Financial bubbles are inevitable and their pathologies virtually identical. The only real variable is timing. For this reason financial crises appear so obvious in hindsight yet remain frustratingly hard to predict.
A couple of years ago, the hedge fund Winton Capital produced a handsome and richly-illustrated book called The Pit and also the Pendulum, chronicling many, but by no means all, from the financial crises throughout history.
Markets are human constructs. As such, they are prey to every human foible
Winton makes its money by using sophisticated mathematical models to detect when assets are mispriced. It shouldn’t work, according to the efficient market hypothesis, which posits that current prices fully and accurately reflect all available information. But David Harding, the founder and leader of Winton Capital, thinks the hypothesis is bunkum. He recently told a conference that, if financial markets are efficient, he must be either “a lucky monkey or a fraudster”, adding that “neither of these characterizations appeals”.
Markets are, Harding argues, human constructs. As a result, they are prey to every human foible. His comprehensive chronicle of speculative mania and panics was meant to hammer home the purpose.
Related
- Market turmoil doesn’t spell impending doom for growthGoldman Sachs channels FDR’s ‘nothing to fear but fear itself’ with call to sell goldNo requirement for market gloom on China – the eurozone is the real economic disaster to worry about
-
-
-
The book includes well-known bubbles, like the tulip mania that gripped 17th century Holland, and also the boom in U.S. subprime lending which led to the 2008 economic crisis. Along the way, it ventures in the wilds of Qajar Persia to the bazaars of Constantinople, and highlights little-known bubbles like the Japanese rabbit mania of 1873, during which fluffy bunnies imported from Europe could fetch as much as yen 600, at a time when the average monthly salary was about yen 0.6. (Apparently individuals with yellow ears were particularly highly prized.)
The same thing happened with diving patents within the 17th century (which were supposedly likely to be used to salvage sunken Spanish gold within the Caribbean); Brazilian rubber in the 1700s; and Spanish merino sheep, mulberry trees, and British railway securities in the 1800s. And so forth and so on: history stuck on repeat.
Such financial crises have a tendency to occur every 2 to 3 years typically, according to Danske Bank, which helpfully highlights the 4g iphone, the European sovereign debt crisis, ended a lot more than 3 years ago. The pattern is definitely exactly the same. Cheap money floods the economic climate. In 1800s Japan it had been compensation payments made to samurai who were disbanded within the wake of the Meiji Revolution. Since 2008, her been the 637 individual interest rate cuts perpetrated by global central banks and their combined purchase of over $12 trillion in assets, according to Bank of America Merrill Lynch.
That money flows into the less risky assets and pushes their yield (which moves inversely to price) down. Investors get greedy and begin taking a look at riskier assets. Additionally they start borrowing money to make these investments. This drags within the banks. Leverage accumulates. Bubbles start to inflate.
So where might this currently be happening? Where to start? Emerging market debt is a good candidate, as are U.S. high-yield bonds. The Chinese construction bubble has arguably already burst and dragged global commodity prices down. But we have still got London house prices, government bonds, energy and commodity companies (especially U.S. shale producers) and additional Tier 1 securities from bank, to mention but a few frothy assets.
At some time, money will end up less cheap and also the process goes into reverse. This is why the financial world is hanging on every word the chairman from the U.S. Fed, Janet Yellen, utters. It’s also the reason behind the current dependence on the efficacy of negative interest rates in certain areas of the world.
In Denmark and Switzerland, banks have to pay to place money on deposit using their central banks. Some are passing this onto customers by, for example, increasing home loan rates. Why is that important? This means that central bank monetary policy decisions that have been designed to stimulate the economy are in fact producing a tightening of credit. This really is, needless to say, far from ideal. It may be one of the primary, faint signs the world’s central banks are not having enough room for manoeuvre.
Are we near to the crucial reason for every crisis – commonly known as as the Minsky moment – when overconfidence flips over into fear? This is what causes markets to crash, banks to start withdrawing credit and economies to plunge into recession.
Emotion plays a crucial role, because markets are not efficient. Jeffrey Currie, the senior commodity analyst at Goldman Sachs, put out a note on Monday which argued that the markets had “absolutely nothing to fear but fear itself.” But that’s not too reassuring, because fear appears to be establishing itself. Gold has risen by a lot more than 14 percent this season; Bank of America’s latest fund manager survey discovered that investors possess a bigger part of their portfolios invested in cash than anytime since 2001.
Perhaps the admittedly benign economic fundamentals outweigh the financial dislocations. But increase the latter a palpable sense of fear and also the balance begins to tip.
That is the reason why all eyes are trained around the meeting of G20 finance minister and central bank governors, in Shanghai, appropriately enough, last month 26 and 27.
Bubbles always burst. But some grow a little larger and float an impression longer around the breeze before they are doing. The question, therefore, isn’t “if” but “when.” One wrong step by the world’s central banks which could be at some point.
