41 Market Bubbles: Past examples and preventing future ones. Sam Rose

Market bubbles: past examples and preventing future ones

Sam Rose Upper Sixth

2008 market crash

A market bubble is defined, by Investopedia, as “an economic cycle characterized by the rapid escalation of asset prices followed by a contraction”. The sudden change in asset price inevitably has dire consequences for the market and sometimes the global financial system, as we will explore. No economist can say bubbles are not a problem; so how do they keep occurring? What allows them to get out of control? And what can we do to stop this cycle?

Before we can attempt to treat the problem, it is first essential to understand real examples of bubbles in our history. One key example of a bubble occurred in the early 1700s when a French official called John Law had access to both the French Mississippi company and French monetary policy. As brilliantly detailed in Niall Ferguson’s book, The Ascent of Money (2009), Law encouraged all members of the public to purchase company bonds. This began to inflate their price as the market forces adjusted for increased demand. The key feature that made this a bubble, however, was when Law was granted the power of the Mint with his Banque Royale. He began to move French currency away from coinage to paper notes. This allowed much easier expansion of the money supply and Law used this to full advantage. He expanded the supply of money significantly and, to his credit, brought France out of a deep recession. Law was granted the power of control over the French tax system. This was to become the final straw as Law began to finance debt collection by the issuing of more Mississippi company shares. “On 17 June 1719 the Mississippi Company issued 50,000 of these [shares] at a price of 550 livres apiece”. forced to re-introduce gold and silver currency to promote stability.

After all this France was virtually bankrupt and went on struggling from one desperate reform to another before the monarchy finally declared bankruptcy. This sparked the Revolution. One might have noticed that during this time the British South Sea bubble was beginning to occur, but the harsh reality is that its losses were nothing compared to that of the French. The key reason for this was that that the South Sea Company never got control of the Bank of England.

The story of the Mississippi company demonstrates the huge dangers of bubbles perfectly. Minsky explains the five stages of a bubble to be: Displacement, Boom, Euphoria, Profit-taking and Panic. This final stage was all too eminent in 1720 France as the bubble caused such panic and unrest as to entirely overthrow the French monarchy in the later revolution. There is no doubt that certain bubbles can destroy economies.

Furthermore, Law produced even more new shares at 1000 livres to maintain his monopoly over the Mint. This was substantiated by the promise of more profits coming from the company in Louisiana. This was not to be hence we now have a bubble. The price of the company shares was unprecedently high (9000 livres in autumn 1719) and There is no continuing to grow. It was then only a matter of time before the collapse. This doubt that certain bubbles was accelerated by Law’s appointment as French Minister of Finance in can destroy economies. December 1719. Sure enough, by 1720 prices began to fall and there was further mass inflation followed by deflationary controls and price manipulation. France lost almost all confidence in Mississippi shares but, more importantly, the Livre. In late May 1720 This is further evidenced by the 2008 Law resigned and was placed under house financial crisis, where a US housing bubble arrest. By October the government was eventually caused the collapse of most of

Mississippi Bubble 1720

the world’s financial system. For a detailed account I recommend Adam Tooze’s book: Crashed (2019). On a smaller scale, however, bubbles will at least cause major financial losses. People who buy in the “Euphoria” stage will be buying high. The Euphoria stage is even described as when “caution is thrown out the window”. People are ignoring the high price and potential losses and pour money into the asset. The “profit taking” stage is only for a small number, however, and most people suffer the “panic”. When the price plummets people sell for less than they bought and lose money. Overall bubbles will cause people to suffer financially. This much is clear, but the degree to which they suffer very much depends, as already demonstrated with John Law, on the magnitude and the tools we have to fight them. One method to prevent, or at least mitigate the effect of, bubbles is, as shown by the Mississippi bubble, is to maintain a strong and independent regulatory body for monetary policy. The Mississippi bubble would not have been nearly as destructive if John Law hadn’t acquired control over French monetary policy. The evidence for this can be seen with the modern-day Bank of England model. Keeping a powerful body solely responsible for controlling inflation, and as a derivative: asset prices, is a strong start to maintaining price stability. When one remembers that bubbles can only occur when prices increase unsustainably, keep-

ing prices stable will help prevent them. That said, interest rates will affect all levels of spending in an economy. The Bank of England cannot micromanage individual asset prices. On the fiscal side, however, a price cap could be effective. Using the example of 2008, a price cap on collateralised debt obligations (CDOs) and mortgage-backed securities (MBS) funds would have limited the incentive to make more. It was the massive demand (profit [T]he bubbles we need to worry motivated) that brought on the oversupply that was eventually filled with about are the subprime options that exceptions to the rules. fell through. That said, looking back at traditional economic theory, a maximum price that is set below the market equilibrium will lead to a welfare loss and market inefficiency. The question we must ask ourselves, therefore, is what is more important? Market efficiency or preventing potential economic collapse? The key issue with bubbles, however, is that they are all unique. Whilst the blanket solutions previously discussed may work for many economic issues, the bubbles we need to worry about are the exceptions to the rules. They are always “Black Swans” as Taleb would put it. Bubbles must always, therefore, be treated on a case by case basis. The dotcom bubble could have been battled by putting greater restrictions on venture capital investment, paying greater attention to beta coefficients (a value that indicates the degree to which a value of a stock changes in correlation with the state of the economy) and tightening server access laws. The 2008 situation could have been prevented by greater study of the mortgages involved, regulation to prevent tranches (a security that can be divicdeddivided into smaller segments and put up for investment) traunching and regulatory control over the ratings agencies. Another problem lies in that we know all of this in hindsight. If bubbles truly are Black Swans, then they cannot be predicted.