Monday, August 24, 2009

A Few Words On Market Manias

David Warsh is giving economic advice to the Queen of England on how to avoid bubbles and financial panics in the future.

The disarming question you asked when you visited the London School of Economics last autumn – why did nobody notice that the credit crunch was on its way? – produced a thoughtful letter from the various authorities who gathered recently at the British Academy to ponder and draft a measured answer.

A panel of economists, regulators, market participants and journalists examined the usual suspects among the leading causes – global imbalances, technological optimism, deregulatory zeal, euphoria and hubris – and concluded that overspecialization among experts was the real culprit. The unanticipated virulence of the crisis derived from “the failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole.”
So what is my take? The short answer is that high profits are to blame. Let me explain.

It all starts with "expected future value" or "expected future profits".

And it doesn't require a central bank pumping the money supply. A high rate of profit that releases sufficient capital will suffice. We have had a 30 year run of that with microprocessor/electronics technology.

So where did we go wrong? Not enough investment in research. i.e. not enough good new ideas to absorb the generated capital. Compared to the losses we are currently sustaining research is very cheap. The difficulty is that it requires a LOT of brainpower. And there is never enough to go around. And way too much is going into banking and marketing (it is where the money is) and not enough into sciences and engineering.

In other words - we don't apply the right valuation to our overall situation. Hence - financial bubbles vs technological bubbles. Financial bubbles are looting. Technological bubbles are foundations for the future (the dot com bust left us with infrastructure - which when marked to market led to the current communications boom).

Here are a few books on the subject that might be of some use:

Knowledge and the Wealth of Nations: A Story of Economic Discovery by David Warsh

Manias, Panics, and Crashes: A History of Financial Crises

Here is a 150 year old classic on the subject:

Memoirs of Extraordinary Popular Delusions and the Madness of Crowds

And here is one due out on September 30th:

This Time is Different: Eight Centuries of Financial Folly

Cross Posted at Classical Values

1 comment:

LarryD said...

Experimental research seems to indicate inexperience in trading is a major factor. When a market becomes attractive enough to draw in a lot of people who haven't previously traded, their inexperience overwhelms the judgment of experience traders and a bubble forms.

Bubbles and Experience: An Experiment on Speculation

The possibility of insider trading also appears to be a crucial element. Surprisingly, communication among the traders reduces the probability of bubbles forming.

Asset Bubbles without Dividends

Pop Psychology

Market Bubbles and Tinkering