Bubbles, Booms and Crashes part 5. Their exponential growth and long-term effects

The growth of social epidemics like bubbles is exponential and nothing happens overnight. They can last from days to decades. Unlimited growth has a certain profile to which four parts can be attached: the slow onset of low exponents, the rapid rise of high exponents, the peaking of rising exponents, and the decline. The first profile is clearest when not restricted or regulated. The profile changes with restrictions and regulations. Exponential growth in stock or house prices are difficult to monitor because each has a different impact on epidemics. Therefore, it makes more sense to follow the exponential changes in other figures such as money supply.

Social epidemics rarely grow steadily. They do not follow a normal distribution and their growth cannot be predicted, although claims to the contrary are normal. The exponents vary at different time intervals. They can take a backseat even if the general direction is upwards. There may be variations in the exponents due to the time of measurement. For example, the weekly variations in the current Covid-19 pandemic are so great that it is not worth looking at daily exponents but at weekly readings.

One of the most important things to monitor is the change in exponential growth. In other words, the progression of epidemics can be monitored by observing exponential changes at regular intervals. A significant slowdown in growth is a sign that the epidemic is fading. This cannot be seen from the individual figures. Sometimes epidemics end in single exponential peaks. The following fictional exponents tell of acceleration first and then decline:

1.0, .1.1, 1.3, 1.6, 2.2, 3.2, 3.8, 4.2, 4.3, 4.0, 3.2, 2.4, 1.3, 1.1, 0.9, 0.7...

In the first phase of an epidemic, the exponent is often a little over one for a long time and does not change much before collapsing or moving on to the next phase. Most of the epidemics are not progressing further. The second phase distinguishes the most contagious epidemics from others. Initially, exponential growth accelerates. It is significant and ongoing. At the same time, the critical mass of the epidemic is reached, that is, it becomes unstoppable for a moment. The exponent is often the largest after that moment and may decrease momentarily before turning back up. The trend continues until there is a gradual decrease or a short steep peak with a potentially record exponent. The former is the most likely option when the epidemic is contained and the latter when it is not affected. The peak is followed by a decline, which in most cases is on average steeper than an increase in economic epidemics.

Long-term effects

Bubbles, booms and crashes have long-term effects. The true nature and duration of the resulting collapse is impossible to assess in advance. One significant factor is how banks operate during a bubble and/or a boom. The second is the source of the money. In addition, the actions of central banks and other regulators are significant factors. In the best case, the collapse will be cleared quickly and in the worst, the consequences will be visible for decades. The more bubbles in different asset classes, the longer the footprint. Declines can be short if not all investments instruments are expensive. Therefore, the dot-com boom of the 21st century did not leave large traces in the U.S. economy as bonds and real estate were affordable.

The devastation of the banking crises caused by the big bubbles and/or booms is awful. House prices will fall by an average of 35%, stock prices by an average of 55%, GDP by an average of 9% over the next two years and unemployment will rise by an average of 7% over the next four years. Without banking crises, the devastation will be smaller on a larger scale, although stock markets, for example, may fall more. The problems without the banking crises can be repaired in a few years. The flight of foreign capital exacerbates problems if it has played a significant role. Roughly speaking, the smaller the local market, the greater the devastation that may result from the outflow of foreign capital.

The aftermath of the Japanese boom tells the harsh language of the consequences. Individual investors may never overcome their losses. The Nikkei index has not reached its previous peak of more than 30 years ago. Property prices also peaked decades ago. Even long-term index investing is not worth it when the boom overheats. The aftermath of the Japanese boom is an example of the crash of simultaneous stock and real estate booms. Not all countries will recover even in several decades. The consequences can be complete changes in societal structures such as the transition from market economies to planned ones.

Bubbles, Booms and Crashes part 4. Political factors

Political factors may include more than just politicians. These include e.g. society's attitudes towards property, other regulators and price formation mechanisms. By the first, I mean whether individual citizens or businesses have a right to their property. In socialist states, it is almost impossible for bubbles and booms to occur because the state owns everything. They may have distorted supply and demand imbalances in the form of high prices or shortages. When the state sets prices, no bubbles or booms arise. In other words, the right to private property is essential for bubbles, booms and crashes.

Politicians can decide to socialize or liberalize property rights. They can also decide how much of the revenue generated by private citizens and businesses will receive by deciding on tax rates or seizures and exemptions of property. Increasing ownership or revenue for individuals and businesses can be drivers of bubbles and booms. Reducing them can cause crashes. The former concern not only the rights of domestic operators but also foreign ones. Opportunities for action can be limited e.g. customs duties.

Politicians can decide on other regulations, such as bank solvency requirements. In addition, they decide on government indebtedness which can increase or decrease the likelihood of bubbles, booms, and collapses. More on that later. Politicians are also responsible for managing state-owned companies, facilitating, impeding or closing down private companies. The above reinforces extremes. They are rarely the decisive reasons for their emergence. They are more common as boom reinforcers, but are less used during bubbles.

Law-deciding politicians, central bankers, and other regulators are also responsible for the moral hazard strengthening bubbles and booms, with risk-takers reaping the greatest benefits while taxpayers offsetting much of the losses. The amount of insanity can multiply due to moral hazard. This can be seen e.g. guarantees provided by state-owned companies, compensation for capital required by bank losses, and other business support during collapses.

In addition, central bankers can increase money supply to support businesses or reduce their debt service costs to help businesses survive bankruptcies. For example, it is reasonable to see Alan Greenspan, initiating the current moral hazard in the United States, announcing his readiness to lower the cost of debt management for investors in the 1987 stock market crash. Since then, rescuing investors has been one of the Fed’s most significant ways to keep financial markets working. At the same time, moral decay has been created.

The role of regulators is reflected in the failure to control new investment products in bubbles and booms. New investment products increase the amount of money on the market, hiding risks. They must prevent the risks posed by complex investment products from being passed on from sellers to buyers and kept so small that they do not pose a risk to the financial markets as large losses. Complex products contain thousands of pages of information and figures. Regulators do not always know their content or risks. In other words, regulators should actually make sure that not a lot of them are put on the market. Unfortunately, this does not happen during booms except in exceptional cases.

The role of central banks in setting the price of money through changes in money supply and interest rates is undeniable, although banks can change their margins when lending money forward. There is no cheap money without low central bank interest rates or the “rumble” of the printing press. Controlling the price of money can have surprising consequences, as banks, companies that borrow money from them, and consumers can misinterpret price signals, making bubbles, booms, and crashes more likely to occur. The worst part is that they have no part in the models that central bankers use to decide the price of money.

Bubbles, Booms and Crashes part 3. Psychology

 Bubbles, booms and collapses are social epidemics and follow their principles. Epidemics have three components: the right people, the right message, and the right environment. They are influenced by several psychological factors such as social proof, authorities, scarcity principle, excess self-regard, and the illusion of availability. They increase both the attractiveness of the message and the effects of the environment on bubbles, booms and collapses. Different people have different effects on both individuals and large crowds.

The messages from the bubbles and booms are simple and engaging. They say everyone gets rich easily and quickly without much effort as long as they invest in new ideas. The message includes attractive predictions of a rise in the pattern “Bitcoin rises to $ 500,000 (now about $ 40,000)” “This time it’s different” is another message available in large-scale bubbles and booms. They often also contain a message of a carefree tomorrow and the prosperity of the nation. The message often has some truth in it, but its significance is exaggerated. The realization of the message is often far in the future, even though the masses believe in sudden enrichment and rapid change. One message is that those who do not participate in the boom are stupid.

Bubbles, booms, and crashes will not occur without massive social proof in which herd behavior is rampant. During booms, it produces a desire to buy the same investments or consume like large crowds. Crashes create a desire to sell and reduce consumption while others do the same. In them, many have to do so because they do not have enough money to consume. Roughly speaking, the closer and more people produce social proof, the more confident the individual becomes and acts like others.

Even large numbers of people can be made to act like a small number of people as long as the latter has credibility. People have an inherent belief in authority. In bubbles and booms, a small number of lucky fools can make millions while believing in the goodness of nonsensical investments because they have happened to succeed fabulously for a short time. Usually these ”authorities” tell the general public what they want to hear. They can get rewards from people like them or the media. In addition, the masses are demanding so-called anti-authorities who tell them they are wrong. They are most often people who have been enriched by the old rules and have not agreed to pay the prices produced by the bubble or boom. They are considered losers during bubbles and booms.

The scarcity principle means that the less a person has something or the harder it is to obtain it, the higher the value. In addition, it works in the other direction. The bubbles and booms in some investments have a shortage of supply relative to demand. Large-scale bubbles are mainly affected by the other side of the coin, i.e. the fact that money moves fast and enriches a large crowd. The above raises both the prices of investments and increases absurd consumption. At the same time, the real economy is growing strongly which raises the above. Too much money significantly increases stupid investment and consumption decisions.

The excessive self-regard manifests itself as excessive faith to one’s own beliefs, qualities, skills, and possessions. Faith of an increasing mass of investors strengthens with the bubble or boom to the heights rarely seen, which raises the prices of “hot” investments. At the same time, larger and larger sums of money find the above items. Faith is not even shaken by failures or losses. They are explained by bad luck or some other absurd reason, and in the worst case, the ego is further inflated. Losses and failures increase the need for investors to look for sources of information that emphasize their own beliefs and skills. One major factor in the bubbles and booms is that investments become more valuable in price as soon as they are purchased.

The excessive self-regard also increases booms and bubbles, with big money portfolio managers acting as one of the reinforcing factors. One of the truths of their work is this: "It's better to lose money like others than to do something different." Many of them protect their own jobs. This is reflected in the so-called hidden indexation of funds, where the investments of the active portfolio manager resemble the benchmark index, differing slightly from it. This also applies to other moments, but the phenomenon is at its strongest in booms due to reflexivity.

The overemphasis on egos is not limited to investors. It manifests itself in central bankers and other regulators. The majority of central bankers have had a long career believing in the theories they have learned and the models they have used. They work well most of the time while increasing regulators’ confidence in them and themselves. The performance of theories and models in the short term increases the excesses of bubbles and booms as well as the devastation resulting from crashes. It is important to ask whether the actions of central bankers and the models they use have a positive net effect?

The illusion of availability means that people give more value to stimuli that are better available. Availability can be both an external and an internal stimulus. It can be improved by an increase in the number of stimuli, recency, or characteristics. Examples of the latter are surprise, novelty, ambiguity, and threat. The illusion of availability is reinforced by the media reporting on fortunate individuals who quickly enriched and took advantage of the new message. The media is full of half-truths or misunderstandings about the basic principles of investing. The illusion of availability is at its strongest when a bubble or boom reaches euphoria. It is also strengthened by other psychological factors.

Avoiding the negative effects of the psychological factors of bubbles, booms, and collapses is not easy. There are a few good rules of thumb to reduce the effects. When you find that a security or asset class is more popular in your immediate circle than others, it is a likely sign of bubble prices. Combining the former with a new economy or investment vehicle should be seen as a bigger alarm signal. Never believe words that contain the message, “It’s different now,” whoever tells you so.

Don’t listen to people who do not have a proven track-record of investing at least a decade above the market average talking about future returns or losses, or who promise high double-digit returns on investment, even in the medium term. Their numbers in public will increase during booms and bubbles. At the same time, the number of people who are wrong is growing. During booms and bubbles, it is even more important to listen to people who have done better than average for several decades. The same is true during a crash. Also, don’t believe people who predict the “end of the world” during them.

Don’t believe yourself if you do not have a better-than-average return rate, or think you’ll be able to achieve high double-digit returns in the medium term. Don’t let your ego make you believe you are right when the price of an investment collapses well below the amount you paid. This is especially true of the losses caused by the crash. You don’t have to prove you’re right by immediately putting more money into a losing investment. This is a mistake because there is no need to quickly return an erroneous investment with the same investment target. It is safer to take a breather and think about what went wrong.

Do not look at the price of a security before making a cash flow statement. Your subconscious can steer the end result towards it when its availability is high. Do not look at the price you paid when making a new cash flow statement for your investment. Your investment does not know how much you paid. The price you pay may not matter at this time.

Bubbles/Booms and crashes part 2 Their reinforcement, and the effect of the money supply

 

Bubbles, booms and crashes reinforce themselves

The financial markets are seen to return to a so-called equilibrium quickly after they have temporarily left it. Mainstream (neoclassical) economists talk about external shocks or momentary changes created by the news that change the reality markets confront. They have a strong faith for a quick return to equilibrium that real life events do not seem to change their perception in one direction or another. Even the prior booms that offered insane prices, and the crashes that followed, have not shaken this faith. Financial markets have escaped equilibrium too far too often. The farther they escape the worse they recover without major damage. Booms and busts go too far from equilibrium and stay there too long for economists’ claims of quick returns to be true.

Exaggerations in the financial markets produce self-reinforcing prices that are too high or too low. One way to explain their reasons is George Soros’s theory of market reflexivity. In engineering terms, there is self-reinforcing feedback. The actions of market participants can be divided into two distinct parts: a situation where participants perceive a situation where they find themselves or where participants influence the situation. Reflexivity is a two-way feedback mechanism where reality shapes thinking and thinking shapes reality. The former is a chain of events where thought and reality converge but never meet. They create self-fulfilling connections that reinforce misunderstandings. Rising prices increase demand without increasing supply and falling prices increase supply without increasing demand.

Reflexivity occurs from time to time. It is important to understand it because it describes situations where misunderstandings can affect prices. Impact requires a strong two-way interaction between participants and the market, reinforcing misunderstandings that become the prevailing reality. Developments that move beyond the market equilibrium have limits. Eventually, the power of change will prove unsustainable and return the market to equilibrium with a self-reinforcing development. Reflexivity moves prices in both directions. Prices may go far below equilibrium. It rarely happens without exorbitant prices.

Effect of the money supply

It is logical that bubbles and booms require an increase in the supply of money in the market and crashes require a decrease in the supply. The above is easy to see by looking at historical statistics on money supply. There are significant differences between the bubbles and normal market fluctuations. The amount of money can rise by tens of percent in a few years. At best, they do the same thing every year. By monitoring the money supply, you can get a better picture of the magnitude of the boom and the duration of its aftermath. Following it, the outbreak of the boom can only be timed afterwards because it is only one factor in a bubble.

The majority of the increase in supply comes from the increase in debt. The increase in volume is influenced by e.g. the price and the amounts and values ​​of the securities required. As the price decreases, demand increases, increasing the money supply, and as it increases, it decreases, while the supply of money is the same. A reduction in the required collateral increases the amount of debt like increases in value. An increase in collateral reduces the amount of debt, such as write-downs. The amount of debt increases the most as prices fall, the amount of collateral required decreases and values rise. The biggest bubbles and booms arise from the self-reinforcing spiral of the previous interaction.

The worst collapses occur when the combined effect of the above raises the amount of debt to unsustainable levels, causing an inverse, self-reinforcing phenomenon in which the amount of debt decreases, additional collateral is required and the value of collateral decreases. The situation is rapidly getting worse. More on these mechanisms can be found in the chapter on the long debt cycle. By monitoring the supply of money, it is not possible to accurately assess the likelihood of a bubble. By only following it, it is not possible to assess whether a crash will occur. Without a sufficient increase in money supply, there will be no booms and the supply of money will almost never be reduced so much that there would be collapses without bubbles.

The amount of money can grow unmanageable, both on its own and with foreign aid. In the first case, government finances need to be large enough for money to grow without a significant weakening of the currency. Examples of the former are the real estate bubbles of the current century in China and the United States. One of the hallmarks of the latter is the massive cash flows from abroad that strengthen the domestic currency. The Asian economic boom of the 1990s is a good example.