The Nature of the Economic Bubbles - Essay Example

INTRODUCTION The global economic crisis that started in December 2007 and is ongoing has been attributed to a combination of factors that included overvalued home prices and the subsequent inflation of the mortgage backed securities to excessive risk taking lending and trading practices. The valuation of CDO’s (Collateralized Debt Obligations) reached unheard of peaks and then when the home market began to bottom out the overlying mountain of securities that were built on top of that began to crumble as well (Philips, 2008). This paper discusses the nature of the economic bubbles and irrational exuberance and the experience of one such instance, the dotcom bubble. Further, the question as to whether the current rally in the equity markets is a recovery or a bubble is dealt with as well. It is the contention of this writer that the worst is not over as far as the economic crisis is concerned, particularly when one considers the exposure to derivatives and other toxic assets that are still clogging the balance sheets of most of the financial majors. ECONOMIC BUBBLES AND IRRATIONAL EXUBERANCE An economic bubble is a rally in the prices of assets or equities more than what the economic fundamentals governing these asset classes would dictate. Hence, a bubble in any classes of assets (real or virtual) that is not supported by the underlying fundamentals is termed as a bubble. Mostly, economic bubbles are the result of excessive speculation and risky trading practices arising out of easy availability of money. Whenever the interest rates are low, the resultant surge in liquidity finds itself migrating to assets or equities that seem attractive for the returns that they provide (Greenspan, 2007). Economic bubbles are characterized by what Alan Greenspan called “irrational exuberance” that arises from a market behavior that defies normal economic logic in terms of risk and return (Federal Reserve, 2008). Economic theory suggests that returns are high when the corresponding risk is high as well. Hence, Economists factor in the risk associated with these returns and invest in stocks accordingly. Irrational exuberance results when investors disregard the high risk and invest in the equities with an eye on the expected returns. When the returns do not materialize the corresponding fall in the prices of these assets results in the bursting of the bubble. DOTCOM BUBBLE During the closing years of the last decade of the millennium, there was frenzy in the stock market for stocks of tech companies that were overvalued by a high ratio and that came crashing down with the bursting of the bubble in the year 2000 and 2001. The name dotcom bubble was coined because the companies whose valuations shot through the roof were primarily web based startups that were given the name “click and mortar” companies to distinguish them from the traditional companies known as “brick and mortar” companies. The dotcom bubble was fuelled because of the low interest rate policy adopted by the Fed under the leadership of Alan Greenspan who kept the Federal funds rate close to zero (which after adjusting for inflation became negative) and this encouraged excessive speculation and risk taking by investors who invested heavily in the stocks of these companies. Any bubble is fuelled by cheap money and the dotcom bubble was no exception. As this paper points out, investors have always betted on the assumption that things would turn out better this time around. However, if one studies the nature of bubbles in the past, there is no indication that this is necessarily true as can be seen from the recurrent episodes of financial crises over the last three decades. The underlying rationale behind the valuations of these companies was based on the supposed superiority of their business models and the assumption that the business cycles could be done away with the emergence of the new economy where everything was going to just in time and hence no lag between the supply and demand constraints that characterized the old economy (Greenspan, 2007). However, over a period of time, investors realized that the business models of these tech companies and the web based companies was not based on sound economic fundamentals because of their reliance on “eyeballs” and “clicks” based revenue expectations. As discussed in the section related to economic bubbles, once investors realized that these companies are not going to generate the expected returns, they deserted these stocks and this lead to the bubble being pricked. The dotcom bubble taught the investors that high valuations of equities of companies may not necessarily reflect the underlying economic fundamentals and there can be such a thing as excessive speculation coupled with poor regulation that is at the heart of any economic bubble. It is sad that the lessons from the dotcom bubble were soon forgotten and the current economic crisis is an example that we have not learnt anything from the bubbles of the past. RECOVERY OR A BUBBLE To answer the question as to whether the current recovery is a bubble in the making or a normal upturn of the business cycle that involves periodic bouts of recessionary pressures as well as a significant upward revisions in the market, it is pertinent to see the source of the funds that have been pouring into the stock and asset markets. A perusal of the articles related to the current recovery appears to me that what we are witnessing is the amount of funds that were pumped into the system by the Federal Reserve making their way into the equity markets. Though this would mean that all the talk about recovery is false, it is nonetheless a fact that certain sectors of the economy are growing and this fuelling the recovery. What this apparent contradiction means is that the money going into the stock markets is not necessarily from the sectors that are showing growth and we might be witnessing one more equity bubble in the making. As to Odey’s remark about “irrational exuberance is not evident today. It is rational to have revalued companies upwards by 50 per cent from those frozen post-Lehman days as the world recognized that they were not going out of business, and it is rational to expect further upgrading of equity valuations. We are living a rational bubble. Beware, then, of writing it off. That way lays missed opportunity” (Odey, 2009), the point needs to be mentioned that the current equity valuations are rather high and this does not seem to me like it is a rational bubble. On the other hand, I have every reason to believe that we are witnessing one more equity bubble because of the messy state of the commercial real estate market. As the latest issue of Business Week states on its cover story, the real estate markets as well as the commercial properties market are in a state of absolute mess and the vagaries of these markets are not expected to settle down for some more time. Hence, the assumption that we are witnessing a market rebound needs to be countered with some healthy skepticism. To rebut the other point from Odey’s remark, it is by no means certain that the world has realized that the worst is over. If we look at the statistics of bank failures and other economic indicators, it is apparent that we are still a long way to go before we can conclude that we are out of the woods. And given the fact that the unemployment rate is growing by the month indicates a “jobless” recovery at best and a choice of either deflation or stagflation depending on the money that the Fed is willing to throw at the economy, the current upsurge in equities might be just another bubble in the making. CONCLUSION This paper has discussed the nature of the economic bubbles and the recurring patterns that we have seen right from the stock market crash of 1929 to the current economic recession. The fact that these recessions have been explained as the natural boom-bust cycle of capitalistic and free market economies does not take away the pain and suffering felt by millions of jobless people and investors who lost their savings in the process. The dotcom frenzy was touted as capitalism having reached a stage where the boom-bust cycle could be done away with. However, experience showed otherwise and hence, we have to remember the lessons from these bubbles if we are to avoid repeating the mistakes of the past. In conclusion, I end the paper with the famous quote “those who forget history are condemned to repeat it”. Hence, it is the contention of this writer that we should be careful before we reach the conclusion that the current rally in equity prices reflects a genuine recovery. List of References Board of Governors of the Federal Reserve System (2008) [Online]. Available from: http://www.federalreserve.gov/newsevents/press/monetary/20080318a.htm (Accessed: 15 Nov 2009). Jennifer, Dorroh. (2005). ‘Dotcom Bloom: The Web Seems Poised to Blossom with Stand-Alone News Sites’. American Journalism Review, Vol. 27, June-July 2005.  Greenspan, Alan. (2007). The Age of Turbulence: Adventures in a New World. Allen Lane. London. Odey, J. (2009). ‘Is this a bubble or a recovery”? Financial Times website. [Online] Available from: http://www.ft.com/cms/s/0/571555b8-a7da-11de-b0ee- 00144feabdc0.html?nclick_check=1 (Accessed: 15 Nov 2009). Philips, Kevin. (2008) Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism. New York: Penguin. Philips, Kevin. (2009). After the Fall: The Inexcusable failure of American Finance. New York: Penguin.   Read More