Why financial bubbles keep coming back

The way the financial system is structured, much more money can be made by saying all is well than by becoming the purveyor of bad news.
The way the financial system is structured, much more money can be made by saying all is well than by becoming the purveyor of bad news.


Industry insiders have an interest in their inflation while regulators are wary of calling them out.

There have been huge bubbles in the stock market, real estate, cryptos and venture capital funding over the last three years. This comes on the back of massive bubbles over the last three-and-a-half decades. The mid to late 1980s saw bubbles in Japanese stocks and real estate. The late 1990s and early 2000s saw a bubble in dotcom companies with no business models. The 2000s saw a huge real estate bubble along with a bubble in stocks.

In the past one year, bubbles in real estate through much of the rich world have deflated, as with cryptos and venture capital funding. Stock prices have also lost steam to some extent.

The interesting thing is that once a bubble bursts, in hindsight it seems very obvious. Hence, if the bubble is so obvious in hindsight, why does it flourish in the first place and not burst quickly? Darren Tseng, Stephen Diehl and Jan Akalin make an important point in Popping the Crypto Bubble: Market Manias, Phony Populism, Techno-Solutionism: “The unfortunate truth of the world is that there is a fundamental asymmetry to returns to humoring delusion for personal gain compared to the downside of reporting reality as it is."

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What this basically means is that a certain set of people can make more money by ensuring that the bubble continues to thrive and inflate than by calling it out and letting it burst too soon. In fact, economic historian Charles P. Kindleberger talks about two kinds of investors in any market: insiders and outsiders. The insiders want any bubble to keep growing and seek benefits at the cost of outsiders.

Let’s try and understand this in the context of cryptos. The insiders were individuals running stock exchanges, the venture capitalists funding these exchanges, and influencers talking about how important it was to own cryptos as a part of an investment portfolio. Many influencers didn’t tell the world at large that they had been paid to say the same.

It was in the interests of these insiders that the crypto bubble kept growing bigger. The more the insiders propped up cryptos, the more outsiders (that is retail investors) got into buying tokens. As Charles Kindleberger writes in Manias, Panics and Crashes in a more broader context: “The purchases of [financial] securities… by ‘outsiders’ means that the insiders—those who owned or purchased these assets earlier—sell the same securities… and take some profits." So, insiders need to be perpetually positive.

A similar dynamic was at play when companies with next to no profits and weak business models came up with their initial public offering (IPO) at massive valuations through 2021 and early 2022. The insiders, that is company promoters, venture capitalists, investment bankers and brokerage analysts, kept propping up these stocks, in the process creating huge demand for the IPO. The way the financial system is structured, there is much more money to be made by saying all is well and the future is bright than to become a purveyor of bad news.

Further, regulators are also reluctant to call out bubbles. First, because no one really knows when a bubble is likely to burst. Second, as and when a bubble bursts, it can create trouble in the overall economy and no regulator wants that to happen on its watch.

In fact, as Alan Greenspan, the long-serving chairperson of the US Federal Reserve, said in 1999: “Bubbles are generally perceptible only after the fact." Of course, the problem with this argument is that if a bubble isn’t perceptible while it’s on, how can it suddenly become perceptible after it has burst?

Indeed, a similar reluctance to acknowledge a problem could be seen even during the period Indian public sector banks were accumulating bad loans. The insiders kept saying all is well. During the period 2010 to 2016, several chairpersons of public sector banks kept saying that the worst is over when it comes to bad loans. Bad loans of banks are largely loans that haven’t been repaid for 90 days or more. The bad loans of Indian banks on the whole peaked at 10.36 trillion only as of end-March 2018. Clearly, the worst wasn’t over when the chairpersons said it was.

This situation is similar to not calling out a bubble simply because bankers are not ready to recognize mispricing of assets. A loan is an asset for a bank. When a borrower stops repaying a loan, the bank needs to mark down the value of this asset. If it does not do so, like the case of an investment bubble, it amounts to mispricing that asset.

Such mispricing over a period of time can create a problem for the economy at large, as did happen with public sector banks. This happens primarily because insiders are only interested in propping up the message of ‘all is well’. Their optimism is believed and it sells.

On the flip side, not enough outsiders call out these bubbles. As Tseng, Diehl and Akalin put it: “It takes ten times as much energy to refute bullshit as it does to produce it." Ultimately, the outsiders fall for the story sold by insiders and lose money in the process.

As the old Latin phrase goes, “Mundus vult decipi, ergo decipiatur," meaning “The world wants to be deceived, so let it be deceived." And this explains why bubbles keep coming back over and over again.

Vivek Kaul is the author of ‘Bad Money’.

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