Mantek Singh Chadha IB12
An asset bubble essentially describes a state wherein an abnormal spike in the price of any asset class such as commodities, stocks or real estatetakes place over a short period of time, in tandem with a significant spurt in it’s traded volumes;whereby the prevailing price fails to justifyor rather far exceedsthe underlying fundamental value of that asset class.
Inevitably, at some point in time, such irrationally high prices can no longer be sustained andthat is when the bubble bursts, bringing about a steep decline in prices and causing a great deal of stress in the economy- in short- financial mayhem.
History is replete with evidence that bubbles, though quite unpredictable, happen with a fair consistency and are often decisively identified only in retrospect. Some of the biggest and most destructive bubbles of the last few centuries were:
The Dutch Tulip Mania/ Tulipomania (1634-1637)
The South Sea Bubble (1716-1720)
The Mississippi Bubble (1716-1720)
The British “Railway Mania” Bubble (1840-1846)
Japan’s Bubble Economy of the 1980s
The Dot-com Bubble (Late 1990s)
The US Housing bubble (2002–2007)
Causes
The usual suspects in this cycle of boom & bust are ofcourse greed & fear- in that order. But there’s more to this than meets the eye and these primal abstracts manifest themselves in many ways- most, seemingly innocuous, to begin with.
Asset bubbles can be caused by factors such as excessive liquidity, phenomenally low interest rates,demand-pull inflation, immoderate leverage and/ orthe widespread adoption of a financial (mortgage/ subprime), logistical (railroad) or technological (e-tail) innovation with pervasive effects. Some less discussed causes- and perhaps the only ones where people can’t blame the Government or the Financial Institutions- can be bundled as the Social Psychology Factors (irrational exuberance, exaggerated expectations et al). I plan to cover these in my subsequent article on Behavioral Finance-which is a science unto itself.
Buy land, they’re not making it anymore- Mark Twain
A very true aphorism, but not handled well in the world of excesses!
In my humble opinion, all the bubbles listed above-their notoriety notwithstanding- are small change compared to the impending Chinese real estate bubble. Despite China’sauthoritarian capitalism that even controls the (negative) news flow, it is apparent that there are numerous ghost towns where a plethora of apartments have sprung up but there’s negligible occupancy. It would be nothing short of a miracle if China successfully averts the looming catastrophe; but if it fails, it will create a domino effect across the globe as the mother of all bubbles goes bust.
In India, while the jury is still out on whether the real estate market went through a ‘Minsky Moment’ in the recent past, the pain of the softening prices across the sector has somewhat been alleviated by the psychological shot in the arm that came about with the advent of the new government. Hope is a wonderful drug- till it lasts, that is.
So have our markets been spared? Certainly not!
The price of real estate across most geography has come down substantially and the humongous pile of inventory lying unsold with the builders doesn’t bode well. Besides, let us not forget that the correction in the value of assets may happen across 2 spectrums- monetary value & time.
So, if a property holder has been spared the pain of a deep slash in the value of the realty, it still imperils his financial health, as incessant inflation akin to a termite relentlessly gnaws away at the intrinsic value of any asset that does not commensurately appreciate for a long period of time.
Now that we have covered what causes an asset bubble (aka financial bubble, economic bubble, speculative bubble or speculative mania), let us delve deeper into its mechanism.
The following anecdote will throw light on the genesis, growth and ultimately, the popping of an ‘asset bubble’.
ANCEDOTE –
Once there was a remote island country, Atlantis, that was totally insulated from the rest of the world. The land of this country was thetiny island itself. The total money in circulation was 2 guineas as therewere only two pieces of 1 guinea coins circulating around.
1) There were 3 citizens living on this island country. X owned the land. Yand Zeach owned 1 guinea.
2) Ydecided to purchase the land from X for 1 guinea. So, X and Z now eachowned 1 guinea while Yowned a piece of land that was worth 1 guinea.
3) Z thought that since there is only one piece of land in the country and more can’t be created; its value must definitely go up. So, heborrowed 1 guinea from X and coupled with the 1 guinea he already held, he bought the land from Y for 2 guineas.
At this stage:
X has a loan to Z of 1 guinea, so his net asset is 1 guinea.
Y had sold his land and got 2 guinea, so his net asset is 2 guinea.
Z owned the piece of land worth 2 guinea but with his 1 guinea debt to X,his net asset is 1 guinea.
The net asset of the country = 4 guinea.
And we’ve just about started!
4) X saw that the land he once owned has risen in value. He regrettedselling it. Luckily, he has a 1 guinea loan to Z. He then borrowed 2 guineasfrom Y and acquired the land back from Z for 3 guineas. The payment is by2 guinea cash (which he borrowed) and cancellation of the 1 guinea loan toZ.
As a result, X now owned a piece of land that is worth 3 guineas. But sincehe owed Y2 guineas, his net asset is 1 guinea.
Yloaned 2 guineasto X and therefore his net asset is 2 guineas. Znow has the 2 coins. His net asset is also 2 guineas.
The net asset of the country = 5 guineas. A bubble is building up.
(5) Ysaw that the value of land kept rising. He also wanted to own theland. So he bought the land from X for 4 guineas. The payment is by borrowing2 guineas from Z and cancellation of his 2 guineas loan to X.
As a result, X has got his debt cleared and he got the 2 coins. His netasset is 2 guineas.
Yowned a piece of land that is worth 4 guineas but since he has a debt of 2guineas with Z, his net Asset is 2 guineas.
Z loaned 2 guineas to Y, so his net asset is 2 guineas.
The net asset of the country = 6 guineas. Even though, the country has onlyone piece of land and 2 guineas in circulation.
(6) Everybody has made money and everybody felt happy and prosperous.
(7) One day Z was in a pessimistic frame of mind and he thought to himself: “Hey,what if the land price stops going up, how could Yrepay my loan. There isonly 2 guineas in circulation, the value ofY’sand is at best 1 guinea only.”
He bounced this thought to Xwho readily concurred.
(8) Nobody wanted to buy land anymore. In the end, X owns the 2 guineas, his net asset is 2 guineas. Yowed Z 2 guineas and the land he ownedwhich he thought worth 4 guineas is now 1 guinea. His net asset value is -1guinea.
Z has a loan of 2 guineas to Y but Y has lost the capability to pay back. Although Z’s net assetis still 2 guineas, he’s at risk of losing it all.
The net asset of the country = 3 guineas again.
Who has stolen the 3 guineas from the country?
Of course, before the bubble burst Ythought his land worth 4 guineas.
Actually, right before the collapse, the net asset of the country was 6guineas. While Y’s net asset is still 2 guineas on papers,he knows he will not be able to realize this value through the sale of his asset.
The net asset of the country = 3 guineas again.
(9) Yhad no choice but to declare bankruptcy. Zhas to relinquish his 2guineas bad debt to Y but in return he acquires the land from him,which is worth 1guinea now.
X owns the 2 coins, his net asset is 2 guineas. Yis bankrupt, his net assetis 0 guinea.Z ends up with a landworth only 1 guinea (Z lost one guinea). The net asset of the country = 3guineas.
There is however a redistribution of wealth.
X is the winner, Yis the loser, Z is lucky that he is spared.
A few points worth noting:
(1) When a bubble is building up, the debt of individual in a country to oneanother is also building up.
(2) This story of the island is a close system whereby there is no othercountry and hence no foreign debt. The worth of the asset can only becalculated using the island’s own currency. Hence, there is no net loss.
(3) An over-damped system is assumed when the bubble burst, meaning theland’s value did not go down to below 1 guinea.
(4) When the bubble burst, the fellow with cash is the winner. The fellowshaving the land or extending loan to others are the loser. The asset valuecouldshrink or in worst case, they go bankrupt.
(5) If there is another citizen W either holding a guinea or another pieceof land,who refrainsfrom taking part in the game- he willneither win nor lose, but he will see the value of his money or land go upand down like a see-saw.
(6) When the bubble was in the growing phase, everybody made money.
(7) If you are smart and know that you are living in a growing bubble, it isworthwhile to borrow money (like X) and take part in the game. But you mustknow when to cash out of the market- easy said than done.
(8) Instead of land, the above applies to stocks as well.
(9) The actual worth of land or stocks depends largely on psychology.
In summation, an a posteriori at best tells us that there is no certitude when it comes to the formation or for that matter even the growth of a bubble. However, more often than not it does indicate it as an event once it’s aftermath befalls us.
Also, all bubbles eventually get deflated, and the longer they last, the more pain (shrinking economy, unemployment, bankruptcies, social & political turmoil) they engender upon going bust. Unbridled speculation eventually culminates in a financial crisis or total collapse of the economy.
Since bubbles can’t be timed judiciously for a profitable entry or a risk-mitigating exit, it makes sense to diversify one’s investments across various asset classes, namely, stocks, bonds, gold and real estate in order to de-risk one’s investment portfolio.
Shriconomics 