Saturday, August 6, 2011

Boombustology: Chapter 2

Asset bubbles are frequently popping up, and back down. They are easy to spot in hindsight, but we appear to lack the tools to recognize them ahead of time. Vikram Mansharamani aims to rectify that with his book, Boombustology. He applies a multi-lens approach to understanding bubbles with the aim of giving the reader the ability to identify bubbles, and thereby avoid being caught unaware.

This chapter considers the macroeconomic lens through which bubbles should be viewed. First, a justification for expanding beyond simple microeconomics (as discussed in the first chapter). Just because individuals may do things that maximize their own interests, it does not always make everyone better off in the aggregate.

For example, someone may be better off standing (rather than sitting) at a baseball game to get a better view; but if everyone else decides to stand as well, everybody is worse off than they were before. For a financial example, a bank may feel it is in its interest to foreclose to sell a house to recover its loan, but if all banks are doing it at the same time, they will drive down prices and make things worse on themselves. For these reasons, an understanding of macroeconomics is important to understand bubbles.

Mansharamani describes a couple of models to help explain how bubbles and macroeconomics interact. In particular, he describes the theories of Hyman Minsky as well as those of the Austrian school of economics.

Minsky described the macroeconomic state of affairs as going through three stages of debt. Normally, debt levels are taken such that cash flow is adequate to comfortably pay interest as well as principal. But if things stay stable for long, debt will then graduate to a speculative stage, whereby cash flow is only enough to cover interest, with the expectation that refinancing the principal will be possible later. Eventually, debts issued are of a Ponzi nature, where cash flows don't even cover interest, as the expectation is that asset appreciation will allow the borrower to pay debts by incurring even more debts.

Eventually, credit tightens. When this occurs, turmoil ensues, as a debt-deflation spiral occurs. As assets are sold to pay debts, asset prices fall further, causing real debt (that is, debts relative to assets) levels to increase, exacerbating the situation by causing more asset sales still.

In the Austrian school, the belief is that central banks are causing distortions by forcing an interest rate on the economy. When rates are set low, for example, incentives are given to avoid saving and to over-consume. These distortions can lead to overcapacity in some areas and under-investment in others. The idea is that central banks should not interfere in the market-clearing interest rate, as otherwise the distortions will play a detrimental effect later.

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