Analysis of Economic Bubbles

>After investigating a wide variety of economic crises, we can affirm, as a first step for the analysis, that the vast majority of crises were triggered by an economic bubble and as a consequence a recession . These economic bubbles have been caused by the irrational psychology of the human being, such as the pure conviction that the prices (of the good that is suffering from the bubble) will continue to rise.

That said, we are going to delve into the idea that these economic bubbles have a psychological reason as their origin. The bubbles are driven by the euphoria and ambition of those who lived through them, causing the value of the respective assets to begin to rise due to simple speculation.

In economic bubbles it is assumed that, as the value rises disproportionately, it will continue to rise unabated. This causes everyone to want to take advantage of this fictitious increase in value, and in all cases the theory of the dumbest arises. This theory is summed up in the following sentence:

As long as you can find a fool to sell the good to at a higher price than you bought it, you will not be the fool.

However, there comes a time when the value of the assets is no longer based on a theoretical value or, at least, on a value that could be reasonably justified. That is when the economy itself regulates the merely financial and largely fictitious price of value, to adjust it to its true value. Taking it back to its origin and leading to a stampede effect of the asset that causes a brutal collapse in prices, destroying the fortune and all the assets of the people who had relied on that asset.

Once the most psychological aspect of this type of economic crisis has been nuanced, we are going to analyze why this type of economic bubble is born, how its development and inflation are allowed and even promulgated. Because as Mark Twain said "history does not repeat itself, but it rhymes" an economic bubble will probably be created again in the future.

Origin of economic bubbles

Economic bubbles are born in periods of economic or cultural boom as in the South Seas bubble . The "bubbled" asset takes center stage and becomes the symbol of that economic growth. In the respective crises analyzed, it would be the tulip, the shares of the companies of the South Seas and the Mississippi, the stock market in the crash of 29, the web pages in the dot com bubble and the houses in the current crisis. All of them come from a period of prosperity, which as a result of growth, causes people to tend to think that something is changing and that it will always be better.

As an example, before the financial crisis of 2008, a famous economist went so far as to say that the capitalist model of economic cycles had ended and that from now on, the economy would always grow. This extreme confidence in the future leads to betting heavily on the star asset that is guiding this powerful growth. Since at first everyone wins, the value of the asset begins to grow nonstop, further increasing the desire to invest in it, thus being a snowball process that causes a spectacular rise in the price of that asset, since everything the world wants to invest, many times without having knowledge of the good or sector in question.

At this point of bubble expansion there is practically no going back. For further economic bubbles before reaching this point is when the bubble should be stopped, or if we are an investor, run away. The problem is that at this point it is still very difficult to know if the asset faithfully represents the value given to it or if it is overvalued.

To situate ourselves a bit, we would say that this point would be at the beginning of the century in the tulip crisis, when the English Government granted more concessions to the South Seas company, imitating the Mississippi company, around 1927 in the crash of the 29, in the years 1995-2000 in the dot com bubble and between 2003 and 2006 in the current crisis. Here there are many interests that the bubble continues to develop, the experts in the field to continue making money and the governments that either directly or indirectly inject money and promote the bubble to create a greater sense of growth and economic prosperity and then crash medal for having led the country to success.

Divergence real value and "bubbled" value

Now that all these crises are past and we can analyze them, we are at the point mentioned and we know that the asset at that time is overvalued, but it is still not moved solely by speculation, but rather there is a solid asset behind it that supports the price and explains the reason for this increase in value.

A technically justifiable value (VTJ) for these assets is that which in itself is worth any good, without taking into account the value produced by the supply-demand relationship. Depending on the type of good, the calculation of the technically justifiable value, different properties of the same will be valued. Thus, you can see what would be the VTJ's of the goods to take into account in the different economic bubbles:

  • Tulip crisis : In this case the value would be a price similar to that of the different types of decorative flowers of the time, perhaps a little higher given the long period of cultivation that this plant has. The VTJ could also increase if extraordinary properties (atypical color, shape or smell) were found in the tulip.
  • Bubble of the South Seas : We are in front of two companies, the one from the South Seas and the one from the Mississippi. The assets on which these speculative bubbles developed are the shares of these companies, which at first glance are assets that are more difficult to value since they depend on the future value of the company. To calculate the VTJ today, various valuation methods are used (FCF discount, ratios, multiples), but it can be ensured that for these companies a VTJ could be the theoretical accounting value of the net worth.
  • The crash of 1929 : As in the previous case, the goods to be valued are shares of the industrial companies of the time. In this case, the VTJ can also be valued by various methods, such as the PER, which had an average of 32.6 in the shares that made up SandP. A P/E ratio above 25 may be due to high expectations of future earnings growth, or the company is in the context of a speculative financial bubble and prices are inflated.
  • The dot-com crises : On this occasion, the goods are also actions but these have a peculiarity. And it is that if it is already difficult to value a company that is dedicated to traditional sectors such as commerce or production, it is even more difficult when dealing with electronic and Internet-based companies. Some companies in which neither the investor himself understands nor knows how to value the businesses in which these companies are engaged. A VTJ in these types of companies.
  • The real estate bubble in Spain: This case is simpler when it comes to analyzing an objective value for the property in question. The VTJ for a home is given by many variables such as the size of the home, quality of the materials, geographical location, construction costs, etc. The price of a home could also be valued as the current value of a perpetual rent, the installment of this rent being what would be paid for rent and at the risk-free interest rate.

When the value that the asset has "bubbled", begins to separate from the value that can be technically justified and begins to be moved by speculation, the price is headed towards a maelstrom of increase in value in which the bubble begins to inflate in such a way that the process is irreversible and when such a bubble bursts, the fall will not be smooth, what is more, the longer you endure in this situation, the stronger the blowout will be.

For example, in the current real estate crisis, in 2005, a few years before the real estate bubble burst, Spain built the same houses as France, Germany and Italy combined, that is, a country of 46 million inhabitants built the same houses than three countries with a total of 200 million inhabitants. At this time, trading in the good is beyond logic. It seems that whoever does not invest in good is not very intelligent (euphemism). The commodity market is being swept away at this point by a current of buying euphoria that makes its smooth decline impossible without reaching a brutal cascade.

Euphoria, the most dangerous point

This is the most dangerous point, at which, as occurs in all economic bubbles, a good part of the population ceases to work to dedicate itself to the bubbling asset sector. Cultivate tulips, create companies with concessions in the South Seas bubble, become a stockbroker, create web pages or become a real estate developer, as the case may be. In other words, the economy stops focusing on the real economy and begins to rely on a good with a fictitious value that is driven by euphoria and speculation. If you ever experience a bubble and start to see these symptoms, our advice is to run, run as fast as you can and don't look back.

A curious anecdote about the crash of 29 tells how a famous broker leaving the New York Stock Exchange building on Wall Street, was riding in the car talking to his driver, when the driver began to tell him all the shares he was buying , who invested in this and that, at the same time reasoned with the typical explanations that the stock market is a bargain, that this is always going to rise, the economy is at its best moment to invest, etc. The day after this conversation with his driver, the broker returned to his job at the stock exchange and sold all of his shares. A few weeks later, Black Thursday took place on the Wall Street stock market, where the stock market fell by almost 10%.

Once we are at this point, the dumbest theory explained above occurs. At this moment is when you have to close your eyes and cover your ears so that the explosion of the bubble does not harm us, since its bursting is only a matter of time.

History repeats itself over and over again because ambition is in the nature of being human. Without letting a bubble end, we are already beginning to talk about what is now the best asset to invest in. If gold were not that, gold, we would say that there was a small bubble since the beginning of this crisis since it acted as a refuge value and doubled its value in a few years, even surpassing the value of platinum.

Role of banks in economic bubbles

The main role that financial institutions usually play in economic crises is due to the fact that many times the loans they grant are directed to the “bubbled” asset, so there is a financial leverage that contributes enormously to the inflation of the asset price. When the effects of the bubbles are transferred to the real economy, the investors and the people who depend on these investors go bankrupt, and these in turn cannot face their loans with the banks, causing defaults, which leads to the banks make losses or even go bankrupt.

If rumors arise among the population that the banks may fail, there will be a massive neurosis and people will go to the banks to withdraw their money, fulfilling their fears and thereby aggravating the effects of the crisis, since many people It depends on the banks.

In three of the crises analyzed, financial companies played a very important role, which we are going to analyze:

  • In the Crack of 29 , the financial sector was one of the causes of the subsequent crisis, between the loans made to people by banks simply to speculate with them on the stock market, which could not be repaid, and the withdrawal of deposits for fear of lose them, in 1929 they had failed forty banks, in 1931 there were two thousand. On the other hand, banks cannot recover long-term investments in the industry. The bank failure paralyzed investment, which drastically reduced production by half and nearly one hundred thousand companies closed their doors. They also played an active role in trying to revive the stock market by buying large blocks of shares above their price.
  • In the dotcom crisis, the US central bank (the Federal Reserve) decided to carry out an expansive monetary policy of abundant and cheap money with the aim of reactivating the economy. The reactivation was carried out by reducing interest rates to the lowest levels of recent decades. This cunning move was one of the causes of the housing bubble and the current crisis.
  • In the real estate bubble, since its inception in the US, banks have been the main cause of it. As we well know, the bubble created around housing, in part, originated due to the ease with which banks lent money for mortgages, since housing was available as collateral, which would never drop in price. They are also credited with the creation of totalization funds (MBS's) and complex assets that made it difficult to detect toxic assets and increased uncertainty in the markets.

Conclusion of economic bubbles

At present we have been able to verify that these economic bubbles occur repeatedly, each time in shorter periods of time. Although historically crises have occasionally affected certain countries or territories, the development of new information and communication technologies and the globalization of the economy have also meant the globalization of crises.

In today's world, the interrelation of financial markets, the possibility of investing in any sector and country on the planet, cause the bubbles or crises that occur in the most important economies in the world, such as the US, the European Union, China and emerging countries. lead to an immediate contagion result for everyone else.

The analysis of how these economic bubbles have been produced throughout the financial history of humanity, as well as the study of the crises already experienced, should help us in the future to anticipate their formation and prevent them from leading to real crises; difficult task. The human being in his innovative and speculative tendency will be able to invent new assumptions, which due to their novelty will distort the accumulated experiences and new economic bubbles will be created.