Anyone unfortunate enough to stumble across my blog may be led to believe that I have no time or inclination for writing - after all, if I did there would be more posts, wouldn't there? The truth is rather different - I find it hard to choose what to write about, because it seems there are so many topics that urgently require my inspection. As a result I may make extensive notes about an idea and then never use it. It is a fact that I have fairly recently returned my appetite for knowledge so I must be a nett consumer of information if I am to get anywhere with anything. Hopefully I can return the fruits of my investigations to whoever is willing to read.
Lately I've been bending my will towards understanding economics. It seems that he field is muddy even to the experts, and assumptions and pitfalls abound. The 2008 crash showed that the banks didn't really know what they were doing, and before the crisis everyone thought the world was hunky-dory, so no-one else knew either, except a few like this guy. In fact I would hazard a guess that no one really knows what causes things like inflation, bubbles, deflation, crashes and the like. All we know is that generally if we put pressure on point x we get a response y. Thus when a country's official interest rate is lowered, inflation increases, and vice versa.
Most of today's economy seems to revolve around investors, in one way or another. The thinking is that no investor will willingly throw money away by buying into a bad deal, but the crash of 2008 showed this belief to be a fantasy. Governments can borrow money because investors are willing to give it to them - if they expect a return. Currencies are strengthen or weaken depending on how much faith investors have that the currency will stay strong or will weaken further. Companies can borrow money if banks think they will get a nett return, same for individuals. Investors bank money if they think the bank's practices are lucrative.
It does not take long to realise that this whole thing is a positive feedback loop. It all works if people are confident, but it rapidly goes down the toilet if people lose confidence. Granted this is a simplification but let's work with it for a moment. What are the checks? Where is the point where investment confidence is lost? Where is it gained? This article lists some of the causes and effects of four major crashes over the last century or so. They all have in common the formation of a "bubble" leading up to the crash. The first three have new rules associated with them that were intended to prevent future crashes. All of them failed. The Economists apparently ran out of talent, too, because no additional rules or institutions have resulted from the most recent crash, in order to prevent such a thing happening again. Instead we had costly bailouts, humiliatingly paid for by countries we might consider backward - China and the oil nations of the Middle East. In fact China is now the US's biggest creditor. The crashes we have suffered were either necessary, or they should direct us to restructure our finance. No one is claiming they were necessary and the Arab world laughed at us, saying their financial structures were more robust. So have we changed the way we do business? I should coco.
You may think I am having a downer on investors - after all, they are the link in the chain that has the most influence on the positive feedback - but I'm not, really. They are part of the problem but they are not the problem. The real problem is the way we do business. This article and the comments it sparked have some very interesting views, and suggest some solutions that are presently beyond me. It suggests that financial engineers are to blame for the crash, and to an extent they may be, but what is it about the system that makes financial engineering a tempting prospect in the first place? Why do bubbles form at all?
The answers to those questions are by no means obvious, and there is debate among economists on the answers. There are some things we can say with a reasonable degree of conviction, though. Firstly both the bubble and the crash are in principle based on investor psychology. It doesn't seem possible to identify one particular cause, instead a range of factors come into play.
A bubble is a type of inflation, except that in the real world if inflation causes a rise in the cost of, say, electricity, each kWh still has a genuine worth based on the production and distribution cost. Its worth is anchored in the work required to create it and get it into your house, or factory, or whatever. Of course demand can increase its price, but ultimately its worth can never go much above the economic benefit it gives to the buyer. Stocks, too, are subject to supply and demand. When a company is goes public its apparent worth is divided among stocks or shares, giving each of those shares a value that is defined by the total value of the company. The money raised from this partial sale is used to further the business. Over time the stocks of the company increase or decrease in value as investors buy or sell depending on whether they believe the company is growing or shrinking. Bad news, such as under-target profits, tend to depress the value of stock, and vice versa. But ultimately the real-terms value of stock is not known, it is only inferred from the company's past performance, market conditions and the company's current performance. So if investors suddenly believed that a company was going down the tubes they might sell all the public stock back to the company, resulting in a price drop that might make going down the tubes inevitable. A self-fulfilling prophecy. There is no anchor for the value of stocks, they are worth exactly what investors think they are worth. This becomes a problem when investors' beliefs are based on the beliefs of other investors. This was illustrated nicely when the dotcom bubble ocurred. Investors were so confident in the new business model that they thought such companies were worth more than their real value, resulting in a runaway investment boom that ended when everybody realised it was chaff. Some people legally made shed loads of cash by taking advantage of the investors' credulity. There is a word for such people. It is "conman". More can be found here. Similarly the bubble bursts when investors realise the bubble can no longer be sustained and opt out. A "correction" results, which, if the number of investors in the bubble is large enough, can become a crash, as investors with no exit strategy panic and sell as fast as possible to avoid heavy losses.
The model allows for rapid increases in stock prices, thus growing a company very fast, which can be a good thing, for sure, but this very volatility also gives rise to the possibility of a massive crash, resulting in a company losing value, likely ending up being undervalued. Instability is inherent in the system, so we either have to accept that crashes will occur and hope that the times of plenty make up for them, or we have to design a new system where stock valuations are not so volatile.
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