Tuesday, November 18, 2008

Niall Ferguson at Vanity Fair on the Meltdown

Long article of which I understood maybe a third but I did like this:

This is no new insight. In the 400 years since the first shares were bought and sold on the Amsterdam Beurs, there has been a long succession of financial bubbles. Time and again, asset prices have soared to unsustainable heights only to crash downward again. So familiar is this pattern—described by the economic historian Charles Kindleberger—that it is possible to distill it into five stages:

(1) Displacement: Some change in economic circumstances creates new and profitable opportunities. (2) Euphoria, or overtrading: A feedback process sets in whereby expectation of rising profits leads to rapid growth in asset prices. (3) Mania, or bubble: The prospect of easy capital gains attracts first-time investors and swindlers eager to mulct them of their money. (4) Distress: The insiders discern that profits cannot possibly justify the now exorbitant price of the assets and begin to take profits by selling. (5) Revulsion, or discredit: As asset prices fall, the outsiders stampede for the exits, causing the bubble to burst.

The key point is that without easy credit creation a true bubble cannot occur. That is why so many bubbles have their origins in the sins of omission and commission of central banks.


Stephanie said...

So is there any harm in regulation to prevent the bubble? What should be left would be reasonable, reliable, modest growth, right? Isn't that enough? Do we need winners/losers of the bubble game?

Stephanie said...

And I wasn't asking that rhetorically. I'm really asking, "Are the bubbles a necessary part of the functioning of a free market? or can you still get healthy growth etc but just avoid the bubbles?"

Scooter said...

I have no idea but, as you might suspect, my initial reaction is to shun regulation. I’d have to see what the regulation looked like. I can’t begin to fathom how this would work in the financial markets.

For an example my little mind can get around, let’s take the “flip” market. At what point would we say:

Sorry Ms Flipper, you cannot buy that house. You flippers are creating (or at least helping create) an irrational exuberance in the real estate market. We must avoid that real estate bubble.

Stephanie said...

Well, no, that wouldn't work.

But, for example, with the credit default swaps, how about "you can't promise to insure amounts greater than you can pay off". I'm guessing there are similar sorts of regulations for the normal insurance industry. (Well, maybe not; see AIG.)

Scooter said...

Shootin’ from the hip b/c I’m in way over my head (to mix metaphors):

On the insurance issue, it is a bit like banking and Ferguson does address some of that. Banks should have some reasonable amount of deposits, it seems to me, for each dollar loaned. I have no idea what the proper ratio should be.

I suppose the insurance industry should also have some proper asset to liability ratio, too. I guess the question would be whether you want someone in D.C. making that determination or the market. Of course, make the regulation too restrictive and hurt maximum profitability in favor of stability or bubble-avoidance and greedy bubble blowers will move elsewhere.

Here in Texas, my guess is that the insurance industry is among the most heavily regulated but I think that the regs are all about pricing and coverages, etc.. not balance sheets.

Stephanie said...

Of course, the states back insurance company policies (up to a limit), so there's a policy reason that states regulate an asset to liability ratio. Prior to this bailout, maybe it would have been hard for fed or state govt to make the case that it had an interest in regulating the credit default swaps (contracts between consenting capitalists, after all).

Should note that I haven't read the Ferguson piece yet, beyond your quoted segment, but will.

Scooter said...

It's long and for me there is much that is difficult. I like Fergie, though, so I gave it my best shot. You've an obviously better grasp on some of the complicated stuff such as insuring the credit default stops. I have to think in terms of things I pretend to know.