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Bubbles

Bubbles. Overview. Current crisis is more than a credit crunch in Ireland 4 Aspects or causes with effect on AD Asset market Bubble: I Government Budget: G Banks: C+I International Credit Conditions: C+I, NX Solutions General: shift in AD Special: unusual aspects of current crisis.

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Bubbles

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  1. Bubbles

  2. Overview • Current crisis is more than a credit crunch in Ireland • 4 Aspects or causes with effect on AD • Asset market Bubble: I • Government Budget: G • Banks: C+I • International Credit Conditions: C+I, NX • Solutions • General: shift in AD • Special: unusual aspects of current crisis

  3. Overview of the Overview NX costs Foreign Borrowing Banks Inv budget

  4. What is a Bubble? • Bubbles can occur in asset markets in general • US, UK, Ireland have housing market bubble • Bubble in thoroughbred horses • Dot.com bubble • Bubble is sustained price increase substantially above the “fundamental value” • not just a rapid price increase. This could be justified • Sustained: not temporary blip

  5. Key issue: bubble distorts behaviour • End up with too many houses or dot coms • Wasted resources • Collateral damage

  6. Fundamental Value • Value is a slippery concept • Value is what someone will pay for it • Not much use in a bubble • Fundamental Value • Long term sustained • Determined by rational analysis of other variables: income, interest rates etc • Notion is that the relationship between variables does not change over time • The opposite of New Era story

  7. Example: Dot-Com • See Shiller’s book for details and website for updates • http://www.irrationalexuberance.com/ • Expect the price of share to be related to the earnings of companies. • Expect P\E ratio to be constant • Price clearly out of line with “fundamental” in 1990s • More complicated model: same story

  8. Faced with that evidence how could anyone deny that there was a bubble? • Wishful thinking promotes “New Era” story • “This time it is different because of X” • Where x is semi plausible • “X” in the dot-com boom was • Internet improves productivity • Earnings will grow faster so pay high P\E now • Easy to show that lead to unrealistic consequences: profits growing 2 as fast as GDP

  9. Shiller details the “New Era” debate • New Era proponents come up with increasingly unlikely counter arguments • Wishful thinking • Example: profit share of GDP • “This time it is different” • China keep wages down • Example: tech creators vs enablers • “This time it is different”

  10. Example: House Prices • See Shiller’s website for US house prices • http://www.irrationalexuberance.com/ • Expect the price of house to be related to rental income (like P/E) • Rental data is difficult to get • Relate price to average income • Price clearly out of line with “fundamental” after 1997 in both US and Ireland

  11. As always there are a “New Era” counter arguments • Growing economy • Immigration • Housing stock • Irish people pre-disposed to ownership • Low interest rates • A more complicated model can take account of these factors • See note on website • And discussion on www.dontpanic.ie

  12. Consequences of Bubbles • Distributional effects i.e. transfer between groups • Land owners/ house owners • Trickle down to other sectors • Salaries etc • Cost of financial distress & crunch • Collateral damage to the banks • Resource allocation effect • important in long run • People respond to the price rise by switching resources to the bubble activity • Example Dot com: capital invested in firms • See “boo hoo” on boo.com • Detracted from more productive investment • Crowding out

  13. Consequences ofHouse Price Boom • Distributional issues • Landowners • Look at detail later • See dontpanic.ie • Trickle down • Wages • Govt revenue • See dontpanic.ie • Cost of financial distress • Look at banks later

  14. Misallocation of resources • An important and neglected aspect of the boom • Apparently high return on property • Large investment in property • Boost to GDP & Employment & Incomes (see graph) • GDP falls when bubble burst (8% of GDP) • Income and employment fall also • Trickle down effect

  15. Waste • Illusory: unproductive • Famine folly • Much of the constructed property may be demolished • It is worth less than its cost • Price> fundamentals

  16. Crowding Out • A big consequence of this misallocation of resources was to crowd out other aspects of the economy • Productive investment • Infrastructure • Exports • Boom forces up prices and competitiveness suffers • Don’t notice during boom (because I is high) • Notice now! • Good that the bubble burst

  17. Psychology • Evidence of the bubble was obvious • Price>fundamentals • Huge share of GDP • So why did people persist in believing it? • Already seen New Era argument • Wishful thinking • Quasi-economic argument • Psychological processes amplified the boom

  18. Quote from Mackay • "Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."

  19. Psychological Processes • Culture: pre-disposition to buy property • Admire property owners/developers • Property porn • Anchor: “never go down” • Emotions: fear of being left behind • Herd behaviour • “A step on the property ladder” • Media • Shape opinion: contrarian opinions unusual • Hype • Vested interests

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