Showing posts with label Boombustology. Show all posts
Showing posts with label Boombustology. Show all posts
Monday, September 5, 2011
Boombustology: Chapter 12
Sunday, September 4, 2011
Boombustology: Chapter 11
Saturday, September 3, 2011
Boombustology: Chapter 10
Sunday, August 28, 2011
Boombustology: Chapter 9
Saturday, August 27, 2011
Boombustology: Chapter 8
Sunday, August 21, 2011
Boombustology: Chapter 7
Saturday, August 20, 2011
Boombustology: Chapter 6
No part of the world has proven itself immune to bubbles. Each of the next few chapters examines a bubble from the point of view of the five lenses described in the first five chapters.
The topic of this chapter is Tulipmania, a bubble for tulip bulbs that took place in Holland in the 1630's. Some background is in order so that the context is understood. Holland had just gained independence from Spain through war, and was intercepting some Spanish ships carrying goods from the West Indies. The country found itself newly prosperous as an innovative, trade-friendly country. At the same time, however, scores of its population were dying as a result of bubonic plague.
Tulips were a relatively newly discovered type of flower (brought over from the Mediterranean) with colour schemes that had not yet been seen before. Many bulbs carried unique patterns, and offspring could not be grown quickly. Because bulbs had to be in the ground most of the year, they could only be exchanged in May and October, so futures contracts were created to facilitate sales that did not take place in those months. At one point during the bubble, many elites (including politicians) lost money when prices retreated. As such, the laws were changed so that futures contracts became options contracts, whereby the buyer would get to choose whether to take delivery of the bulbs when the time came to exchange.
Here is how the bubble may be viewed through the five lenses described in the previous five chapters:
1) Microeconomic: Many buyers were hoarding bulbs, signaling a breakdown of equilibrium pricing. Price was affecting, rather than reflecting demand.
2) Macroeconomic: Due to the capital inflows through successful trade and seizure of Spanish ships, there was a dramatic increase in the money supply in Holland. Easy money was undoubtedly making its way into this bubble.
3) Psychology: The massive deaths caused by the plague were giving citizens a short-term mentality. Since death might be near, thoughts of long-term repercussions to actions were at a low.
4) Regulatory: Because futures contracts were changed to options contracts, highly levered speculation ensued. People could buy the upside of bulbs without much downside, resulting in asymmetric risks. Shortly after the regulation was switched back, prices plummeted.
5) Biological: Citizens in all fields took part, from nobles to chimney sweeps. From the epidemic model, we know that this leaves very few people to be "infected", resulting in an eventual pop.
Sunday, August 14, 2011
Boombustology: Chapter 5
The fifth and final lens through which bubbles are considered is the biological lens. The authors describes a couple of frameworks through which this lens can be viewed, namely using epidemic models and emergent behaviour.
Mansharamani references Robert Shiller's work in this regard. The idea is that a tellable story infects the population, eventually leading to an epidemic whereby there is a prevalent belief that results in bubble behaviour.
If the "idea" that results in bubble behaviour is considered a "disease", the epidemic model can be used to ascertain the relative maturity of the bubble. (Note that this does not allow one to time a bubble, it only gives one a rough idea of the stage at which a bubble has reached.) Epidemic models where the infection rate is greater than the removal rate follow a bell curve in terms of a population's infection (assuming the infection rate is greater than the removal, or cure, rate). Trying to ascertain where we are on that curve can help gauge bubble maturity levels.
The emergence framework has to do with how we behave in groups. Various animal groups are discussed whereby seemingly independent individual organisms appear to act as single entities when part of a group. There are a number of signals, both conscious and unconscious, that individual organisms pass on to other individual organisms that result in co-ordinated behaviour.
Humans are not immune from this type of behaviour. One example of this behaviour is an information cascade. For example, if a couple happen upon two empty restaurants and have no information about which is better, they may be indifferent as to which restaurant to choose. The next couple will have no additional information, but will see that there is one couple in one restaurant. Believing that the first couple behaved rationally in choosing their restaurant, they may choose the same one. This can occur many times, resulting in one full restaurant and one empty restaurant, even though the empty restaurant might be better. Mansharamani likens this to investors who purchase what other investors have purchased, believing that other investors must have done their homework.
Saturday, August 13, 2011
Boombustology: Chapter 4
The political environment is a major factor in the culmination of booms and busts. As such, this chapter examines the boom/bust phenomenon through the political lens.
For a boom and bust to exist, property rights must exist. In other words, a particular entity must have exclusive rights to use or sell some asset.
As a result, the author argues that only capitalist countries appear susceptible to booms and busts. In communist countries, the government owns everything so there is no incentive to speculate since there are no profits to be had.
Though many communist countries allow some property rights, often the prices of those assets are fixed. As a result, there is no price volatility. (Although price volatility is avoided, however, there is often volatility in the availability of the assets themselves, since there is no price signal to either encourage or discourage supply and demand.)
Mansharamani then goes on to discuss some political factors that affect the likelihood of booms and busts for countries that fall in between communism and laissez-faire capitalism. When governments place restrictions on property rights, for example, they reduce the incidences of booms and busts. On the other hand, the lifting of restrictions can lead to increases in the chances of booms and busts.
Also, when governments focus on the short-term (as democratic leaders often do, because of their relatively short-term mandates), it can lead to increased distortions that lead to booms and busts. Examples of this are minimum wage laws (which increase unemployment, but which are popular in the short term) and rent controls (which reduce rents in the short-term, to the delight of renters, but cause shortages in the long-term). These distortions increase the likelihood of under/over-investment, which increases the likelihood of booms and busts.
Sunday, August 7, 2011
Boombustology: Chapter 3
Generally, economic models assume individuals are perfectly rational. That is to say, they weigh costs and benefits appropriately, and seek to maximize profit with the cold-hearted zeal of a calculating machine.
But recently, a new field called behavioral economics has shown this to be a simplistic view. Humans actually have a number of biases, many of which (discussed through example later in the book) contribute to bubble-forming events.
Mansharamani discusses a number of biases and offers a number of quizzes and puzzles to the reader that illustrate how we fall victim to biases without ever knowing it. Many of the biases fall under the category of heuristics, whereby we seek shortcuts in our brains in order to determine the answers to complex questions.
Among some of the biases illustrated and discussed are overconfidence, anchoring, framing, representativeness and availability. A number of these biases have been summarized a few times in different ways on this site, including here.
Saturday, August 6, 2011
Boombustology: Chapter 2
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.
Sunday, July 31, 2011
Boombustology: Chapter 1
Bubbles cannot be understood through traditional tools of financial analysis. A number of factors are interacting with each other that cause markets to fluctuate wildly from fundamentals. Mansharamani therefore advocates a multi-lens approach, to better understand bubbles. Each of the first five chapters covers one of the five lenses through which bubbles may be viewed. In the first chapter, the "micro-economic" lens is explored and described.
Price tends to regulate markets in the micro-economy. When prices are higher than they should be, demand falls and supply increases, helping push prices towards some stable equilibrium state. Most of the time, this mechanism works because of the immense power of supply and demand, or as Adam Smith would call it, the invisible hand.
But there are times when this system breaks down. For example, sometimes higher prices actually invite, rather than quell, demand. To understand this phenomenon, Mansharamani describes George Soros' theory of reflexivity. Under this theory, market observers are not simply observers of events, as their perceptions actually change reality. Reality and perception are constantly engaged in a dynamic, two-way feedback mechanism.
A good example of this phenomenon in action occurs in the real estate industry. The reality may be that an increased willingness to lend is resulting in higher real estate demand, which leads to higher real estate prices. Perception, however, may be that some other reason is causing real estate prices to rise. This perception itself results in higher prices that in turn increase the willingness to lend. What follows is a situation where there is no equilibrium state, as prices start running on a course towards an unknown destination.
Mansharamani concludes that most of the time, the supply/demand equilibrium model works in viewing systems from a micro-economic lens. But there are times when an asset's situation can best be understood from a reflexivity point of view.
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