Asset Bubbles and Financial Manias - Breaking the Dollar Podcast
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Asset Bubbles and Financial Manias

Everett Millman
By Everett Millman
Published July 02, 2019

Bubbles are one of the stranger and most controversial subjects in all of economics and finance. Like many topics related to money, these phenomena ultimately boil down to human psychology. Find out what defines an asset "bubble" in this episode with some notable examples throughout history.

This is Breaking The Dollar the podcast that dismantles some of the biggest misconceptions about money. Presented by Gainesville Coins.

Hello and welcome back to Breaking The Dollar. I'm your host Everett Millman and on today's episode we will be discussing asset bubbles, how they happen, what are they, where they come from, and some of the signs you can look for to pick up on whether or not we are in a bubble in any particular market

I think that's kind of the main point of why bubbles are such a big deal.

Nobody sees it while it's happening. It's only after there's a crash that anybody realizes, oh, it looks like we were in a bubble.

So let me begin with a story about how this happened.

It really begins with one or two very big systemically important banks entering a time of financial distress, a time of trouble, and it really leads to a domino effect where when one big bank is in trouble, all of the other banks down the line are now caught in the same situation.

Because they're all interconnected.

They've all made loans to each other, and when one bank starts calling in those loans and they can't be repaid, you get just a series of defaults that leads to people selling off their investments because they realize they're losing money.

That drives prices down even further, which again is sort of a snowball effect that you can't easily turn off or stop once it's started.

Then when word gets down to everyone else that something's wrong with the banks and investments are losing value, people will tend to pull their money out of the bank.

That's called a run on the bank.

It has the same effect where only so many people can pull their money out at once before the bank just fails and defaults.

That leads to a freeze in credit because if nobody is able to repay their loans, they're not going to be making new ones.

You only attempted a resolution to that kind of a crisis is the government stepping in and bailing everyone out.

So that can be just providing them with direct liquidity where they print a bunch of money essentially and give it to the banks in order to keep them solvent.

And it also entails slashing interest rates, cutting interest rates so low that there's really no cost to making and taking out loans.

They try and grease those wheels of the credit cycle and get banks and businesses running.

That little scenario I just laid out might sound familiar to you.

You might be thinking, I'm talking about the financial crisis 10 years ago and you wouldn't be wrong.

But in fact it applies to several instances in history going all the way back to ancient Rome.

So really everything that I just told you about happened in the first century AD in Rome.

There was a financial panic because one or two banks failed and all the other banks were connected with loans and relationships to those banks and people panicked.

That's why a run on banks happens, because people are panicked now.

They often say history does not repeat itself, but it does usually rhyme.

So we get these similar scenarios popping up every so often. And it's really nothing new. We keep repeating similar mistakes over and over going all the way back to ancient Rome.

So this, the situation I described happened under the rule of Tiberius.

There was a full fledged financial panic and banks all over the empire were failing.

It's kind of strange to imagine that something that occurred 2000 years ago can still happen today and it does. It was eerily reminiscent of the global financial crisis about 10 years ago.

And I'll just walk you through how shockingly common it is for these types of asset bubbles to appear and pop.

So let's do a quick and dirty definition of what is a bubble because they don't necessarily come out of nowhere.

The best way I can explain it is that when an asset price or a group of assets have their prices disconnected from reality.

It all comes down to human psychology, as human beings are not always rational.

Greed is a normal part of how financial markets work.

Sometimes it does sort of feed on itself where everyone thinks all this is going to go up forever and you get greedy and you want it to keep going.

That also plays into FOMO, which for our listeners who are over the age of about 35 that stands for fear of missing out, and that is a very powerful psychological driver for people.

When you see other people making money and you think, God, I got to get in on that.

It's too easy. It's easy money.

Probably the classic example everyone always brings up is from almost 400 years ago, the Dutch Tulip Bulb mania,

There's a reason they call it a mania because prices of tulip bulbs which are just flowers, skyrocketed in a matter of a few years.

This is an interesting psychological dynamic to how financial markets work because when people see the price of something rising rapidly, everyone wants to get in on that. Everyone thinks that they can make an easy buck if it's just going to go up forever,

But in reality, Tulip Bulbs are not that rare. They're not that difficult to grow. They're not that valuable.

It was a bubble.

Prices got way higher than they deserved to be and eventually they crashed.

And everyone who made huge investments in Tulip Bulbs lost their money.

And if you look into it, there was nothing special about those Tulip Bulbs.

They were pretty flowers I'm sure, and people wanted them, but it wasn't that there was some lack of supply of them or some scarcity that logically drove prices higher. That would be just supply and demand.

A bubble is when it doesn't make sense when you are disconnected from the fundamental reasons that make anything valuable.

So with the Tulip Bulb mania, and you're going to hear the word mania come up a few times because it is such a psychological thing where everybody just starts piling in because they see everyone else making money.

They see prices going up.

But the point with the Tulip Bulbs also was that much of, it was sort of trading on paper only.

It was speculation.

So people weren't getting thousands more Tulip Bulbs than they had before, they just kept trading the ownership rights to them.

And there's a concept called the greater fool fallacy, that you see a lot with rare collectibles that have no real intrinsic value. They're only worth what a interested collector is willing to pay.

The only way you can make money in a market like that is to find someone who is a bigger fool than you.

And that's, that's basically what happened with Tulip Bulbs. If you're looking at it just from the standpoint of how useful, a Tulip is, they have some value, you know, people are willing to pay for it.

But at its height, one tulip bulb was trading for five times the price of an average house in 17th century Dutch society.

That's insane.

How much more valuable is a flower than the home?

A place to live.

In the 1700s there was one of the early charters from the English Crown for a company called the South Sea Company.

It was a similar situation where perception was that their business was growing and they were making tons of money and everyone wanted to be invested in the South Sea Company.

Isaac Newton was a heavy investor in this bubble. He put a lot of money into it and at one point in the mania, the share price of the South Sea Company went from 100 British pounds to a thousand pounds

It went up 10 times in less than a year.

For some context on a thousand pounds, in the 1700s it is the equivalent of over a quarter million dollars today.

In the intervening centuries, there were several more examples of these financial panics.

Throughout the 1800s in the United States, there were runs on banks. There were bank failures to the point where the whole system almost collapsed and we had to start over.

The easiest example is also the Great Depression where the stock market got into a huge bubble and came crashing down and pulled down so many other businesses with it and so many other people's livelihoods were destroyed because these investments lost value.

If you fast forward a little bit to more modern times, you have the bubble in the Japanese economy in the 1980s.

After about 30 years of massive growth, Japan's currency, the Yen rose too rapidly in value.

So in order to counteract that, the government stepped in and tried to lower the value of the Yen by flooding the market with them.

And in doing so, they caused massive inflation in real estate prices and stock prices that can't last forever.

So within a matter of a few years, Japan went from the most vibrant economy in the world to what's called the Lost Decade, where there was almost zero growth whatsoever.

And although Japan is still the third largest economy in the world, they've never quite recovered from that bubble. It's never quite gotten to the point again where Japanese markets have reclaimed their all time highs from the late eighties.

Now for an example of a bubble that most people might remember, you can go to 1999 early 2000 with the dot com bust where there were so many internet start ups and early companies in the infancy of the internet that everyone thought the values were gonna skyrocket.

And for a short time they did.

But eventually the bubble popped.

People realize that not every corporation with dot com at the end of their name was going to be a winner.

So the whole market fell back.

Another example from around that time period was the bubble and crash in the video game market in the early eighties.

Every company that had anything to do with computers or technology realized people like playing these video games. We should make our own.

And there were so many out there, that consumers lost confidence in the market because many of them were either cheap knockoffs or just not very good technology.

And it brought the whole industry down.

So you can have a bubble in one asset. Like with the Tulip Bulbs, you can have a bubble in a particular sector like the tech sector for dot com.

Another good example that is probably most present on everyone's minds is the global financial crisis in 2007 2008.

It began with a bubble in the housing market and not just the US housing market, it spread all around the world.

That's one of the common themes you'll see with bubbles is that they tend to spread and cause a domino effect across markets that are very far away. Geographically speaking it affects everyone.

If you have ever seen the movie The Big Short, one of the signs that they realize that there was definitely a bubble in real estate and housing was that even at the strip clubs, the strippers were flipping houses.

It's similar to the example I brought up in one of my earlier episodes about right before the Great Depression shoeshine boys were giving stock picks.

When anyone and everyone is invested in something or thinks they know about some great investment, that's usually a pretty good sign that there's a bubble.

If everyone has been a winner for months and months or even years, it's probably a bubble. There's probably going to be a regression toward the mean, which means correcting back toward the historical average of something.

And the reason this is all relevant is that we're starting to see these signs again now.

Probably the most obvious sign right now is how high valuations are for companies that either don't make a lot of money yet or any profit yet, and companies that it's not entirely clear what they do or what they offer.

So kind of across the stock market, it's not isolated just to financial markets or just to technology firms. Really across markets.

We see almost any company that is got enough buzz in the media and has enough excitement generated around the idea behind the company.

We'll get massive multi-billion dollar valuations before they've ever sold a single product, before they've ever turned a single factory operational.

Now the reasoning behind it is that, oh there's potential there. That their future earnings will offer a return.

And it is true that if you go back to some of the companies that survived the dot com bubble like Amazon and Google, that yes, it took them many years before they became profitable and that they had to deal with those growing pains and those bumps in the road before everything was developed.

But those are unicorns. Those are outliers.

We really live in an age where it seems almost every company that comes out of the woodwork seems to get this enthusiastic response from investors and from the big banks who underwrite these initial public offerings.

Not only is that not sustainable, not every company can be a winner before you even know what they do or what their product is, but it's sort of irrational.

One of the main themes that underlies this phenomenon of bubbles and why it keeps happening throughout history across thousands of years, is we seem to be making the same mistake because you can't escape human psychology.

That's why these things happen.

It's human behavior that leads to irrational exuberance.

That's kind of the technical term for when investors are just way too excited and they don't choose to see any of the red flags.

It's easy to ignore the potential risks when you're just very optimistic and you have some short time frame of a track record to say, Oh look, I've been right. The stock just keeps going up. We're doing great.

But as we've seen with the other examples I brought up, that usually only lasts for so long.

You can't keep a bubble inflated forever.

That's why it's a good analogy for how these financial panics happen and what's interesting is that the response is seemingly always the same.

If you take my example from ancient Rome, the emperor Tiberius basically did what our central banks did in 2008.

They bailed everyone out. They cut interest rates and put a moratorium on when they'd have to pay things back.

Granted it did keep those banks and companies afloat, but it's really more of a band-aid than a solution.

It's not going to make everyone whole who lost their money in the crash, in the bubble popping.

You don't have to even go further back than the financial crisis to see that.

What's overlooked is that these types of bubbles, they happen inevitably every so often as people's memories are short.

Nobody's really looking for the bubble, but the risk of them popping is always there.

It is ever present and although I'm connecting this to human psychology and behavior, what's perhaps most terrifying right now is that we've given the keys to the car to computers, to artificial intelligence.

A large portion of stock trading is done through computer algorithms now and there's an obvious advantage that the computers can be programmed to react to signals in the market or changes in prices and do so immediately and you don't even have to worry about it.

You set the computer and you forget it.

The problem with that is it becomes a self fulfilling prophecy.

Again, that perception is reality. So if all the programs and algorithms to trade stocks are all seeing the same signs and then reacting to them, it can obviously cause a snowball effect.

Just another example from recent history preceding the popping of the bubble and the Japanese stock market in 1987 there was kind of a flash crash where there was a massive popping of a bubble, but it recovered rather quickly. Everybody panicked and all global markets were affected by this sort of accidental trade in Japanese markets.

In 1987 the Dow Jones reacted even back then. They had a lot of computer trading and programmed trading algorithms. They were less sophisticated and less quick than today's, but the same concept happened once a few of these algorithms started selling, all of the other programs that were programmed to react did the same thing and it becomes like an avalanche and that's where the panic sets in because nobody knows when it's going to stop going down.

So they sell and then that causes prices to go down even further. If it keeps happening and if you're a participant in markets or you're an investor or a trader, you really can't avoid any of this.

Once there's an asset bubble, there's no safe place to just avoid the losses if you're invested in that sector, so it stresses the importance of being hedged against the possibility of kind of a panic or a run on the banks.

Like I said before, they can happen at any time. The risk is always there because it is so dependent on human psychology and then what are today called high frequency trading algorithms.

Once the computer algorithms start reacting and people see prices going down and panicking, it's like a black hole. There's really no escape.

It's going to suck everything down and hopefully from the examples I provided, you can pick up on that this has happened enough times where we haven't learned our lesson.

Your only defense is to be diversified and hedged against this because it's not particularly useful advice for me to tell you to just avoid all investments whatsoever because it's always going to end in a crash.

That's probably a little too extreme, but it is true that timing a bubble is very risky.

Trying to just get out before everyone else does and look like a genius, the odds of that happening are very low.

A better alternative is to first and foremost protect yourself with safe havens and other safe, tangible investments like physical gold that are not affected by these types of things.

And also to look out for the signs.

If you're hearing from all of your friends or coworkers or family members about these great investments they have or how we're in the greatest bull market of all time for, you know, pick whatever asset you want, that should probably be a red flag. That's a bad sign.

When the average person on the street who has no expertise in finance starts giving you financial advice or telling you about how great their investments are doing, that's usually a sign that something is a amiss, that we're in some type of a bubble.

And you do tend to see it with even consumer products.

So think about the Beanie Baby craze.

You know, only people of a certain age will recall how insanely popular Beanie Babies were.

But there was definitely a time where everyone had to get in on that. Everyone was buying up as many beanie babies as they could and putting them in storage and taking out insurance policies on their

Beanie Baby investment because it was going to be worth so much money in 25 years.

When's the last time you saw or bought a beanie baby?

How much do you think those old beanie babies are worth?

Probably not as much as anyone expected, probably not much, and in fact in most cases, probably less than when people bought them.

Those are the kinds of signs that you're in the midst of a asset bubble and as unfortunate as it is to say, it's really undeniable that we're seeing that right now with the equity market.

Every new idea, every innovative company that comes out is touted as the next billion dollar idea.

The next way to get rich.

And I have to tell you, if you hear that, you should probably be running for the exits.

When everyone thinks they're right and that they've got the answer for the next great investment, it's usually a bad sign.

So you're probably asking yourself, why does any of this matter? You may not be invested in stocks at all, or you don't really pay attention to the biggest craze when people are buying toys or collectibles or whatever mania the next bubble appears in.

And that's a fair question.

I can go back to the Tulip Bulbs example.

A lot of economic historians sort of dispute the idea that it was a bubble at all because the people who lost a lot of money were a select few.

There was only a handful of people who really got burned by the Tulip Bulb craze.

The vast majority of everyone else, it was neither here nor there, even if they had bought or traded a few. So it sort of defies the definition of a bubble.

But what makes it different now is that we see bubbles in the major financial markets, housing, real estate, stocks.

If there's a bubble in one of those markets, it doesn't matter if you have no exposure to it or no investment in it or no connection to it because the institutions that do, like big banks, if they fail, everybody's in bad shape.

And to be quite frank, that's what made the last global financial crisis so bad.

It's not like everyone was invested in the banks.

No, I think most people aren't, but when the banks can't meet margin calls and the banks are the ones who lost a lot of money in a bubble, that trickles down to everyone else.

Then that starts hurting main street and the average investor even when they had nothing to do with it.

Thanks for listening to today's episode.

Join us next time when we discuss one of the potential triggers for the next financial crisis that not enough people are talking about.

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Everett Millman

Everett Millman

Managing Editor | Analyst, Commodities and Finance

Everett has been the head content writer and market analyst at Gainesville Coins since 2013. He has a background in History and is deeply interested in how gold and silver have historically fit into the financial system.

In addition to blogging, Everett's work has been featured in Reuters, CNN Business, Bloomberg Radio, TD Ameritrade Network, CoinWeek, and has been referenced by the Washington Post.