Why The Bust After A Boom

[Bloo Loo]

How massive credit bubbles are linked to market crashes

So how did this group of very smart scientists come to the conclusion that massive credit bubbles might be linked in some way to the crashes that always seem to happen right after a massive credit bubble?

No, they didn’t check their portfolios. What they did was come up with a sophisticated computer model stuffed full of little computerised hedge fund managers, virtual bankers and digitised ordinary investors. Each of these little artificial intelligences is programmed with its own goals, and the scientists then basically let them loose and see what they get up to.

According to New Scientist, “the model’s hedge funds try to identify momentarily mispriced securities, and make a profit by buying or selling in the expectation that the price will return to a realistic value in the future. As in the real world, they ‘leverage’ their investments by borrowing from the banks.”

Have a guess what happens next. That’s right. They borrow too much money. And the simulation revealed that this build-up in leverage could have “alarming consequences.” When a hedge fund borrows money to invest, it not only stands a chance of losing its own money, but it can “also lose money it has borrowed from a bank, possibly putting that bank into difficulties.”

A certain amount of leverage was OK. But once there was more than a certain level of leverage spread throughout the system, it became “overwhelmingly likely that a single chance failure will send waves of trouble through the entire market.” Why? Because “increasing levels of credit create stronger links between market players, heightening the chance that the failure of one can put an unsustainable burden on others.” In other words, the more debt there is in the system as a whole, the greater the chance that if person A goes bankrupt, the amount that he owes person B is enough to drive that person into bankruptcy too, and so on down the line.

It must really gall the scientists in question (who include an ex-hedge fund manager turned physicist) that they spent all their time programming this computer simulation, when they could just have sat on the backsides and watched the business news unfold for the past year or so.

Investors across the world borrowed too much money to invest in property, and to buy securities backed by loans made to people who never had enough money to buy a property in the first place. The first signs everything was going wrong were when a couple of hugely leveraged Bear Stearns hedge funds detonated back in the middle of last year, after a large chunk of the people who’d been given money to buy property simply didn’t pay it back. Suddenly everyone panicked that everyone else was over-exposed to the property market. They stopped lending against property, and to each other. Property prices fell harder, and thus the bubble burst.

But I’m being unfair to the scientists here. It’s easy to have a laugh at their expense, but the fact that their research can be seen as some sort of breakthrough proves just how devoid of any common sense the rarified world of economics is. It shouldn’t be difficult to grasp that if you throw an infinite amount of money at a finite resource, then the price of the resource is going to rise. Not because it’s worth anything more – but because the money is worth less and less, the more there is of it. And yet, with every bubble, there’s a new, structural reason to justify why “it’s different this time”.

The only way stop future financial crises

So how did the scientists conclude we could stop these bubbles building in the first place? Pretty simple really – the only way to stop future crises is to prevent the level of leverage in the system from reaching the point where it becomes dangerous. But that’s where the key problem arises – human nature being what it is, no one wants to stop a party when it just seems to be getting started.

Bubbles – particularly house price bubbles – are a lot of fun for those involved, and governments love them because they spread great dollops of ‘feel-good factor’ among the electorate. For example, central banks should have called a halt to proceedings in the property market by hiking interest rates sharply while they had the chance. But instead they looked for all sorts of reasons to ignore the surge in asset prices, and focused instead on worrying about keeping the price of clothes and PCs from China from falling too far.

The only way to put any kind of limit on rampant credit creation is to find some way of controlling the money supply. That’s not so easy to do - for more on this, you should read my colleague Dominic Frisby’s potted history of money from Wednesday’s Money Morning (click here to read it: A brief history of money).

In the meantime, perhaps our scientists could turn their attention to other pressing matters – such as finding out just why it is that horrendous hangovers always seem to be preceded by copious amounts of alcohol intake…

Edited July 18, 2008 by Bloo Loo

[Fully Detached]

I kept thinking of the guinea pigs in the Egg Card advert when he talks about modelling. In a way, that advert was kind of disturbing - it was like saying:

"Here you go folks, you're the guinea pigs in our little experiment. We're going to throw ****** loads of cheap credit at you, let you spunk it all away on tat, and then see what happens when we take our ball away."

[Fudge]

Yes this is equal in significance to the scientific discovery that cornflakes go soggy when you put milk on them.

[bobthe~]

i am now truly worried.

the fact that scientists have run computer simulations to prove that we get a bust after a boom makes me uneasy.

Next stop: The International Panel on Credit Crunches.

[thedebtisreal]

i am now truly worried.

the fact that scientists have run computer simulations to prove that we get a bust after a boom makes me uneasy.

Next stop: The International Panel on Credit Crunches.

You have no idea. One of my colleagues has a masters in economics. I made an offhand comment about how strange it is that too much credit always leads to having too little. He looked at me askance and didn't think that was true.

I pointed out the Japanese bubble, the asian crisis, the lawson boom, the roaring twenties, the south sea bubble, tulip mania. Credit expansion to credit crunch each and every time. He conceeded the point, but still.

[Tiger Woods?]

You have no idea. One of my colleagues has a masters in economics. I made an offhand comment about how strange it is that too much credit always leads to having too little. He looked at me askance and didn't think that was true.

I pointed out the Japanese bubble, the asian crisis, the lawson boom, the roaring twenties, the south sea bubble, tulip mania. Credit expansion to credit crunch each and every time. He conceeded the point, but still.

Having been an academic myself, I concur. Met so many clueless people with Ph.D.s during my time.

[R K]

Having been an academic myself, I concur. Met so many clueless people with Ph.D.s during my time.

Seconded. I'm not an academic but known a few who couldn't tie their own shoelaces without a computer model telling them how to.

[sossij]

Having been an academic myself, I concur. Met so many clueless people with Ph.D.s during my time.

Indeed. I've got one and I'm as thick as shit. Haven't got a f.ucking clue, me.

[crash2006]

You have no idea. One of my colleagues has a masters in economics. I made an offhand comment about how strange it is that too much credit always leads to having too little. He looked at me askance and didn't think that was true.

I pointed out the Japanese bubble, the asian crisis, the lawson boom, the roaring twenties, the south sea bubble, tulip mania. Credit expansion to credit crunch each and every time. He conceeded the point, but still.

Your not allowed to think outsside the box, so many things ive question about economics, yet i must stay in line with other thoughts.

[Laura]

Two sons between us.

Both economic degrees (amongst other bits of paper to impress).

Both were warned way back about the aftermath of the loon boom

Neither listened

Both will be in neg eq by the year's end, though no doubt will deny it.

[Guest DissipatedYouthIsValuable]

It's nice to know that my neural net is still better than a computer model.

[Sinking Feeling]

The output of a computer model is totally dependent on its inputs - therefore this proves nothing!

[oracle]

Having been an academic myself, I concur. Met so many clueless people with Ph.D.s during my time.

That's because they are an expert in what they have been told is the case by the syllabus.

I've met so many grads like it.Come out of uni and into a job thinking they know it all.

Boy do they get a rude awakening.They might know tons of theory but it's on-the-job training that matters.

That and the ability to innovate and improvise(sadly lacking in modern curricula)

a nice little analogy would be to give them 3 years studying the finer points on wallpapering.

Now throw them into the practical and see what a hash they make of it!!!

[interestrateripoff]

Didn't they do a similar experiment to work out why biscuits go soggy in tea as well?