The Causes of Economic Bubble and the Role of Behavioural Finance in Predicting Them

This article explores some of the factors that contribute to the creation of economic bubbles. The subprime bubble is the most recent bubble, but it is not an isolated case. It comes as the latest in a long line of economic bubbles. Over the last 50 years we have seen major bubbles in things like conglomerates, inflation, commodities, Japanese real estate, dotcom, and subprime mortgages. Clearly, there is something intrinsic to human nature which creates bubbles.

Bubbles in themselves are not a problem. The real problem is caused by the increase in relative pricing levels. This causes misallocations of capital towards the areas achieving high price rises. The subsequent correction (as the trend proves unsustainable) causes severe structural difficulties in the economy.

A lot of books and ‘after the event’ wisdom has been published on the subject of bubbles. However, very few of them, go into explaining how you can actually profit from future situations. This article looks at some of the mechanisms by which bubbles takes place. It outlines some examples of the causes and, suggests ways in which investors can recognise bubbles.

Anchoring

Anchoring is the behavioural finance perspective whereby people have the tendency to over emphasise one specific value and then adjust to that value. That ‘anchor’ is laid down and decisions are made with a bias towards that value.

A classic example would be with the housing market, whereby whole neighbourhoods ‘adjust’ to rising home prices. The price becomes the anchor, to then spur prices higher, as everybody focuses on rising prices. However, what they are not focusing on are values such as house price to income, house price to monthly mortgage payments and other mortgage affordability metrics. The result is a severe dislocation in the allocation of resources with an economy. This can be seen in the continuing oversupply of housing in the US.

Soros' Reflexivity in Markets

Reflexivity in bubbles is the process whereby the fact that prices are rising causes the underlying fundamentals to improve, which then feeds back into higher prices as agents see better fundamentals. This positive feedback loop grows until, at some point, this relationship breaks down and, the positive feedback loop then becomes a negative one. It is easy to confuse this process with anchoring-in fact anchoring contributes to reflexivity-however it should be noted that with reflexivity, the underlying fundamentals are, in fact, improving. This makes this type of bubble, even more dangerous.

An example of this can be seen with gold, whereby increasing prices have seen sentiment shift towards gold being seen as a ‘safe haven,’ uncorrelated asset class, for investors. Similarly, rising prices have seen an increase in Exchange Traded Funds ETF issuance, which has encouraged new investment. The increase in ETF investment then fuels further higher prices and the positive feedback loop goes on.

Structural and Cultural Causes

Not all economies are driven by free market supply and demand. Furthermore, different cultures value economic ends differently. Furthermore, many countries are at different stages of development to each other, In other words, economies and asset prices are driven by other considerations than purely supply and demand. This can create a bubble if the marginal increase in demand from one culture or country causes price inelasticity.

For example, consider that most of the Far East Asian countries (particularly China and India) are in early stage development. In these countries, significant social unrest would ensue if employment or living conditions got noticeably worse for the large poorer section of their populations. Therefore, as oil prices rose in 2008, many of these countries (China, India, Malaysia) continued to use their public surplus to subsidise Oil prices for the poorer segments of their populations. The subsidies helped mask the underlying price rise and this caused global Oil demand to be price inelastic. Whether this is sustainable longer term is another question.

Corporate Necessity, Fear and Greed

Corporate decision making isn’t necessarily driven by profit maximisation, or following shareholder interests, or even adherence to the underlying fundamental metrics in their industry. Directors may decide to acquire companies simply because they want to further their own careers (conglomerate boom) or they fall foul to the latest fad (dotcom boom).

Furthermore, they could driven by their own self-interest in grabbing short term profit, even if they know it is detrimental to the long term interests (subprime mortgage, SIVs and mortgage bonds) of their shareholders. Similarly, the staff of these companies could be made aware that if they do not adhere to this mania, then they will be replaced by someone who does!

Another factor is that corporations could be forced to exacerbate bubble conditions further, even if they know that their industry is on an unsustainable trend. An example of this was the issuance of 3G licences in the UK. This is seen as the pinnacle of the dotcom bubble, but what else were the incumbent mobile telecom companies supposed to do?

Their raison d’etre is to offer upgraded services to their customers. The licences were limited in number and, they had to have them, even if the price they paid (to outbid newcomers who were flush with investor cash) might have been seen as ‘bubbly.' They weren’t paying what they thought was fundamentally sound, but rather what they had to pay in order to keep their company offering updated 3G services.

Behavioural Finance Explains Bubbles

All of the factors outlined in this article are intrinsic to human behaviour and, illustrative of the point that human behaviour creates bubbles. Therefore, bubble behaviour will always be around. Greater understanding of these causes can create opportunity for investors to take advantage and avoid potential bubble scenarios.