Causes And Anatomy Of Asset Bubble

The classical liberal perspective

A.Causes and anatomy of asset bubble:

The reason for the creation of asset bubble is the great white whale of finance theory. The proper answer to this query is not only important for individuals for undertaking their financial planning but also for the entire economy as a sudden crash in the prices of the asset can leave the growth in a dwindling state for years (Teeter and Sandberg 2017).

Asset bubble in general terms is a phenomenon wherein the asset prices rise way more than their real prices. This causes instability in eh prices of the asset and ultimately results in the sudden fall in the prices of the asset either down to its real price or even below it sometimes (Galariotis et al. 2015). In order to understand the causes of an asset bubble we are going to take up two perspectives they are as follows:

The classical liberal perspective:

In the modern day, finance environment the role of central banks is considered to be of paramount importance. This is because of the fact that it is expected to manage the economic growth and persevere towards sustainable prosperity by using or manipulating tools like interest rates at its disposal. However, the classical economists have an opposite view regarding them (De Koning 2015). They consider them to be useless and the prime reasons for abnormal market behaviour. They are of the opinion that the interventions taken up by the central banks of the country and their corresponding monetary policies are the prime reasons for creation of asset bubbles.

In his book “Early speculative bubbles and Increases in the money supply” economist Douglas E. French writes that printing of currencies by the central banks lowers the interest rate below their normal rate and this encourages the investors to undertake investments that otherwise they would not have. This subsequently creates and asset bubble having a volatile nature. The sudden outburst of the bubble is the result of the liquidation of the mal investments (Taffler et al. 2017). He further states that careful study of the history shows government meddling with the financial and monetary affairs resulting in economic booms and the inevitable bursts thereafter, the mainstream economists keep on blaming the phenomenon on the ‘animal spirits’ of the market participants.

The view of the author finds substance in the phenomenon that rocked the markets in the 1990s and the early 2000 due to the easy money policies of the government. The easy money policy led to the easy flow of credit in the markets which resulted in a lot of unwise investments on the part of the market participants. This led to the gradual creation of an asset bubble particularly in high technology items (Wu and Olson 2015). The rampant investments led to the NASDAQ boom but, due to the unstable nature of the bubble that had been created all it took to burst it open was a slight uptick in the interest rates. The slight uptick in the interest rates caused the entire technology sector to collapse.

The Keynesian perspective

The Keynesian perspective:

In case of the Keynesian theory or perspective, there is nothing odd in the recessions or depressions taking place in the market. The theory suggests that they are bound to happen and there is nothing in anyone’s capacity to control it or stop it. It emphasises on the point that the role of the central banks of the country is paramount in mitigating the aftermath of the depressions (Kruse 2017). Hence unlike the classical liberal policy it emphasises on the importance of the central banks rather than claiming them to be the reason for the asset bubble creation.

The anatomy of the asset bubble is as follows:

Before the creation of any asset bubble the asset passes through several stages and careful study of these stages can enable a shareholder to ascertain in which cycle the asset is currently located and what is the future prospect of the assets and whether it will be able to fulfil the requirements of the investor (Asekome and Agbonkhese 2015). 

The various stages of the asset bubble creation are as follows:

Inception:

The asset bubble starts to build up at a certain point though the prices of the asset may become unjustifiable in the end, the reasons for the notable increase in its price is generally due to some valid reasons.

For e.g. the dot com bubble was created due to the optimism of the people or the larger mass for the technological development happening at that time. It was logical that due to the daily increase in the number of persons using the internet the investors thought that the technology sector especially those start-ups coming up at that time would always yield good results for them and hence the creation of an asset bubble began with that mindset of investment (Brunnermeier et al. 2017).   

Gaining momentum:

The rate of the increase in the prices of the asset may be slow in the beginning but as more and more investors come in the picture the rate increases substantially. It is further accelerated by the media coverage and professionals comments.

Euphoria:

The asset bubble reaches this stage when the greed of the investors overcomes their caution. They try to justify the increase in the price as a result of the fact that the fundamentals of the asset are strong and would become stronger in the future. This is easily demonstrated by the case study of the morocco real estate bubble. In this case, during the booming period of the economy the real estate developers predicted a growth in population and the purchasing power of the citizens to be much higher than the reality (Yilmaz et al. 2015). They had already built up towns having a population capacity of 300,000 residents whereas in reality the population inhabiting the towns is merely 32,000 people.

Stages of asset bubble creation

Profit making:

All the prudent investors tend to liquidate their investment when it has reached a particular level. But the process and the time of profit booking can be extremely difficult to predict. This is the stage where the investors sell their investments and book their profits by selling the asset at higher price.

Panic:

This is the stage wherein due to substantial amount of profit booking the sentiment of the investors gets reversed. The same sentiment which was pushing the prices above gets changed and takes a U-turn. The reasons for a panic can be many like failure of a bank, firm too stretched, or the news of revelation of a swindle (Asness and Liew 2017).

Revulsion:

This is the stage wherein the investors do not want to buy any further stocks or reinvest in them due to their prior bad experience with it, as a result of the drastic fall in the price of the stocks. Hence, due to the reduction in the price of the stock and simultaneous non-participation of the investors the prices of the asset does not go up quickly again (Jones et al. 2018).  

B.The comparison between the Black Monday, black Thursday and the Japanese crash is as follows:

Black Monday

It is referred to a crash in the stock market al across the world on October 19, 1987 and it was a Monday. It resulted in the eradication a huge amount of shareholders value in a very short period of time. It started in Hong Kong and spread like a wild fire to all of Europe and finally hitting United States after other markets were deeply affected by it resulting in loss of huge amount of value by them (Jarrow 2017). 

Market effects

The effect on the markets all over the world was immense. The value of the markets of Hong Kong, Australia, Spain, United Kingdom, The United States, and Canada fell by 45.5%, 41.8%, 31%, 26.45%, 22.68%, and 22.5% respectively. The worst hit market was that of the New Zealand. The value of its market fell by 60% from its peak value recorded by it in the year 1987. It took several years for its economy to recover from the damage.

Causes

Various economists stated various reasons for the crash like overvaluation, illiquidity, program trading and market psychology. However, the majority of the public held program trading responsible for the crash. It is because of the way program trading works. It executes large amount of stock trades based upon the external inputs it has received (Ashfaq 2016). The systems made use of arbitrage and portfolio insurance strategies. Due to the intensive use of program trading within the Wall Street when the prices started to fall the program trading mechanism engaged itself in extensive selling of the stocks which further brought the prices down to a devastating extent.

Inception

Black Thursday

It is considered to be the worst market crashes in the history of United States. It began on 24^th October 1929. It is so considered due the effect it had on the country’s economy and the duration for which it lasted. It marked the start of the 12 year long Great Depression that would gut out all the industrialised western countries.

Effects

The Black Thursday and The Great Depression were together able to pull off a financial crisis that would be termed as the largest in the twentieth century. It also resulted in a depression in Europe (Chen and Lai 2015). The problem was severed by the inability of the economists to understand the intensity of the crash of United States. The intense interconnectivity of the Western economy during that time was only understood after the entire European economy was reeling under the aftermaths of the crash that had occurred in the United States markets.

Cause

It was primarily the result of a booming the speculations entered into by the citizen pf United States in the 1920s. During that period of time several industries involved in the business of manufacturing and steel production were booming and recoding historic profits (McNeil et al. 2015). The people were of the opinion that the stocks will never come down which created in over speculation. The loan amount taken up by the people to fund their investment was $8.5 billion that was more than the total currency in circulation in the United States during that time. 

Japanese crash in 1920s

This financial panic occurred in the year 1927 under the reign of the emperor Hirohito of Japan. The crisis was responsible for bringing down the government of the Prime Minister Wakatsuki Reijiro. Subsequently, the Zaibatsu took over the banking industry of Japan.

Causes

The main cause was the creation of an economic bubble as a result of an increased amount of investment on the part of the public in pursuance of reaping the benefits of the increased production capability of many of the businesses. After 1920 the country faced an economic slowdown and the Great Kanto Earthquake in the year 1923 led to further deterioration of the situation (Razin 2017). In order to intervene the government issued discounted earthquake bonds in favour of the overextended banks. In the year 1927 when the government contemplated about redeeming the bonds a rumour spread in the market that the banks holding these bonds were supposed to go bankrupt. This led the whole situation to go out of control.

Gaining momentum

The similarity that can be noticed in all these cases or the common thing among them is the belief of the investors regarding the performance of a particular sector. In case of the black Monday, it was the belief of the investors that the prices of the technology related companies swill never come down. It was same with the black Thursday and Japanese crash where investors believed that the steel producing company’s prices will never come down and the companies with increased producing capacity are deemed to perform well in all situations respectively (Razin 2017). The belief that the market will remain in a constant trend over a long period of time led to the downfall in the economy. This was the direct result of the creation of the economic bubble due to the demand presented by the investors in the market.  

C.Some of the measures that can be taken to prevent another financial crisis in the future are as follows:

Avoiding misleading mortgage products:

Some of the economies around the world provide mortgage products that have a teaser rate meaning a more appealing introductory rate for the first two or more years and then suddenly the interest rates would shot up (Engel et al. 2016). This created immense and sudden economic burden on the part of the borrower and subsequently lead to default.

Improving the capital ratios of the banks:

Prior to the crisis period it was seen that due to the boom in the economy the banks were offering ridiculous amount of loans and were degrading their capital ratios on a daily basis (Wang et al. 2018). This lead to their vulnerability during the credit crunch period. If the banks are made to keep more capital with them, it would help them to cope up situations like abnormal exuberance on the part of the people. The fund kept with the banks could be remitted back to them during the difficult times.

Putting cap on dividend and pay:

One of the startling facts about the great depression was that during that period the banks faced a loss of $60 billion and at the same time were paying dividend to the tune of $60 billion. The banks that were listed on the stock exchange were under pressure to pay dividend and to keep lowering their reserves (Uwilingiye et al. 2018). Hence, in case of banks the German model should be preferred that is less preference is should be given on stock market listing and on equity.

Euphoria

Monetary policy:

The role the central bank plays in an economy is immense. It is seen that prior to any depression the interest rates are generally kept lower for a longer period of time. The primary focuses of the banks are centred on inflation. But, they generally miss the aftermaths of the bursting of the economic bubble that is being created in the economy due to the steps taken to control inflation.

Hence, the focus of the central banks of the countries should be broadened from merely on inflation. 

D.As per the definition stated out by the US Financial regulator Securities Exchange Commission, the Ponzi is a pyramid structure scheme that primarily functions on the “rob Peter to pay Paul” principle. In these schemes the fraudster promises one investor of huge returns on his money and then uses that money to pay back the dues of the other investors. The system collapses once the money stops coming in from new investors (Lusyana and Sherif 2016). The loser in this entire scheme is the person who is making the last investment to the fraudster ass the due of all the other investors are cleared whereas there are no more funds available to pay off the dues of the newest entrant. The scheme was named after a fraudster named Charles Ponzi.  The man promised the investors of New England to give a return of 40% on their investments as compared to the 5% present return they were earning from their saving accounts. The returns was to be paid by him from the profits he was expecting to make out of the difference in the exchange rates of US Dollars and other currencies for the purpose of buying and selling international coupons at a profit (Menzel et al. 2017).  The success of the scheme was immense as can be inferred from the fact that he was able to earn a whopping $420000 in May 1920 which boils down to $5.13 million in 2017 currency. Within the month of June people were actually investing around $2.5 million in Ponzi’s scheme and by the month of July he was able to rank in millions of dollars per week and it were rising. By the end of the month the amount was close to a million per day.  After the collapse of the entire system it was shockingly discovered that he had purchased international coupon to the tune of only $30 and the entire system was based on such a small amount or rather zero amount of investment.

Profit making

Rich families who had huge funds to invest but no knowledge of the same regarded the safe side would be to keep it under the custody of the wealth managers, hedge funds and private banks (Lobe and Walkshäusl 2016). These institutions then choose specialist funds managers who have been consistent in their performance. Madoff being a consistent performer was a clear choice for them. Its popularity leads it to create specialist funds which would directly feed money into Madoff in charge of a fee. The problem started when Madoff instead of investing the money started paying the profits back to the clients. As the financial crisis hit the economy every client came back to ask for their money. Due to the absence of money of such a huge amount at that particular moment of time, the entire fraud was exposed.      

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