they usually know how to limit their risk to a bearable level. The investors who really suffer are those who are drawn in, often at the late stages of a bubble, with very little experience of how to manage risks.

For a bubble to continue to inflate it needs more and more people to invest, risking more and more money. The end of the bubble occurs either because there is nobody left to be drawn in, or because some event makes people start to sell. If bubbles affected only a few investors, with little impact on the overall economy, they would be of limited importance. Some bubbles are indeed like that. The bubble in classic car prices in the late 1980s, for example, had only minor repercussions. A few people made a lot of money on the way up and some lost when prices crashed at the end of the decade, but the numbers involved were small. Obviously classic cars cannot be newly manufactured so, although there were some new dealers who set up during the bubble and then closed after the bust, the wasted resources involved were small. The bubble in impressionist paintings at the same time had a similarly limited effect, as did bubbles in silver and gold prices in the 1970s.

However, bubbles can cause major problems when they occur in an asset that is widely held. Then, not only do a large number of people suffer directly when the bubble bursts, as the bubble inflates it also interacts with the economy, creating a self-reinforcing boom and bust. The dangerous bubbles, therefore, are usually the ones in stocks and property.

Extracted from When Bubbles Burst: Surviving the Financial Fallout by John Calverley, Nicholas Brealey Publishing £12.99.