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.