The brave new world of finance-14: The next bubble?

(For previous posts in this series, see here.)

In this final post in this series, I want to look at what might be the next bubble looming on the horizon.

In his article The next bubble: Priming the markets for tomorrow’s big crash (Harper’s Magazine, February 2008) Eric Janszen says that the total value of real estate, if priced according to historical growth rates, should be about twelve trillion dollars. But the real estate boom drove the prices up to about double that, to twenty four trillion. If this is truly a bubble phenomenon and real estate values drop to what they should be historically or even below, suddenly twelve trillion dollars worth of assets would have essentially vanished into thin air.

It may not be that catastrophic. As has been pointed out elsewhere, real estate prices have not dropped that precipitously as yet (and in some areas of the country have not dropped at all) and some are speculating that it won’t. Such people argue that while prices have declined from the peak, that it has now reached a new equilibrium and will not sink further. I think we won’t know for sure which is the case for a couple of years, until all the dust settles from the subprime crisis and all the losses have been tallied. At present, there is considerable guesswork as to the full extent of the losses, both real and potential.

But there is a serious danger that the subprime losses can trigger a recession or even a depression and both the government and the business sectors are trying to find ways to stave it off.

Janszen argues that to make up for the losses generated by the subprime crisis, the financial sector is already gearing up to generate, and thus benefit from, the next bubble sector. What area of business would make a good candidate for the next bubble? Based on recent history, Janszen says that it has to meet certain criteria:

We have learned that the industry in any given bubble must support hundreds or thousands of separate firms financed not by billions but trillions of dollars in new securities that Wall Street will create and sell. Like housing in the late 1990s, this sector of the economy must already be formed and growing even as the previous bubble deflates. For those investing in that sector, legislation guaranteeing favorable tax treatment, along with other protections and advantages for investors, should already be in place or under review. Finally, the industry must be popular, its name on the lips of government policymakers and journalists. It should be familiar to those who watch television news or read newspapers.

He looks at various possible candidates for the next bubble, such as the health care, pharmaceutical, and biotechnology industries, and finds each one problematic for various reasons. He thinks that the only sector that meets all the criteria is alternative energy, because it is one of the few sectors big enough to serve the purpose. He thinks that this is already in the process of being “branded” as the next big thing.

Riding the wave of the environmental movement and people’s concern about the future of the globe, he says we are going to see immense investment by the government in alternative energy sources (nuclear, hydrogen, geothermal, solar, hydrogen, ethanol), not because of any deep environmental concerns, but because it will enable the government to subsidize the energy industry by the tens of trillions of dollars necessary to make up for the disappearance of the assets incurred by the collapse of the real estate bubble.

He predicts that we will soon start seeing highly increased hype for various forms of alternative energy and companies that deal in them will start going public, issuing stock and cashing in on the hyped-up interest in this area, just the way internet startups did a few years ago. Janszen also points out that Al Gore has joined the big venture capital firm of Kleiner, Perkins, Caulfied & Byers that was involved in the IPOs of Google and Amazon. Thus despite the initial skepticism Gore received from traditional business and media when he raised the alarm about global warming, he may turn out to be useful to them as the poster boy for the new alternative energy bubble. Joshua Frank also raises questions about the support that the energy industry (including nuclear and coal) are giving Obama and what they might be expecting in return.

I must say that initially I was skeptical about Janszen’s fingering of alternative energy as the next bubble but more recently I have seen disturbing reports that he may be on to something. President Bush, John McCain and Congressional Republicans are now talking enthusiastically about the virtues of alternative energy and green technologies, even while ridiculing the notion of global warming and strongly resisting efforts at conservation. President Bush, for example, now talks up hydrogen-powered cars and solar and wind power as the way of the future, even as he opposes far more direct energy conserving measures such as raising fuel efficiency standards for cars and trucks.

Like many other people, I am very worried about the long-term health of the planet and in favor of reducing our consumption of all resources, including oil. One has the sense that the tide is turning on this issue, that more and more people are beginning to think that we cannot go on consuming resources at the current rate. It is very disturbing to think that the government-industry-Wall Street complex will hijack the general public’s very real concern and cynically use it to siphon yet more vast amounts of public money into the hands of private investors and speculators, the way people’s support for home ownership was used to pump up the profits of those financial institutions involved with real estate.

The next president will play an important role in determining whether we have real conservation efforts or are merely going to create an alternative energy bubble, and we clearly need to watch developments carefully.

POST SCRIPT: Will Tim Russert denounce and reject his ties to Stalin?

Yesterday, I wrote about Tim Russert’s appalling performance as moderator of Tuesday’s debate. General J. C. Christian is worried about what might happen if Tim Russert’s tortured logic in linking Obama to Farrakhan is applied to Russert himself.

The brave new world of finance-13: The new bubble cycle

(For previous posts in this series, see here.)

Karl Marx famously argued that capitalism, while being remarkably resilient in overcoming problems and capable of releasing enormous productive capabilities, also carries within itself the seeds of its own eventual destruction because of its incapacity to accept an equilibrium state. Capitalism requires that companies have to push for continuous expansion and growth and this leads to the creation of monopolies and instabilities that inevitably result in crashes. I never quite understood that aspect of the Marxist critique of capitalism. After all, why couldn’t a company, once it had developed a good product and business model, just continue to plug away at a steady rate of manufacture and sales and profits? Why did it need to grow and expand in size in order to survive? I know that it cannot simply stay the same since developments and competitors will leave it behind. I can understand the need to improve products, even change the product line, and increase efficiency. But why must there also be an imperative to increase market share and profit margins, which often means that one must take actions that are harmful in the long run? Is it caused by simple greed? It seems to be too simplistic to ascribe human emotions as drivers of macro-economic behavior.
[Read more…]

The brave new world of finance-12: The consequences of the primacy of shareholders

(For previous posts in this series, see here.)

As I discussed in the previous post, the instability caused by shareholder demands for steadily increasing rates of return infects every area of business for the worse. Furthermore, the law requires of management that businesses be run purely for the benefit of its stockholders. While this is meant to prevent management from acting negligently or even fraudulently to enrich themselves, it also has the effect that even an enlightened management has to be very careful about taking measures that are (say) motivated by concern for the environment or by the needs of its employees or the community in which the business is situated. Unless those actions can also be justified as leading to greater stockholder value, the stockholders have a legal right to accuse the management of acting illegally and to sue to demand changes.
[Read more…]

The brave new world of finance-11: The changing emphasis of business

(For previous posts in this series, see here.)

The problem with the modern business world, as I see it, is that it is no longer enough that a company be successful in the traditional sense of steadily producing revenues in excess of expenditures. That model of a successful business is considered hopeless naïve these days. What investors want is not steady profits but a steadily increasing rate of return on investments and this is leading to chronic instability.

Let me give an example. Suppose I start a business that returns a 20% profit on my investment. That is a nice return, allowing me to provide good salary and benefits to employees, reinvest something in the company to improve the product, expand and improve the product, and so on. You would think that if I could continue to produce roughly 20% profits every year, I would be having a good company. After all, I am employing people, producing useful things, and making a reasonable amount of money. And as long as the company is privately owned by me, that might be true.
[Read more…]

The brave new world of finance-10: Who’s to blame?

(For previous posts in this series, see here.)

As is typical with bubbles, people involved at all levels of the subprime mortgage debacle seemed to deliberately shut their eyes to any negative information, as if they thought that wishing things were just peachy would make it so. As long as nobody looked too closely at the structure, no one would notice that it was a house of cards, and the good times would continue forever. But they never do. The house of cards always collapses.

(Some observers have pointed out that it may not be completely accurate to call the current subprime crisis a bubble. In classic bubbles, the prices of the commodity fall precipitously to their pre-bubble values or even below. This has not happened yet with home prices but the crisis is not yet over. The behavior of the principal characters in this drama, however, exhibit all the qualities of those involved in previous bubbles.)

Who is to blame for this situation? To be sure, there is enough blame to go around.

It is true that some of the homebuyers were outright dishonest, colluding with brokers to fake documents and income in order to pass a cursory scrutiny before getting the money to buy houses they could not afford. And it is true that some of these homebuyers acted with almost unbelievable ignorance and even stupidity about what they were getting into when they signed the papers to buy their homes. The Cleveland Plain Dealer had an excellent series on the foreclosure crisis by Phillip Morris and one story featured a man with a well-paying job who lost his home because he did not keep up with his $1,200 monthly mortgage payments. Meanwhile he was spending $40 a day on the lottery, hoping to strike it rich!

But apart from the criminal and the almost criminally stupid, it is true that many people buying homes in these go-go times should have suspected that things were too good to be true, that it was unlikely that many of them could actually afford the houses they bought. And yet, the dream of owning their very own home for the first time must have been powerful enough that they were willing to believe the promises of brokers and bankers, who were merely using them to enrich themselves. We also live in a time when people are told that living beyond their means, spending money they might not have ‘stimulates the economy’ and is thus a good thing.

We now see a backlash, with some policymakers blaming these buyers for the mess they find themselves in. But apart from those who willingly participated in fraud, such attacks are unfair. Buying a house is an enormously complicated affair, beyond the comprehension of most people. Although I am fairly literate and numerate and reasonably savvy regarding personal finance, I recall being overwhelmed by all the legalistic documents that we had to sign when we bought our house. I could understand the key points, but there were pages and pages of detailed jargon that we were assured were standard boilerplate language. I recall thinking how easy it would be to be swindled by the bankers and other people involved in the process. I had to trust that they were acting in good faith. Has it come to a point where we each have to have a lawyer and accountant with us when we enter into any reasonably major transaction?

Homebuyers are largely dependent on the honesty of the professionals who they think are acting on their behalf. As Duncan Black (aka blogger ‘Atrios’) says:

The inability of the Republican lizard brains to even fake the slightest bit of empathy or sympathy for those experience economic troubles, or in fact to even restrain from outright hostility, is rather fascinating.

That isn’t to say all of those in foreclosures are victims. But there were a lot of people ripped off by mortgage brokers they thought were acting in their interests who instead were pushing them into crappier loans for bigger commissions. When you hire someone whose job you think it is to get you the best loan possible, and their incentives are actually to get you the shittiest loan possible and you are unaware of that fact, there’s a wee bit of a problem in the system.

But there were also more sophisticated buyers who were well aware that their mortgage interest rates would soon go up but did not care. They were those who believed in the ‘greater fool‘ theory and saw themselves as smart investors who were planning to sell their property for a tidy profit before the rates rose. And as long as the prices kept going up and demand was high, that strategy would have worked. But as the subprime crisis unraveled and the number of foreclosed houses started shooting up, there was a glut in the market, buyers became more fearful and choosy, and prices started dropping and even the richer, more sophisticated buyers found themselves stuck with properties they did not want. It was cheaper for them to cut their losses and to walk away from their property than to sell it for a huge loss. This constitutes another wave of abandoned home foreclosures.

Sadly, the end is not yet near for this crisis. 2008 will be another year in which many initially low-interest teaser adjustable mortgage rates will rise, leading to another wave of foreclosures due to people’s monthly payments rising above what they can afford. About 1.6 million homes were foreclosed last year and this year is expected to bring a similar number. The government and a consortium of six major banks involved in the subprime market announced a plan called Project Lifeline to give homeowners facing foreclosure thirty days more to try and refinance their homes so that they can afford them, but it is not clear if this will work. There are strong fears that this is inadequate.

Next: How did things get this way?

POST SCRIPT: Hype in sports

David Mitchell (one partner of That Mitchell and Webb Look) makes fun of the nonstop breathless hype by sports announcers, where every upcoming game is made to sound momentous. Here he is talking about English football (‘soccer’ in the US).

The brave new world of finance-9: Two case studies of destroyed communties

(For previous posts in this series, see here.)

Up to now, I have been looking somewhat generally at the problems created by the collapse of the subprime mortgage market: how the problem was created and the scale of the problem. But to really appreciate how it worked and its impact on actual people, one can look at two case studies, in Stockton, CA and Cleveland, OH.

CBS’s 60 Minutes had a report on the community in Stockton that showed how the pyramid scheme worked:

Most of the mortgages issued in Stockton, and half of those now in default or foreclosure, were something called subprime loans, meaning less than prime quality. The borrowers often had sketchy credit, were financially strapped or lacked sufficient income to qualify for a standard mortgage. After a year of artificially low payments, the interest rates on subprime loans jumped all the way to ten or 11 percent.

And yet, these loans were marketed aggressively. As Jim Grant, a leading expert on credit markets said: “When you opened your mailbox in 2004, 2005, you could barely — people were pressing on you, if you were not institutionalized, all matters of schemes in which to expand your personal debt and mortgage debt. You could, and people did, borrow more than 100 percent of the price of a house with the most fragile of financial bonafides.” Little or no attempt was made to verify ability to pay.

Grant calls it an invitation to fraud. “You apply to a bank, or a mortgage broker for a loan. And you would fill out a form. And you would say, ‘I have an income of, oh, $400,000 a year.’ They say, ‘You do? Fine. Just sign right there.’ And they would nod, and because they were being paid, not by the veracity of the information, but by the consummation of the deal. The lending office would say, ‘Ah. You have verified this?’ ‘Why, yes, we have.’ And the lending officer would say, ‘Great. So do I,'”

Almost all of the people involved in the transactions made good money, then passed the risk onto someone else. Instead of keeping the dicey loans in their own portfolios, the big banks and giant mortgage companies that originally underwrote them, resold the mortgages to big New York investment houses.

Firms like Bear Stearns and Merrill Lynch sliced the loans into little pieces and packaged them up with other investments, then sold them to their best customers around the world as high-yield mortgage-backed securities, turning sows’ ears into silk purses, all with the blessing of rating agencies like Standard & Poor’s.

“At every step in the way, somebody has his or her hand out, getting paid. And everyone, for the time, is happy. The broker got paid. He or she was happy. The lending officer, ditto. The rating agencies got paid for passing judgment on these securities. They, too, were pleased, and their stockholders were happy. And on and on. And it would never end, except that it did,” Grant says.

It was all predicated on the idea that real estate prices would keep going up, and up and up, and for a long time they did. But by the summer of 2005, speculators flipping houses in Stockton had helped drive the price of that four-bedroom house to more than $400,000 and the market began to soften, then to tumble.

All of a sudden those subprime borrowers who had taken the free money found themselves upside down, owing more on their new house than it was worth.

Some unsophisticated buyers actually wanted to live in the houses they bought but did not realize that after a year or two the monthly payments would skyrocket out of their range. They consist one group of defaulters, and these people are overwhelmingly low-income or middle class. Cleveland’s Mount Union neighborhood was one such community hard hit by these dreams destroyed, as this news report describes:

The streets are empty. Trash rustles down the road past rusted barbecues, abandoned furniture, sagging homes and gardens turned to weed.

This is Mount Pleasant, a neighborhood in southeastern Cleveland ravaged by the subprime mortgage crisis roiling the United States.

Faded “for sale” signs sit in front of deserted houses. The residents are gone, most after being evicted for missing their mortgage payments.

For county treasurer Jim Rokakis, the greed of the banks is to blame for this man-made disaster.

“All you needed was a pulse to buy a house. Some loans were written with no money down, no proof of buyer’s incomes. They did not even check what people were saying. Most of those folks were jobless,” he said in an interview.

The Mount Pleasant community, he said, “was the perfect storm: poor folks, unemployed and a desire to get a piece of the American Dream.”

I have shown this clip by comedians John Bird and John Fortune on the subprime mortgage crisis some months before, but it is worth seeing again because it captures precisely the way the crisis occurred, the cavalier attitude of the banking and financial sectors to the way they used other people’s money, and how the whole house of cards was built on illusion and hype.

Next: Assigning blame

POST SCRIPT: Causing and taking offense

Bill Maher explains why he is not afraid of offending religious sensibilities.

The brave new world of finance-8: The end of the housing dream

(For previous posts in this series, see here.)

The real estate boom fueled by the easy availability of subprime mortgages was a classic pyramid phenomenon, entirely dependent like all such phenomena on an endless stream of new buyers coming along willing to pay the inflated prices. When the crash came, as it inevitably does with all schemes that are based on expectations of permanent and rapid price increases, it turned out to be financially advantageous for many people who had taken these loans to declare bankruptcy and simply abandon their homes and walk away, since the money they owed was often more than the house was worth. Some became homeless as a result, but others who had bought these properties more as investment vehicles did not fare too badly. Many had put no money of their own as down payment so they had essentially rented the houses for a few years, often at below market rates.
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The brave new world of finance-7: The subprime mortgage debacle

(For previous posts in this series, see here.)

The current so-called subprime mortgage crisis is a result of a real estate boom fueled by a combination by ignorance, greed, lax standards and oversight, and outright criminality.

Unlike art or precious stones, in the case of a house, the value can be determined within a fairly narrow range. Knowing the neighborhood, the size and state of repair of the house, historical pricing patterns, etc., one can assess the value of a house fairly accurately. Barring sudden unforeseen events such as finding oil on the property or the discovery that some major new construction is going to occur nearby, or that the house has been built on a toxic waste site, the price of property tends to be fairly stable and predictable.

When it used to be the case that the banks that loaned you the money to buy a house held on to the mortgage themselves, there were built-in checks and balances to prevent the unrealistic pricing of homes. After all, foreclosing and selling a house is a costly and tedious business that banks would like to avoid, so it was in their own interest to ensure that the buyer could afford the house so that default was highly unlikely. It was also in the bank’s interest that the house was being bought at a reasonable price, with a down payment, so that the bank was lending substantially less money than the house was worth so that they could sell it easily in the unlikely event of a default. That was indeed the case when we bought our own house nearly twenty years ago. There were careful checks of the title to make sure the ownership was not challenged, a valuation of the home by an independent appraiser to make sure we were not paying too much, and we had to demonstrate, using tax returns and the like, that we had the steady income that we claimed we had and that it was sufficient to pay the mortgage. The fixed-rate mortgage payments themselves were high enough so that they covered the interest and also part of the principal, so that the money we owed the bank steadily decreased over the time of the loan.

But those days are long gone. Now the banks that loan you the money to buy your house resell your mortgage within days in the secondary market. Since the banks that initially provide the money for the house purchase do not hold on to the mortgage but quickly sell them, this does not require them to look too carefully into what they are financing. Indeed it is better not to do so at all, since the banks make their money at the point of transaction, so that the more mortgages that pass through their hands, the more money they make. This lack of close scrutiny also encourages the emergence of unscrupulous mortgage brokers who make their living on the basis of the number and value of the mortgages they broker between buyer and bank. Hence it is in their interest to obtain as many mortgages as possible for as high a value as possible. This encourages them to inflate the prices of the houses being bought and sold (in which they are aided by appraiser accomplices) and to inflate the incomes of the buyers so that they become eligible.

In order to make even more buyers eligible, buyers with poor credit histories (i.e., those labeled ‘subprime’) were also offered adjustable rate mortgages with no down payment and low teaser interest rates for the first few years so that they could afford the payments, at least initially. Furthermore, they were offered mortgage deals in which the monthly payments were interest only (in which case the money owed never decreased) or, incredibly, did not cover even the interest, so that as time went by the borrower owed more money, not less. The net result of the latter practice was that the value of the mortgage often exceeded the value of the house by substantial amounts.

Why would buyers accept such terms? These practices enabled them to afford to live in a more expensive house than was otherwise possible for the few years during the initial low-interest period and they thought they could sell and move on before the higher rates kicked it. Those who hoped to make the house their permanent home could hope that they would be either earning more money in the future to make the higher payments affordable or were told that they could refinance to a fixed rate mortgage at better rates in a year or two, before the low initial interest rates ended.

As a result of all these dubious lending practices, more people became ‘eligible’ to buy more expensive homes and home prices naturally started going up as a result of the increased demand for them. As long as the real estate market was booming and prices were rising, overextended buyers felt they always had the option of selling the home at a higher price than what they bought it for, thus paying off the mortgage loan with a tidy profit left over. Everyone would be happy. As a result, no one was looking very closely at the underlying value of the properties. There was no incentive to do so, and in fact it was discouraged. Why do that and destroy the dream?

Next: The end of the dream

POST SCRIPT: Lewis Black gives TV executives some good advice

The brave new world of finance-6: Greed and bubbles

(For previous posts in this series, see here.)

One can never underestimate how the power of greed, the thought of making a lot of money quickly, can cause otherwise rational people to lose their senses. A friend of mine works for the white collar crime division of the Cleveland police and he can tell story after story of sensible middle-class or wealthy people, the kinds who could be your neighbors, who are professionals and cautious in most of their dealings, becoming the victims of some racket run by charming men and women. These people often did not even need the money they thought they would quickly make. In each case, it was greed that overcame their judgment, coupled with the desire to feel that they too are smart investors with access to valuable information that the general public did not know. Conmen and conwomen know exactly how to prey on such people.

Greed is also what fuels bubbles. The so-called ‘dot com’ craze of the late 1990s is within recent memory of most of us, where privately-held internet companies would go public and sell stocks, whose values would then skyrocket literally overnight. Initially some people made a lot of money and this soon attracted more naïve investors who assumed that the good times would always last. But they never do and in 2000 the inevitable crash came, wiping out nearly 80% of the paper value of people’s investments.

While most of us are not the kinds of financial high rollers who get invited to participate in such IPOs (Initial Public Offerings), it is easy to get sucked in by the general enthusiasm and try and get in the game later, when the savvy investors have already made most of the money to be made. It may be hard for us to comprehend how people could get so unhinged that they forget the basic rules of investment and fall prey to speculation. But I can see how other naive people like me could easily get sucked in and invest their savings thinking that there was easy money to be made.

As economist Burton Malkiel says in his chapter on bubbles in his book A Random Walk Down Wall Street (1999):

Not all investors in the bubble companies believed in the feasibility of the schemes to which they subscribed. People were “too sensible” for that. They did believe, however, in the “greater fool” theory – that prices would rise, that buyers would be found, and that they would make money. Thus, most investors considered their actions the height of rationality as, at least for a while, they could sell their shares at a premium in the “after market,” that is, the trading market in the shares after their initial issue. (p. 43)
. . .
The consistent losers in the market, from my personal experience, are those who are unable to resist being swept up in some kind of tulip-bulb craze. It is not hard, really, to make money in the market. . .What is hard to avoid is the alluring temptation to throw your money away on short get-rich-quick speculative binges. (p. 53)

During the dot-com boom in the late 1990s, I would read almost every day of yet another internet company that would have an initial release of stock and of those who bought them finding their investment doubling or tripling within days. Even I had the vague feeling that by not participating in this boom, that I was somehow losing out, that I was falling behind by standing still. I felt a tug, a temptation to ‘get in the game’. But I did not actually invest during the dot-com boom because not only do I not understand the stock market, I do not even like the principles on which it works, where bad news for ordinary people seems to mean good news for investors.

For example, I recall the day in July 2005 when terrorists struck the London underground trains, killing many people and causing panic in the financial markets. Brit Hume of Fox News said that when he heard the news, the first thing the occurred to him was that it would be a good day to invest in the stock market, to take advantage of the sudden drop in stock prices due to the tragedy. I was stunned by that shameless display of callousness and greed. I simply cannot imagine thinking like that, to eagerly look forward to tragedy and disaster as opportunities for making money. It seems ghoulish to take advantage, however indirectly, of the misfortunes of others. And so I cannot bring myself to directly ‘play the market’, as they say, although my retirement accounts are presumably being invested by someone who is playing such games, so my hands are by no means clean.

But it is not only big investors who can fall prey to that kind of hype. If you find it hard to imagine that normally level-headed people could go nuts over things like tulip bulbs, recall the idiotic Beanie Baby craze of the 1990s. The prices of those cheaply made and nondescript toys started rising insanely as certain of those stuffed animals, sometimes for no discernible reason other than a rumor that they would become scarce, suddenly became highly sought after items. Ordinary people started lining up at stores on rumors of their availability and started paying far more than what they could afford for things that they thought would become collectors’ items. The idea of an everyday item (a small, mass produced, cheaply made stuffed toy!) becoming a valuable investment vehicle was bizarre. This was such an obvious mass hallucination that I could not believe it was happening before my very eyes. Clearly reality had to prevail at some point and that bubble also crashed, leaving some people with huge quantities of Beanie Babies that they could not sell at even the list prices.

But while the Beanie Baby example was illustrative in the way it caused some people to spend more money than they could afford, it has had nowhere near the devastating impact that the current sub-prime mortgage bubble debacle has spawned. Once again, as with the tulip bulbs or Beanie Babies or the earlier dot-com bubble, the problem begins when the price of an item gets divorced from reality.

Next: The subprime mortgage bubble.

POST SCRIPT: Ricky Gervais in Extras

Comedian Ricky Gervais, who created the original The Office, has a new comedy series called Extras, where he works as an extra and tries desperately to ingratiate himself with the stars in order to get a break or at least a speaking role. This gives the show the chance to have famous actors as guests for each episode.

In this scene, we see him with Patrick Stewart.

The brave new world of finance-5: Crystal ball economics and the rise of bubbles

(For previous posts in this series, see here.)

My first real awareness that my understanding of what constituted sound economics and business practices was orthogonal to how Wall Street viewed it came in the 1990s when company after company sought to increase its stock price by slashing its work force, thus increasing its profits (at least in the short term). I recall that the head of Eastman Kodak at that time fought this expectation that he too follow suit. His argument was simple: His company made products that were in demand, was price competitive, and was making good profits. Why should he get rid of good, loyal, experienced workers, the very people who had made the company successful, for no good business reason but merely to drive up the stock price? I thought he made complete sense, which just shows how much I knew. Outraged stockholders quickly organized his ouster and replaced him with a new CEO who did what they wanted, which was to ruthlessly reduce the payroll, in the process throwing tens of thousands of people out of work. But those actions did drive up profits in the short term, and the stock price rose, which is all that Wall Street cares about. The fate of the Kodak CEO was a warning to other CEOs that they had better not even think about putting the long-term health of the company or its employees above the short-term profit needs of the stockholders.

What seems to have happened that is driving this trend is that the line between appearance and reality in the financial sector has become increasingly blurred. For example, it seems to me that a company’s stock price should reflect its actual performance. So when it releases its annual report that says how well it did the previous year, its stock should rise if the report is good and fall if the report is bad. But that is not the way it works anymore. We are told sagely by analysts that what Wall Street cares about is not the data-based present (what some of us like to call ‘reality’) but expectations for the future. The measure that is used to determine stock price is how the report compares with what ‘experts’ and ‘analysts’ predicted it would say. What determines a stock price now is what analysts expect will be its profits in the future. We have moved from reality-based economics to crystal ball economics.

And therein lies the problem. It seems to me that the more one is separated from actual data, the more shaky the structure becomes. Once you shift the focus away from actual data to predictions about what future data will be, you have started playing a different game, that of appearance and expectations, and this can swiftly spiral out of control, where prices can start to rise based on unrealistic expectations, and then the rise itself seems to retroactively give substance to the expectations, which in turn fuels expectations of even greater rises, which causes even greater price rises, and so on. In short order, one has an accelerating price spiral where the relation of the price to the actual value of the commodity has been severed.

In some cases, fixing the actual value of a commodity is not easy and the price does become the value. This is true where rarity is an important factor is setting the price, such as in gold and precious stones. Art is another such commodity. Clearly the value of a painting by Rembrandt is not based on the raw materials used and the hours he put into its creation.

But apart from such specialized situations, in most situations we do have a rough idea of how much something should rationally be priced at based on some measure of underlying value, such as the cost of raw materials and labor, the cost of similar items in the market, and historical price patterns. When the prices of such things start outstripping the underlying value by wide margins, then we are heading for trouble because of the creation of ‘bubbles’. As Eric Janszen defines it in the February 2008 issue of Harper’s Magazine (p. 39): “A financial bubble is a market aberration manufactured by government, finance, and industry, a shared speculative hallucination and then a crash, followed by depression. . .A better, if ungainly, descriptor would be “asset-price hyperinflation” – the huge spike in asset prices that results from a perverse self-reinforcing belief system, a fog that clouds the judgment of all but the most aware participants in the market. Asset hyperinflation starts at a certain stage of market development under just the right conditions. The bubble is the result of that financial madness, seen only when the fog rolls away.”

The most famous historical example of a bubble (perhaps because it seems so extreme now) was the tulip bulb craze of 1636 where the price of tulip bulb ‘futures’ (i.e., the price expected in the future) skyrocketed, with reports of a single bulb selling for as much as a fashionable house and garden in Amsterdam! The problem with such bubbles is that they are like a Ponzi scheme in which the really savvy investors who get in early make a lot of money. The later people make money only as long as the prices keep rising rapidly because of the arrival of new investors (also known as ‘suckers’) willing to buy at inflated prices, thinking that prices will continue to rise. The need to maintain the illusion of unstoppable growth makes people reluctant to prick the bubble by bringing it into contact with reality, by asking awkward questions about the actual value of the commodities being bought and sold. But of course, rapid price increases are unsustainable and it is only a matter of time before the madness passes. In the tulip bulb bubble, by 1637 people started realizing that these tulip bulb prices were unrealistic and that they had been had. The tulip bulb market then came crashing to the ground, and people left holding these future contracts took a devastating financial hit.

The South Sea bubble that crashed in 1720 was another example of where stock prices rose wildly, and the rise itself fueled expectations of future rises, thus leading to an out-of-control spiral, again followed by a crash.

The Florida real estate boom and bust of 1926 was yet another example of a bubble where land prices sometimes quadrupled in a single year, driven up by speculators and naïve investors who felt that the only way prices could go was up and were thus willing to pay almost anything thinking they could make a future profit.

Next: More recent bubbles

POST SCRIPT: Mythbusting the Canadian health care system

One of the big propaganda efforts in the US has been the way the Canadian single payer health care system is falsely denigrated in order to perpetuate the lie that the US has the Best Health Care System in the World, when in actual fact it is bloated, expensive, wasteful, inefficient, inadequate, and corrupt. (See here for a series of posts on health care.)

Here is the first part of a series that combats the myths about the Canadian system.