Skimming the surface of bubbles

Bubbles are big news in financial markets. The sharp stockmarket falls from 2000 onwards have drawn public attention to the danger of inflated asset prices. More recently, anxiety about the prospect of falling house prices has unnerved an even bigger section of the population.

For these reasons alone, Bubbles and How to Survive Them (Nicholas Brealey, 2004) is worth a read. John Calverley, chief economist and strategist at American Express Bank, has produced a lucid account of the conventional discussion of bubbles.

Calverley’s study is divided into three main parts. The first concentrates on three of the largest bubbles in history and their aftermath: the Great Depression of the 1930s, Japan’s deflation of the 1990s and the more recent “Greenspan bubble”. The second part is an examination of the dangers of a housing market crash in Britain and beyond. Finally, Calverley discusses the theory on bubbles and proposes some strategies, for both policymakers and investors, on dealing with them.

To his credit, Calverley avoids some of the obvious pitfalls into which those writing on the subject often fall. Most important, he does not confuse an association with a cause; for instance, the fact that financial crises often coincide with economic downturns does not necessarily mean that one causes the other. Nor does it follow that the 1929 Wall Street crash caused the Great Depression of the 1930s simply because it preceded it.

The weakness of the book is its conventional approach to the subject, for the orthodox view of finance suffers from two related problems. The first is what could be called the fetishisation of finance. In other words, finance is seen as an autonomous power on its own – largely separate from developments in the real economy.

Such a separation is typical of the contemporary discussion of finance. There is a huge amount of debate on such factors as asset prices, inflation and interest rates, but little on how these relate to such factors in the real economy as productivity or profitability.

The discussion of bubbles, too, is typically framed in narrow financial terms rather than their relationship to real economic developments. From such a narrow perspective, diverse historical experiences – such as tulip mania in Holland in the 1630s, the South Sea bubble in London in 1720 and the Wall Street crash of 1929 – tend to be lumped together.

At best, such discussions can provide a description rather than an explanation of bubbles. For example, Calverley recounts a typical typology of bubbles, from displacement (an external event) to euphoria or mania, to revulsion, to panic. But description is not the same as explanation: to understand each bubble requires an examination of the specific circumstances in which it arises. So the 1929 bubble was a classic symptom of falling profitability, with companies channelling surplus capital into the stockmarket rather than reinvesting productively. In contrast, the recent US bubble was influenced more by factors such as the intense mood of risk-aversion in the markets.

The problem most authorities have with an approach that links finance to the economy is that the relationship between the two is indirect. It is not the case that a strong economy necessarily means there is a vibrant stockmarket – indeed, the opposite has often proved the case. Historically, the rapid growth of financial markets has often coincided with a relative slowdown in the tempo of economic activity.

Examining each bubble properly means looking at how it relates to broader developments in society, including key economic trends and other political as well as social developments. Such an approach is not easy, but it is necessary if the real character of each bubble is to be understood.

The second weakness in Calverley’s approach, which he shares with almost all of today’s authorities, is its narrow perspective. For Calverley’s take on bubbles is essentially a generalisation from the perspective of the individual investor. His understanding of the markets is a developed version of how it appears to members of the investing public.

Such a criticism might appear odd to fund strategists, for those in the investment business are naturally concerned with what developments in the financial markets mean for them and their clients. But it is important to recognise the key distinction between how things appear and their real nature.

For everyday purposes, a superficial understanding of bubbles may be sufficient. But to develop a proper scientific understanding of bubbles involves much theoretical untangling to separate appearance from reality.

The narrow perspective of financial economics is closely related to the fetishisation of finance. The private investor is naturally struck by the obvious symptoms of financial instability, such as volatile asset prices or sharp changes in interest rates. He does not directly experience such key economic factors as profit rates or productivity levels.

All the principal strands of financial economics suffer from this limited outlook. Though there are often heated arguments between the main schools, the similarities between them are more important than the differences. As Calverley clearly recounts, the most influential school of financial economics is efficient markets theory. In its strongest form, this holds that markets are always right. There are no such things as bubbles because the markets always accurately reflect the information available at any given time.

Most proponents of efficient markets theory do not go quite so far. Instead, they insist that the market is generally composed of rational individuals – although, for various reasons, bubbles can develop. In contrast, the advocates of behavioural finance – the application of psychological theories to the financial markets – argue that investors are often irrational. Financial theory should, in their view, incorporate assumptions about the psychology of investors.

It is easy to see why behavioural finance has gained ground in recent years – to the extent that some of its advocates have won Nobel prizes in economics. The difficulty that efficient markets theorists have in accounting for bubbles has increased support for those who argue that individual investors are essentially irrational.

Ultimately, though, the approaches of both efficient markets advocates and behavioural finance supporters are unsatisfactory. At best, both are descriptive rather than explanatory; neither is capable of providing an adequate account of financial markets in general or the phenomenon of bubbles in particular.

DANIEL BEN-AMI
Fund Strategy editor