Boom and bust

I have just finished reading the excellent book "The great crash, 1929" by Galbraith. It (entertainingly) describes the events that led to the crash of 1929, as well as the responses and effects it had. It's a great book, is very readable and informative and I highly recommend reading it.



This is not a review of the book, but a few musings on related themes.

I remember reading a question, a few years ago, which went like this:
"Why is it not possible to end a bubble without a crash? Why can't we have a soft landing?"

The answer is that, during the bubble, wealth is being destroyed but the market only realises this at the time of the crash, and adjusts the prices accordingly. Let's think about this in more detail.

Human's have various tools for understanding and describing the world around us. A big one is language. I can tell you about something that I saw -- I could for example describe a tree with large pink blossoms on it that I saw recently. I can never perfectly describe it to you though -- there are limitations at every stage, from the way my eyes see it, to the way my brain understands what my eyes are seeing, to the way I describe it to you, to the way you understand the words I say and align them with your prior knowledge to visualise the tree I'm describing. Although you might be able to imagine a tree that I'm describing, it will never be the same as what I'm trying to describe, which in turn will never be the same as the actual tree that I saw.

Thus, my ability to perceive something and communicate it to you is limited.

The Market is similar. It is a human tool for understanding and describing an aspect of the world in which we live. We use that tool to allocate resources: high prices indicate demand for a good or service and communicate to people that more of that needs to be provided. Low prices indicate an oversupply and that they should focus their energy elsewhere. It is important to remember, though, that the market is merely a human method of communication, and problems arise when the market does not accurately reflect what is actually going on in the real world (of course, it never describes perfectly what is happening, but the hope is that generally it is close enough).

Where the market diverges from reality, it misinforms people about the demand for various goods and services and results in a misallocation of capital (because all goods and services require some investment of time and/or resources, which is basically what capital is).

When there is a bubble, the market ceases to reflect the underlying reality, usually (as in the years leading up to 1929) because of speculation. Speculation occurs when people buy something, expecting it to increase in value so that they can sell it for a higher price later on. This is different from investment -- let's quickly see how.

If I invest money, say in a business, I am basically loaning them some money to get established and then owning a share of the resulting value that is created. Imagine a factory being built -- there are a lot of up-front expenses that occur before the factory makes any money. These are paid by investors, who then own a share in the completed factory and any profits it creates (the profits are returned to the shareholders as dividends).
In contrast to this, a speculator buys a share in the factory on the assumption that it will increase in value -- not necessarily because anything underlying has changed, but just because the speculator expects that other speculators will also want to buy that factory (this increase in price [though not necessarily the underlying value] is reflected as an increase in the share price).
The best example of a speculative bubble, was the Tulip Bubble that occurred in The Netherlands in the 1600s. The prices of tulip bulbs reached astronomical heights -- a pair of bulbs were reportedly traded for 12 acres of land. Needless to say, nothing had fundamentally changed about the value of tulips -- all buyers of tulips assumed that a "bigger fool" would come along later and pay more.

That is the nature of speculative bubbles. Eventually, the supply of "bigger fools" (with ready cash) ends and the whole thing comes crashing down. But this brings us back to the original question -- can we come down slowly, without the crash?

To answer this we need to think about what is occurring during the bubble: because of the excitement, and the high prices, capital is diverted towards the bubble. People remove capital from productive enterprises, and direct it towards speculative investments in the bubble. People take loans on their houses and direct it towards the bubble. In many cases, people cease their previous employment to work full-time as a speculator. This can drive consumption, because people feel wealthy, but it is important to understand that owning a share of a bubble is not actually valuable until the share is sold and the wealth is realised -- this is something that few people generally do. When the prices start to fall, people realise that they are not as wealthy as they thought, and they try to sell to realise their gains. Unfortunately, the supply of "bigger fools" quickly ceases and the prices plummet. Now we are left in a situation where people are heavily in debt (because they have taken loans to speculate in the bubble) businesses have had money removed from them and directed to the bubble, etc. In other words, the bubble has sucked a whole lot of value out of the economy and destroyed it.

This is why the crash cannot be avoided -- by the time the market crash occurs, the economy has already crashed and the market is playing catch-up.

Lessons (from the great crash):

1. Very few people are aware of the bubble before it crashes. Those that are, and speak out about it, are heavily criticised. In the USA, people were describing the market as "fundamentally sound" right up to (and even during) the crash.
2. The misallocation of resources that occur during the bubble cause the crash, and have effects that percolate right through the economy in non-obvious ways
3. The crash affects people who were themselves not involved in speculation. This happens because after the crash there is no capital to get things done, consumer spending plummets, credit becomes expensive
4. There will be appeals to authority to proclaim that the market is fine and prices will keep increasing. This can come from the highest political, industrial and academic leaders and should not be trusted.

Is this relevant in Australia?

I think it is. I think that we have a housing bubble, right now, that is causing the mis-allocation of resources (ie. the destruction of wealth) in our society. I don't think it is as bad as in 1928, but I think it is unsustainable. To see why, we need to compare the price of houses to income. Relative to income, houses have doubled in price over the last 60 years, and has gone up 50% since 1980. This has caused a lot of capital to be directed towards renovations, extensions, etc. A lot of money is spent on making houses "fancy", and this money is non-productive (ie. if we invested it in manufacturing or businesses it would be more useful). It's fine to spend some money on one's house to make it nicer to live in, but I think the current problem is that people are doing it now on the expectation that it will increase resale value of the house and hence they are spending much more (than what they would if the money was "just" being spent to make the house pretty, without hope of recouping it when the house was sold). That is the mis-allocation of resources, and that is the value that is being destroyed in Australia right now -- and will only become apparent once house prices start to fall to the long-term average of about 1/2 what they are now.

What can't be concluded from a crash?

The bubble occurs when the market diverges sufficiently from reality that resources are misallocated. This misallocation causes the destruction of wealth and a subsequent crash. However, because the market has drifted from reality, you cannot necessarily make conclusions about reality (just that the market no longer reflected reality). For example, it seems possible that we're near the end of a North-American fracking bubble and that a crash looms. In that case, the market has misallocated resources to fracking companies that would have been better used elsewhere in the economy. This does not necessarily mean that fracking is inherently economically unsound, just that the speculative resources that have been put into it (right now) were economically unsound, and that the expectations of speculators (sometimes misnamed "investors") were unrealistic.

However, it might be reasonable to conclude that tight oil is not a good investment when the price of oil is $30 / barrel. This is interesting, because perhaps if the price of oil had remained high, those companies might have remained solvent -- whether they could continue to operate when oil was $100 / barrel is now an open question. I suppose it goes to show that reality is complex, and even processes that might seem out-of-scope (eg. geopolitical changes affecting commodity prices) can show apparently-sound market responses to be unsound.