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Bubbles (Part III)

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In the previous article, I provided a brief outline of the South Sea Bubble of 1711-1720. In this article, I focus on the current financial bubble and its aftermath.

A bubble’s anatomy consists of three main areas: creation, collapse, and aftermath.

Creation

  1. A favorable public psychology - confidence.
  2. A herding instinct.
  3. The means to speculate with money or credit.

Collapse

  1. An investor (just one) willing to sell at a lower price.
  2. The default on loans and evaporation of new credit.
  3. Discovery of massive fraud.

Aftermath

  1. Collapsing prices.
  2. Recriminations of “guilty” parties.
  3. Government attempts to restore public confidence.

I consistently use 1981-1982 as a starting point for the start of our financial bubble. There are demographic and generational forces that served as catalysts. I could write a significant amount on those two topics. Public confidence increased during the 1990s and after a brief dip from 2000-2002, the bubble collapsed in 2007-2008. Investors systematically piled into stocks and real estate not wanting to miss the next sure thing (herding instinct). The means to speculate was made possible through the greatest credit binge in history by private investors and government entities. Rather than label this a stock or real estate bubble, we can really just say it is a financial asset bubble.

Prices in the stock and real estate market started their cascade down when some investors sold at lower prices. Commodity prices collapsed. When these markets broke, we heard officials saying the credit markets “seized up” (aka, the evaporation of new credit). The FBI uncovered dozens of high-profile Ponzi schemes, the Bernard Madoff scheme being the largest. The Ponzi schemes satisfied the massive fraud criteria.

Our aftermath included a continuing collapse of prices. A severe public backlash erupted against leaders of banks, hedge funds, and former market wizards (recriminations of guilty parties). The US government embarked on a spending spree of mythical proportions. Our Congress, with Executive Branch prodding, took legislative measures (Dodd-Frank among them) to combat future bubbles. The Federal Reserve embarked on a formerly incomprehensible spending spree that added trillions to their balance sheet. The euphemism, Quantitative Easing, became part of our financial lexicon. All of these measures satisfy the criteria of government attempts to restore public confidence. [Note: the Fed would not qualify as "government" though their intent of restoring confidence applies]

The problem with our contemporary bubble is its sheer size. Our bubble is a product of unabated confidence (read credit expansion and debt accumulation). It was very difficult for the public to recognize the effects of this bubble since there was no pain felt in its creation. Our political leaders only exacerbated its effects through devastating increases in public debt. Using 1980 as a base year, the outstanding public debt of the United States in its previous 200-year history was $909 Billion. This included debt-creating events such as The Revolutionary War, The War of 1812, The Civil War, The Spanish-American War, World War I, World War II, the Korean War and the Vietnam War. Throw in government efforts to fight the Great Depression of the 1930s, and we have readily identifiable reasons for public debt increases.

After 1980, our public debt tripled to $2.6 trillion by 1988. By 1992, this debt surged to $4 trillion. It took 8 years to reach $5.6 trillion in 2000. By 2007, the top of the bubble, the debt reached $8.7 trillion. As I write this our debt is $17.5 trillion. For those scoring at home, our debt exceeds our GDP by over $1 trillion.

The anatomy of this bubble fits the prerequisites noted earlier. What is most disturbing is not that it meets all the characteristics of a bubble but the sheer magnitude will make the bubble pop feel more like the aftermath of a 10-megaton nuclear blast. You might argue that the bubble popped in 2008 and to a large extent it did. However, governments have coordinated their efforts to employ Keynesian economic stimulus and central bank tinkering to reflate the bubble. So while individuals and businesses recognized the bubble pop and made some economic adjustments, the financial Wizards had other ideas.

Government and central banks are not above the market. They are participants consuming resources, borrowing money, and allocating capital. Governments and central banks do not operate in an orbit around the earth sprinkling magic dust on economic problems. This is the mother of all bubbles and she is still in the house.

Jim Mosquera is the author of E$caping Oz: Protecting your wealth during the financial crisis and is a Principal at Sentinel Consulting.

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