What’s wrong with bubbles?
Photo: Michelle DiNocola. Source: Morguefile
Sir John Templeton once famously noted that the four most expensive words in the English language are, “This time it’s different.” It’s easy to get caught up in the excitement of the moment, to believe that the latest innovation will lead to a new era. But human nature doesn’t change. That’s why it’s so fascinating.
Before the first documented financial bubble—the tulip crisis in 17th century Holland—there were other markets that were manipulated and distorted. In ancient Rome, currencies, bonds, and investments changed hands in the Forum, with little regulation or security. When the emperor ran short of cash—often due to war—he would debase the currency, adding base metal to the coinage. This led to inflation, currency speculation, and economic chaos.
Speculation in Rome was followed by speculation in Holland (tulips), speculation in France (The Mississippi Company), speculation in London (The South Sea bubble, which captured Sir Isaac Newton), speculation in Brazil (Encilhamento), and speculation in New York. They all follow the same pattern: a genuinely new development takes place; prices begin to adjust, investors notice the price movement and jump on board, eventually using leverage to increase their holdings; prices become increasingly divorced from reality; finally, the bubble bursts and prices revert—suddenly—towards a more economically rational level, given current financial conditions.
Photo: Koan. Source: Morguefile
Bubbles cause economic harm in two ways: during the boom they waste resources on over-building that could have been employed productively; and the bust can cause financial retrenchment when borrowers default on underwater asset-based loans. This can lead to a systemic loss of capital in the banking sector causing banks to pull back on lending. When loans contract across an economy, a burst bubble can lead to a recession—or even a depression.
Do we have any sectors of the economy that look like bubbles now? I haven’t noticed any. But one feature of bubbles is that they’re hard to see. We fool ourselves into thinking that a new era has arrived, or is about to: a “new normal.” Hmm, maybe we’re in danger bubble-thinking after all.
Douglas R. Tengdin, CFA
Chief Investment Officer