Friday, May 22, 2009

Double, double, toil, and trouble

Can bubbles be predicted? Can they be avoided? One of the key functions of the financial system is not to avoid bubbles but to blow them. The greatest profits are to be made in skimming money from fools and bubbles offer the ideal prospect. It is the why behind ponzi schemes. It is just most of the time the ability of finance to persuade others to bite is limited, the burden of defectors can be heavy, and all too easily you can end up the fool, the fool being the last one in and last one out.

There are two methods of profiting from bubbles, for investors it is timing them, and for dealers it is trading them. Timing is always difficult, but trading is always profitable. It is just necessary to avoid investing the profits into the bubble.

The book Contrarian Investment Strategies: The Next Generation by David Dreman, begins with a tale of casino with two rooms. The red room is crowded and exciting with large sums being won and lost but the house always gets their cut. The green room is sparse and quiet and actually rewards investors for playing but it is boring. Most people prefer the excitement of the red room to the dull rewards of the green room.

A successful theory of bubbles could be preventative. Yet it is always tempting to believe what you want to believe. Anyone looking at incomes and housing prices or equivalently debt from 2004 on knew we had a bubble. It was apparent they simply could not be afforded. Even knowing this doesn’t tell you how big the bubble will get, when it will burst, where the wreckage will end up, or how bad it will be afterwards. Some will avoid them, some will hope to get out before they burst, some will play them for what they are worth, some will misjudge them, and some will be suckered into them. Bubbles exist, but they are difficult to predict and difficult to profit from them.

I doubt most bubbles could be predicted but that is unnecessarily stringent. A theory might still be useful even if it only made predictions after one burst. One might not be able to avoid them but might still be able to address them after the fact. I don’t even see bubbles as something to be avoided at all costs. They may well play an important part in creative destruction.

Credit bubbles are an altogether different matter. They are tend to be easy to see and prevent by requiring lending be limited to retrospective rather than prospective views and based on income as much as asset values. All losses aren’t preventable but systemic losses usually are. Such a bubble could continue to grow, but only through equity rather than debt. Even this isn't foolproof, though, as debt can be floated rather than formally lent. Debt makes bubbles far worse because its systemic nature results in far larger bubbles, its rigidity makes it difficult to deal with, and its liquidation can lead to deflation.

I view bubbles as a transition from assessing value to assessing other peoples assessment of value, recursively providing convergence in expectations and a positive feedback loop.

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