Bubble Definitions and Some Pictures Fin254f: Spring 2010 Kindleberger/Aliber 2-3(skim)

Outline  Pictures/examples  Minsky taxonomy  Speculation

U.S. Stocks

U.S. Stock (inflation adjusted)

S&P Price/Dividend Ratio

US House Prices

U.S. House Prices (long)

Crash of 1929: U.S.

Crash of 1987: U.S.

Japan

Dot Com Bubble

Dot Com Again

The Big Ten Bubbles <2008  Tulips (Holland 1636)  South Sea Bubble (UK, 1720)  Mississippi Bubble1720  1920's stocks  Developing country lending (1970's)  Japan 1980's (stocks and real estate)  Asia (Thailand, Malaysia, Indonesia others, 1990's)  Mexico, early 1990's  Internet (late 90's)

Minsky Model Overview  Not periodic (many early models are) Kuznets (housing), Kondratief (50 years)  Changes in credit (pro cyclical)  Changes in beliefs (optimism, risk)  Starts with displacement (causes/optimism)

Displacement Examples  US 1920's: Electricity/mass production  Japan 1980's: Financial liberalization/FX appreciation  Asia 1980's: Implosion of Japan bubble/growth miracles  U.S. 90's: Internet  U.S. 2008: ???

Minsky and Credit  Bank credit unstable  Related to bubble growth  Financial regulatory changes

Minsky Taxonomy  Hedge finance  Speculative finance  Ponzi finance

Hedge Finance  Income > Interest + some debt  Common in bad times, and early stages of bubbles

Speculative Finance  Income pays off interest  Income can't pay off old debts  Firms must refinance  Middle stage of bubble

Ponzi Finance  Charles Ponzi : Boston, 1920's  Offers 30 percent interest/month  Finances with new depositors  In month 4: Cash < interest payments Ponzi goes to prison

Ponzi Finance  Income < interest  New debt needed just to make interest payments  Unstable top of bubble

Bubbles and Growth Dividend Discount Model

Growth, Bubbles, Mania and Irrationality  Mania = Irrationality  Bubble trickier definition Run up in price Deviation from fundamental  P/D, P/rental, P/earnings, deviation from PPP months  Beliefs and growth: When are they irrational?

Bubbles in Return and Risk  Return: Optimistic return and growth forecasts Internet bubbles Risk still considered  Risk: Optimistic beliefs on risk Reasonable (not stellar) returns Low risk Securitized debt

Difference When Bursts  Return: Expectations proved wrong, but new values might still fall in tail of belief distribution  Risk Events show entire belief system is completely wrong Investors have no valid probabilities

Propagation  Not part of Minsky model  Mechanisms Arbitrage (example: gold) Trade demands Capital flows Psychological connections  Crash of 87  Asian crisis and Argentina Bankruptcies and bank failures Counterparty risk

Lender of Last Resort  Final lender to stop propagation mechanisms  National level: Central banks  International level: IMF??

Criticisms of Minsky Framework  Each bubble is unique  No longer relevant  Markets are efficient

Uniqueness  "This time is different"  Specific factors  Are there common patterns?

No Longer Relevant  Regulation keeps "ruling out" bubbles  Seems pretty false right now "Great moderation" Central banking of the 90's  Periods of relative stasis

Markets are Efficient  Prices contain all information  Bubbles only appear to be bubbles ex- post  Need more information or  More complete models

Speculation Stages  First stage Investors buy into limited but reasonable asset Want to hold asset Drive price up  Second stage Speculators enter Interested only in quick resale

How to Differentiate?  Real estate: Owner occupancy  Stocks Difficult  Problematic policy question Stop "speculative buying"

Rationality  Difficult to define without theory of how the world works Rational relative to something

Rationality and Markets  Does "individual rationality" -> "group rationality"? Not clear Buy into a bubble  Do markets "aggregate information"? Not clear Truth plus noise No price -> trader feedback

Speculation and Stability  Does speculation destabilize markets?  How can we tell when we see it?  "Eliminate destabilizing speculators"

Stability and Mechanisms  No general market stability theorems in Economics and Finance  Cobweb models Supply responds to last period demand Can generate price cycles Expectations can make things worse

Cobweb Model D S P Q

National Differences?  Speculation patterns??? Sheep grazing -> gambling and speculation ?? U.S. open society and wide open business climate -> speculation??  This evidence is sketchy at best  Few countries/regions safe from bubbles

Outline  Pictures/examples  Minsky taxonomy  Speculation