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Bubble Definitions and Some Pictures

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

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Bubble Definitions and Some Pictures

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  1. Fin254f: Spring 2010 Kindleberger/Aliber 2-3(skim) Bubble Definitionsand Some Pictures

  2. Outline • Pictures/examples • Minsky taxonomy • Speculation

  3. U.S. Stocks

  4. U.S. Stock (inflation adjusted)

  5. S&P Price/Dividend Ratio

  6. US House Prices

  7. U.S. House Prices (long)

  8. Crash of 1929: U.S.

  9. Crash of 1987: U.S.

  10. Japan

  11. Dot Com Bubble

  12. Dot Com Again

  13. 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)

  14. 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)

  15. 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: ???

  16. Minsky and Credit • Bank credit unstable • Related to bubble growth • Financial regulatory changes

  17. Minsky Taxonomy • Hedge finance • Speculative finance • Ponzi finance

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

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

  20. 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

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

  22. Bubbles and GrowthDividend Discount Model

  23. 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 • 14 - 40 months • Beliefs and growth: When are they irrational?

  24. 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

  25. 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

  26. 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

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

  28. Criticisms of Minsky Framework • Each bubble is unique • No longer relevant • Markets are efficient

  29. Uniqueness • "This time is different" • Specific factors • Are there common patterns?

  30. 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

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

  32. 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

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

  34. Rationality • Difficult to define without theory of how the world works • Rational relative to something

  35. 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

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

  37. 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

  38. Cobweb Model P D S Q

  39. 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

  40. Outline • Pictures/examples • Minsky taxonomy • Speculation

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