Financial and credit bubbles “The idea is that unlimited prosperity can be created by the unlimited expansion of credit” Adam Smith, 1776. Financial bubbles are not a new phenomenon. A price bubble for Tulip bulbs was created in the Netherlands as far back as the 17th century. Another well-known bubble is the South Sea bubble in England in the 18th century. More recent bubbles were the Internet bubble in the late 1990s and the oil price bubble of the past few years. Apart from the individual histories of how these bubbles came about and their specific characteristics, there are a few striking similarities between virtually all bubbles: A price bubble begins with an economically-founded reason why the price of a certain good or asset should rise. In time, everybody gets wind of this and, as prices rise further, become increasingly convinced that the underlying economic theory is correct. Prices are then pushed up even further. At the end of the price bubble, a situation arises where virtually all the positive factors important to the price has already been discounted in the price. Expectations are then so high that the situation only has to become slightly less positive for the bubble to burst. Once that happens, prices plunge rapidly and either half of or the entire preceding rise is corrected. Often, a credit bubble is also created at the same time as a price bubble, particularly if economic growth is high at the time of the bubble. There is then a positive interaction between rising asset prices, high growth and more loans for investment or consumption, which boosts asset prices and the economy even further. Bubble psychology can then also be adopted in credit extension so that, in time, the positive situation is taken as the basis for extending credit. You then end up with a situation like that which Adam Smith already described in the 18th century. What is overlooked in such a situation is that, as soon as the productive assets are no longer in proportion to the inflated debts all you have is advanced consumption or asset price rises. In other words, if the credit is used primarily for consumption or buying assets, then the economic situation this generates is never tenable.
Posted on: Fri, 15 Aug 2014 10:30:20 +0000
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