Sunday, August 21, 2011

Boombustology: Chapter 7

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 applies the multilens framework (developed in the first five chapters) to The Great Depression in the United States during the 1930s. Mansharamani argues that the oft-talked about bust could not have been so great had the preceding boom also not been of such extreme magnitude. The roaring 1920's saw economic prosperity as a result of tremendous increases in productivity growth and new technologies. Automobiles and radios were among the technologies adopted by the populace during this period, helping to fuel optimism that a new era was at hand.

Here's how the boom/bust looked through the five lenses:

1) Microeconomic: There was a clear break from equilibrium, as at some point the stock market ran far ahead of the strong economic fundamentals. Large price swings upward resulted in more demand, which is reflective of reflexivity rather than equilibrium. During the ensuing depression, however, investors were sometimes not willing to pay 50% less for a stock that they would have paid full-price for the day before.

2) Macroeconomic: Interest rates were lowered in 1925, contributing to money supply growth. They were then raised to quell speculation in 1929, and tight policy reigned throughout the 1930s, exacerbating the problem.

3) Psychology: Americans were optimistic and confident in the future, having just emerged from World War I and having experienced new technologies that were changing standards of living. Furthermore, as market prices rose, a self-reinforcing idea took hold that dips in prices were buying opportunities on the road to never-ending stock market growth.

4) Regulatory: The bust resulted in blame on speculators. As a result, socialist measures which had never been seen before in the country found their way into the mainstream. Market forces were out of vogue; during the 1930s, America saw the advent of new programs such as federal welfare, housing and work programmes, minimum wages, and social security, among other measures aimed at redistributing wealth.

5) Biogical: The author presents evidence suggesting that a great many individuals who would otherwise have no market participation became speculators in the late 1920s. From this, it was inferred that the "infection" had infiltrated a great portion of the population, suggesting the bubble was nearing maturity.

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