If bubbles are “bad”, why do we let them happen over and over again?!

Susan
By Susan July 16, 2014 12:57

If bubbles are “bad”, why do we let them happen over and over again?!

 

 

An economic bubble is when we let prices go crazily high. We generally can recognize economic bubbles, but often defend them with arguments of “the market has fundamentally changed” or “it’s different this time” or “we’ve learned how to control and slow them down at will”. However an economic bubble can create a lot of damage when it bursts. Shouldn’t we have learned by now?

I was invited on The Moncrieff Show to talk about economic bubble, you can listen to the podcast here.

 

How an economic bubble forms

 

Let’s take the scenario that an economy goes through a healthy stage of growth for a period. Ambitious entrepreneurs borrow money and sell equity (as you see on Dragons’ Den, for example) with a view to expanding; they take on new staff and increase production. This continues iteratively and then after a while, some cracks start to show.

Real estate prices are a good indicator of an economic bubble

Real estate prices are a good indicator of an economic bubble

 

Economic bubble signs

in the labour market

 

The labour market becomes “crowded out”. In a healthy, growing economy, many businesses can expand and might need to hire more staff. Since labour is in demand, the price of it increases, which is reflected in higher wages.

As wages and wage demands rise, they become difficult to sustain for small businesses. There is a situation called “full employment”, which is basically when everybody who can and wants to work, is gainfully employed. As an example, Singapore currently has an unemployment rate of 2.1% and analysts describe this as a “tight labour market”.

If potential foreign direct investors don’t see a labour pool that they can choose from without headhunting, high costs and inflexibility, at some point they may decline to set up operations, or they wind down existing operations, in favour of other locations.

Oftentimes, the ironic consequence of full employment is eventually an increase in unemployment.

Economic bubble Signs:

  • The potential employee starts to interview the potential boss, instead of the other way around.
  • Companies import general labour because they can’t find any in the local economy: local labour has become more educated and specialised and hence more expensive.
  • Small businesses seek to outsource to much cheaper locations.

 

Economic bubble signs in the asset market

 

The asset market (property for example) starts to rise and rise in value until it too becomes “crowded out”. The first time buyer can’t get on the property ladder without taking out a very large mortgage or without moving further away from the higher cost regions. Speculators see the inflation in assets and put their “loose capital” (e.g. not their own personal salaries) into the market, hoping to get a slice of a growing pie, but further fuelling price increases.

Economic bubble Signs:

  • The return on a rental residential property is less than that available on cash deposit.
  • The 100% (and higher) mortgage.
  • Credit flows far too easily as the “terms and conditions” of getting a loan dramatically fall and a lot of money is introduced into the economy, fuelling prices, which is exacerbated by a media reporting frenzy.

 

The effect of bubbles on inflation and consumption

 

Inflation prohibitively devalues the spending power of citizens and “crowds out” the less wealthy tourist. There are two types of inflation: “cost push”, which is when the cost of the inputs pushes up the price of the overall product; and “demand pull”: if there is a lot of demand for a product then the really interested people will pay more for it. This means that the demand is relatively “inelastic”: it stays high even when the price of the desired item is high. The labour market demand wage increases to keep up with inflation… and they get them too, because employers don’t have much choice. For example, wage inflation in Singapore last year was at 4.3%, double the price inflation rate and so far this year, wage inflation is at 3.2% which is treble the price inflation rate of 1% (source: Singapore Department of Statistics, singstat.gov.sg). This leads us back full circle to the first point.

Economic bubble Signs:

  • Tourists begin to express their discontent with high prices and choose to go elsewhere on holidays.
  • People start to refer to their lifestyles not in terms of what it costs, but in how much they need to supply each month to keep up.
  • Consumers “spend forward” i.e. their savings ratio dips below 0% as they aren’t saving based on what they’re earning, but based on the wage increase that they’re expecting shortly. This eventually leads to a build up of short term debt that appears manageable at the time. (This occurred in Ireland over the Celtic Tiger, and we now have the largest household debt in the EU at 220% GDP).

 

So if the signs are that obvious, why do we let

them happen over and over again?

 

1. “Well everybody else thinks so…” – The herd mentality

 

The government, the media, the professions, the neighbours and your colleagues are all talking up the economy. They’re talking about taxation revenues rising, better economic statistics, rising profits, the bonuses that they’re getting in work and the progressively more exotic holidays. Since everybody else seems convinced that this is going to continue, “as the ordinary person”, what evidence do you have to the contrary? In business or in a large organisation, it can be a lonely place to be the “naysayer”, particularly if the downturn doesn’t come as you predict it and eventually you can become worn down and capitulate.

 

2. “I will just take this one last bet…” – The gambler who thinks they’re an investor

 

The more an economy grows, and the longer it goes on, the more the perceived evidence that this is the “new normal”. For example in the property market, after a while, people can sense that it’s overheating, but there might be time left for that one last chance and they don’t want to miss out on the last leg up. Then it works out! They put the money that they have made (because they didn’t have it in the first place anyway) and a little bit more in, and then it works out again!

This goes on for a couple of years and they get very wealthy very fast. They progress to thinking that making money is easy, so they use “leverage” (they borrow money) to make bigger profits. If you borrow money, you can put more money into a deal and get greater rewards. But the downside is that, if the deal falls through or isn’t as profitable as planned, borrowed money still has to be repaid. People don’t look at the downside, because the last time any fall in price happened was further and further back in the past.

This occurs on a wider scale and as speculative money follows speculative money, the market becomes self-generating like a legitimate Ponzi scheme: Person A lends money to Person B, who lends money to Person C. Person C speculates with the money, is lucky to win, and could easily repay Person B. Seeing this, people want to join in and have no difficulty finding lenders.

Eventually, people become convinced that the “market has fundamentally changed” and that these returns are sustainable over a longer period of time and become blind to the risks. This can happen with policymakers as well: they are relying on transaction or consumption taxes to fund future fixed costs. Fixed costs are costs that will have to be sustained over a long period, like paying out civil servants’ wages, pensions and benefits; consumption taxes on the other hand are dependent on people consuming, which can fluctuate…

 

3. Who personally wants to bring it on themselves to cool down an economy? – The “not on my watch” effect

 

A politician sounds the death knell of their career if they campaign for tax increases in a rising market. A manager won’t last long if they rationalise operations and let the competition run ahead of them. There are automatic stabilisers that naturally stall an overactive economy: the more you spend, the more VAT you pay, for example. However, if there is an agenda to people-please, policy-makers may reduce these rates or introduce tax reliefs to add fuel to the fire.

It’s important to remember that if a personality (either an individual or a company) makes a decision, the implications for them last (only) as long as their tenure. As a result long-term view is often replaced by the influence of short term factors such as re-election, bonuses based on recent performance, keeping up with competitors and personal reputation.

 

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Susan
By Susan July 16, 2014 12:57