With so much turmoil in so many markets, it is clear that personal portfolios and economic growth are at great risk when valuations are driven by asset “bubbles”. In recent memory, spurts of wild speculation have been followed by breathtaking collapses of various types of assets, including share prices and property values.
As such, prudent investors must care about what causes bubbles so that they might escape calamity if valuations evaporate in the downdraught of a deflated bubble or the stampede of panic.
Non-economists seeking explanations of bubbles often encounter psychological concepts that allude to “animal spirits” or irrational exuberance or unbridled greed. It is worth considering the implications of these interpretations. First, most psychological explanations depict investor behaviour as irrational, often reflecting herd instincts. Second, by behaving this way, investors cause markets to be inherently unstable. Third, the presumed inherent instability of markets requires greater government regulation to avert disasters.
As it turns out, the opposite is true on all these counts. While herding or schooling is common to some animals, human beings tend to identify themselves as individuals and behave independently. This is obvious in capital markets, where “bulls” (optimists) tend to be offset by “bears” (pessimists), though both have access to the same information.
Much of what is known about bubbles comes from hindsight which reveals that most people made the same sort of wrong guess about the future for long periods of time.
When most investors become unrelenting bulls, it implies they had access to the some faulty information to make what prove to be disastrously wrong guesses about the future. It turns out that the cost of credit is the most important and most widely known information used by investors. And since central bank policy often aims to dictate interest rates, it should be no surprise that this is a key to understanding the behaviour that precedes bubbles.
Almost every bubble in history can be traced to central bank policies that led to too much money being pumped into the economy, forcing interest rates to artificially low levels. This includes the South Sea bubble, tulip-mania and the dotcom bubble.
In the modern context, it all begins when central bankers lend to commercial banks at interest rates below those prevailing in the market. In turn, banks can offer loans at lower rates so that increased borrowing leads to more money in the economy.
This is what happened during the dotcom bubble. While new technologies generated promises of large potential returns and led to perhaps exaggerated optimism, hysteria alone cannot push valuations into the stratosphere.
This is because if one sector of the economy attracts more funds, the number and valuations of transactions elsewhere must fall by offsetting amounts.
But this did not occur. Share values in many other sectors also rose at a breathtaking pace. What happened? Excessive credit expansion engineered by central banks provided financial resources to support “irrational” urges to throw ever more money at speculative bets.
What does this say about the cause of observed market instability? Well, it turns out that wide market swings tend to occur when investors are “victimized” by being supplied information on interest rates that turn out to be misleading.
In general, the fact that there have been so few dramatic instances of bubbles or panics supports the idea that markets are stable. Every day, there are trillions of transactions within millions of different markets for a myriad goods and services conducted by billions of people. And this has occurred with increasing scope over many hundred years.
If neither irrational investors nor unstable markets are to blame for bubbles, then less government regulation of markets is required. Increased regulation involves asking governments to solve problems they have created.
What about the political pressure for central banks or government agencies to intervene to stop prices of overinflated assets from collapsing?
Such interventions are the wrong course of action. As it is, price declines, after a bubble bursts, are necessary adjustments that can restore stability in markets distorted by cheap credit. In other words, market players begin to sober up and realize the party must be over.
Should central bankers refill the punchbowl, ever-more instability will be built into the system.
Central bank policies that cheapen credit set up conditions for speculative bubbles, but they also set into motion an inevitable bust and possible recession. Since bubbles and busts are caused by monetary policy, there is a simple rule to keep markets stable. Y.V. Reddy and other central bankers must stop using monetary levers as Shiva wields his trident. As it is, by conjuring up artificially cheap credit, they unleash destructive powers that eventually turn wealth into ashes.
Christopher Lingle is research scholar at the Centre for Civil Society in New Delhi and Professor of Economics at Universidad Francisco Marroquin in Guatemala. Comments are welcome at firstname.lastname@example.org