Bubble Definitionsand Some Pictures

Fin254f:

Spring 2010

Kindleberger/Aliber 2-3(skim)

Outline

Pictures/examplesMinsky taxonomySpeculation

U.S. Stocks

U.S. Stock (inflation adjusted)

S&P Price/Dividend Ratio

US House Prices

U.S. House Prices (long)

Crash of 1929: U.S.

1925 1930 1935 19400

50

100

150

200

250

300

350

400

Dow Level

Year

Crash of 1987: U.S.

1970 1975 1980 1985 1990 1995500

1000

1500

2000

2500

3000

3500

4000

Year

Dow Level

Japan

Dot Com Bubble

QuickTime™ and aTIFF (Uncompressed) decompressor

are needed to see this picture.

Dot Com Again

The Big Ten Bubbles <2008

Tulips (Holland 1636) South Sea Bubble (UK, 1720) Mississippi Bubble1720 1920's stocks Developing country lending (1970's) Japan 1980's (stocks and real estate) Asia (Thailand, Malaysia, Indonesia others,

1990's) Mexico, early 1990's Internet (late 90's)

Minsky Model Overview

Not periodic (many early models are) Kuznets (housing), Kondratief (50 years)

Changes in credit (pro cyclical)Changes in beliefs (optimism, risk)Starts with displacement

(causes/optimism)

Displacement Examples

US 1920's: Electricity/mass productionJapan 1980's: Financial

liberalization/FX appreciationAsia 1980's: Implosion of Japan

bubble/growth miraclesU.S. 90's: InternetU.S. 2008: ???

Minsky and Credit

Bank credit unstableRelated to bubble growthFinancial regulatory changes

Minsky Taxonomy

Hedge financeSpeculative financePonzi finance

Hedge Finance

Income > Interest + some debtCommon in bad times, and early stages

of bubbles

Speculative Finance

Income pays off interest Income can't pay off old debtsFirms must refinanceMiddle stage of bubble

Ponzi Finance

Charles Ponzi : Boston, 1920'sOffers 30 percent interest/monthFinances with new depositors In month 4:

Cash < interest payments Ponzi goes to prison

Ponzi Finance

Income < interestNew debt needed just to make interest

paymentsUnstable top of bubble

Bubbles and GrowthDividend Discount Model

Pt =Dt

(r −g)D =1,r =7%,g=3%,P =25D =1,r =7%,g=4%,P =33D =1,r =7%,g=6%,P =100

Growth, Bubbles, Mania and Irrationality

Mania = IrrationalityBubble trickier definition

Run up in price Deviation from fundamental

P/D, P/rental, P/earnings, deviation from PPP 14 - 40 months

Beliefs and growth: When are they irrational?

Bubbles in Return and Risk

Return: Optimistic return and growth forecasts

Internet bubbles Risk still considered

Risk: Optimistic beliefs on risk Reasonable (not stellar) returns Low risk Securitized debt

Difference When Bursts

Return: Expectations proved wrong, but new

values might still fall in tail of belief distribution

Risk Events show entire belief system is

completely wrong Investors have no valid probabilities

Propagation

Not part of Minsky model Mechanisms

Arbitrage (example: gold) Trade demands Capital flows Psychological connections

Crash of 87 Asian crisis and Argentina

Bankruptcies and bank failures Counterparty risk

Lender of Last Resort

Final lender to stop propagation mechanisms

National level: Central banks International level: IMF??

Criticisms of Minsky Framework

Each bubble is uniqueNo longer relevantMarkets are efficient

Uniqueness

"This time is different"Specific factorsAre there common patterns?

No Longer Relevant

Regulation keeps "ruling out" bubblesSeems pretty false right now

"Great moderation" Central banking of the 90's

Periods of relative stasis

Markets are Efficient

Prices contain all informationBubbles only appear to be bubbles ex-

postNeed more information orMore complete models

Speculation Stages

First stage Investors buy into limited but reasonable asset Want to hold asset Drive price up

Second stage Speculators enter Interested only in quick resale

How to Differentiate?

Real estate: Owner occupancy

Stocks Difficult

Problematic policy question Stop "speculative buying"

Rationality

Difficult to define without theory of how the world works Rational relative to something

Rationality and Markets

Does "individual rationality" -> "group rationality"?

Not clear Buy into a bubble

Do markets "aggregate information"? Not clear Truth plus noise No price -> trader feedback

Speculation and Stability

Does speculation destabilize markets?How can we tell when we see it?"Eliminate destabilizing speculators"

Stability and Mechanisms

No general market stability theorems in Economics and Finance

Cobweb models Supply responds to last period demand Can generate price cycles Expectations can make things worse

Cobweb Model

D S

P

Q

National Differences?

Speculation patterns??? Sheep grazing -> gambling and

speculation ?? U.S. open society and wide open business

climate -> speculation??This evidence is sketchy at bestFew countries/regions safe from

bubbles

Outline

Pictures/examplesMinsky taxonomySpeculation