Speculative bubbles in the free market

Economics Economics Questions
21

I wouldn’t call that a bubble either. But imagine there’s a new technology like the internet in the 90’s. Many people believe that there’s a “new era” and everything will be different now. Thousands of start-ups emerge, millions of investor pump billions of dollars into companies that haven’t earned one cent yet but are believed to become multi-billion dollar corporations in 5-10 years. After a few years, investors find out that they were too optimistic and panicky try to sell their assets (sometimes even below real intrinsic value).

That scenario is absolutely possible in an unhampered free market economy, since investors didn’t have any experience with the “New Economy”. I agree that monetary policy can and does exacerbate this problem, but since people cannot see into the future and are often lead by herd instinct etc. boom and bust cycles will naturally occur in a free market economy as well.

22

wont someone stop the madness!

23

A bubble is defined by the snowball effect. When you have ever more people buying something just to get a piece of the action on no better basis than that it is seeimingly appreciating without looking at the fundamentals at all. Which in turns triggers even more buying making the snowball self-fueling.

He meant below the price the fundamentals would normally suggest.

24

in a free market, with such blips, the pain falls on those responsible for the blips, and everyone else needn’t take notice.

under state governance, easy money props up the bubble and both widely distorts the structure of production and encourages over consumption across the broad span of the economy. so when the bubble pops, everyone feels the pain.

you can say its such a quantitative difference that it can be considered as pseudo-qualitatively different. certainly one bears thinking about and the other doesn’t. much like the difference between losing skin through gentle friction of ones clothes throughout a normal day, and being flayed alive by a sadistic torturer. two ways of losing skin.

oh is that all? ok

25

Do you agree that there are some things that people but party for their own sake and partly as an investment? Like housing or antiques.

So when people decide how much they are willing to pay for this type of item they have to consider two factors. 1. How much pleasure they will derive from the item for whatever period that they are likely to own it and 2. How much money they estimate they will get for the item when they sell it. If for some reason they were barred from ever selling the item or if there as a 100% tax on profits made then only factor 1 need be considered. What word or phrase should we use to describe the price people are willing to pay given factor 1 alone?

26

buying something as an investement is not for the sake of the investor?

27

I’m not sure I understand what you’re getting at.

Things can be bought partly as an investment and partly for their own sake.

Actually buying something “as an investment” is perhaps overly restrictive. Maybe I should re-phrase my scenario in terms of “with an eye to the potential resale value”. I idid this myself just recently. I was considering how much to bid on ebay for a “concept II” rowing machine. They’re pretty expensive things, and we all know that people often get bored with exersize machines. I thought to myself, “if I keep up my motivation and use it for years and years to come then my cost per workout will end up being very small, and so its not really that expensive after all”. I also thought to myself “If I get bored with it after a few weeks then I can always sell it, and as I know they are very well made and are in gyms all over the world, I should be able so sell it for just about as much as I bought it for.”

So this is an example of a predicted future selling price influencing what I am willing to pay for the item.

Lets put it another way, lets say I was just about to put my bid in on ebay (for amount X) but just before I pressed the [Bid now] button I heard the voice of God saying “Mick, you are not allowed to ever sell this item. If/when you have finished with it, you must give it away for free” then (after I have got over the shock of hearing the voice of God) I would lower my bid to amount Y (which would have been substantially less). What word or expression would an Austrian give this lower price Y?

28

its just your reserve price given your subjective valuation of the good

29

**

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Maybe that’s what Tobbog meant by “intrinsic value”.

30

maybe

maybe not

http://en.wikipedia.org/wiki/Intrinsic_theory_of_value

http://en.wikipedia.org/wiki/Subjective_theory_of_value

31

With intrinsic value I didn’t mean the Marxian term but the concept from investment calculation with discounted cash flows.

There might be also secondary-deflation effects in the short term, harming market participants outside the bubble sectors.

It occurs to me that some people here argue more Chicagoan than Austrian. All human beings fail sometimes (with the difference that market failures are less harmful than government failures). And occasionally, a huge number of people fail collectively (herd behaviour). If people were always perfectly rational, the FED could have printed money forever without there appearing business cycles. Yes, monetary policy aggravates the problem of business cycles, but as long as people cannot foresee the future and are irrationally optimistic or pessimistic, there will be cycles of boom and bust.

But that’s okay - in a world of uncertainty, there is sometimes no better method than trial and error.

32

The Austrian prespective is that bubbles occur from monetary intervention. Anything else is not a bubble at all but somethign entirely different. Speculative bubbles cannot occur without the means to finance them. IE Easy money.

This is not the Austrian prespective.

You need to go back and read up on the ABCT. We just got done hamemring this on Mickanomics, we don’t want to do it again. :frowning:

33

If there is hyperinflation there is no reason to save at all. Just saying.

34

This is your private definition. Most people would explain bubbles as a large number of malinvestments that happen at the same time. And as long as people aren’t perfectly rational godlike creatures, it is possible for bubbles to occur.

The Austrian School sees market participants in a constant struggle to estimate the future. If the majority or a large fraction of the market participants misestimate the future, a boom bust cycle can occur even without monetary intervention. Please tell me the reason why you think that is impossible.

35

In a world ruled by statistical mechanics, almost anything is possible. If all the atoms in your building randomly moved upward, the whole building would rise. But it’s highly unlikely.

In the world of human beings, it is certainly possible that everyone in the world may decide of their own free will to run lemming like into the sea. No one can say that it is impossible. But it is highly unlikely, so unlikely as to be laughable to even discuss when dealing with the real world.

In the world of economics, most people care about their hard earned money and are extremely reluctant to risk it unless the odds heavily favor their success. This is especially true about professional investors, who are mostly walking around with money because they have a track record of success. So they often know what they are doing, many more times than not.

Only monetary intervention, which makes rational people rationally think, "If I do nothing my money will be inflated away to nothing, will make them prefer the unlikely [profit from doubtful speculation] to the inevitable [loss of their bucks to inflation].

Only monetary intervention, which provides free loans to the irrational, allows nut cases to throw their money away on the impossible bubble.

So yes, it is POSSIBLE that a large fraction of the world will all decide to invest in a bubble without monetary intervention, just as it it possible to throw heads on a fair die a trillion times in a row. But both are highly unlikely.

36

Oh, I agree. The only bubbles that matter are those you get called “un-patriotic” for helping to burst.

37

Did you ever hear the term “herd instinct”? It governs which movies we watch, what kind of clothes we wear and which music we listen to. And every few decades, it becomes extremely fashionable to buy stocks, since the Joneses and the Smiths bought them too.

The dotcom bubble I mentioned beforehand was fueled mostly through the stock market and most investors don’t borrow any money in order to buy stocks. The fact was that people saw teenagers becoming millionaires through internet companies and millions of people wanted to be like them. The stocks of internet companies rose ten- or twentyfold which made many people believe that the only direction high tech stocks can take is up, which made even more people invest in them, and so on.

Many people do things, just because many others do it too, they believe things they want to believe and they often think that patterns of the past will transcend into the future. I think the main advantage of the Austrian School was that it sees people as they are, mostly rational, in contrast to the Chicago School that sees people as perfectly rational.

Let me tell you the story of the oil prospector who met St. Peter at the Pearly Gates. When told his occupation, St. Peter said, “Oh, I’m really sorry. You seem to meet all the tests to get into heaven. But we’ve got a terrible problem. See that pen over there? That’s where we keep the oil prospectors waiting to get into heaven. And it’s filled—we haven’t got room for even one more.” The oil prospector thought for a minute and said, “Would you mind if I just said four words to those folks?” “I can’t see any harm in that,” said St. Pete. So the old-timer cupped his hands and yelled out, “Oil discovered in hell!” Immediately, the oil prospectors wrenched the lock off the door of the pen and out they flew, flapping their wings as hard as they could for the lower regions. “You know, that’s a pretty good trick,” St. Pete said. “Move in. The place is yours. You’ve got plenty of room.” The old fellow scratched his head and said, “No. If you don’t mind, I think I’ll go along with the rest of ’em. There may be some truth to that rumor after all."

38

the dotcom bubble was fed-induced.

Wiki - for the what

The “dot-com bubble” (or sometimes the “I.T. bubble”[1]) was a speculative bubble covering roughly 1998–2001 (with a climax on March 10, 2000 with the NASDAQ peaking at 5132.52) during which stock markets in Western nations saw their equity value rise rapidly from growth in the more recent Internet sector and related fields

Mises - for the how

http://www.thefreemanonline.org/featured/a-classic-hayekian-hangover/

After increasing at a rate of less than 2.5 percent during the first three years of the Clinton administration, MZM increased over the next three years (1996–1998) at an annualized rate of over 10 percent, rising during the last half of 1998 at a binge rate of almost 15 percent.

(MZM: Money with zero maturity. This measure equals M2 plus all money market funds, minus time deposits. It measures the supply of financial assets redeemable at par on demand.)

Sean Corrigan, a principal in Capital Insight, a UK-based financial consultancy, details the consequences of the further expansion that came in “autumn 1998, when the world economy, still racked by the problems of the Asian credit bust over the preceding year, then had to cope with the Russian default and the implosion of the mighty Long-Term Capital Management.”

Corrigan goes on: “Over the next eighteen months, the Fed added $55 billion to its portfolio of Treasuries and swelled repos held from $6.5 billion to $22 billion… [T]his translated into a combined money market mutual fund and commercial bank asset increase of $870 billion to the market peak, of $1.2 trillion to the industrial production peak, and of $1.8 trillion to date [August 14, 2001]—twice the level of real GDP added in the same interval” (http://mises.org/daily/754).

The party was in full swing. The Fed cut the fed funds rate 100 basis points between June 1998 and January 1999. The rate on 30-year Treasuries dropped from a high of over 7 percent to a low of 5 percent. Stock markets soared. The NASDAQ composite went from just over 1000 to over 5000, rising over 80 percent in 1999 alone. With abundant credit being freely served to Internet start-ups, hordes of corporate managers, who had seemed married to their stodgy blue-chip companies, suddenly were romancing some sexy dot-com that had just joined the party.

39

Appeal to Numbers?

The Austrian business cycle theory is an explanation of the phenomenon of business cycles held by the Austrian School of economics. The theory views business cycles (or, as some Austrians prefer, “credit cycles”) as the inevitable consequence of excessive growth in bank credit, exacerbated by inherently damaging and ineffective central bank policies, which cause interest rates to remain too low for too long, resulting in excessive credit creation, speculative economic bubbles and lowered savings.[1]

The Wiki Article

And I actually have read up on it a bit in various books ect… [:)]

With a stable monetary base how would market participants magically mis-estimate the future? Animal Spirits?

The fact that your making a statement which passes judgement on what is a rational market participant would lead me to believe you are lacking major chunks of the Austrian School of thought, like Praxeology. Does man act less rational when the quantity of resources is lied about? Not necessarily.

40

There is nothing magical about misjudgements. No one knwos exactly what the future will look like. (If you do, I hope you are at least a trillionaire.) Because of that, everyone can just guess on how the future will be. And from time to time, the great majority of market participants have quite similar estimations of the future (because they read the same newspapers, and magazines, talk to each other, etc. ). And again, it is perfectly possible that this great majority will turn out to be wrong.

So did I. But contrary to some of the others, I consider these writings food for thought, but I don’t see them as the Holy Gospel.

You’ve got me there. I haven’t read “Human Action” but the original “Nationalökonomie”, that’s why I’ve used the wrong terms here. What I wanted to say was that, ex post, we regret many actions that we have commited.

If you think that I’m wrong, please disprove me. Which magic market mechanism will tell people ex ante that their investment decisions will turn out to be wrong??? There is none, unfortunately. And, becauses of that, if many people take a similar investment decision at the same time, which happens quite often, and that decision turns out to be wrong, there will be a good old boom-bust cycle.