A Predictive Analytical Framework For Market Participants

Twenty-one years into the 21st century and we have already been embroiled in three major economic crises. It started with the dot-com bubble bursting, which was caused by excessively optimistic speculative investors in tech companies. The second financial crisis unravelled itself as the 2008 housing crisis, causing rampant devastation in terms of unemployment, loss of income, and aggregate demand, single-handedly sending economies back decades. Now we just witnessed the third economic collapse, which was fuelled by an economic shutdown amidst a global pandemic. With each crisis being worse than the last, and with the rise of unemployment and an unprecedented drop in income, it becomes all the more useful to isolate the variables that cause speculative bubbles in general. This would help investors and policymakers alike to identify and catch the early signs of speculative bubbles.

The conventional explanation of bubbles as the irrational behaviour of investors is unhelpful — in fact, almost useless for understanding bubble dynamics. This is the primary claim advanced by Boom and Bust: A Global History of Financial Bubbles by William Quinn and John D. Turner. Therefore, the book proposes a ‘bubble triangle’ framework wherein financial bubbles are analogous to fire. Much like how fire requires oxygen, fuel, and heat, financial fires require their own elements to thrive. In a financial fire, the analogue chemical components are, respectively, marketability (the ability of a commodity to be marketed), money/credit, and speculation; the spark to the fire is from two sources, technological innovation or government policy. However, in their quest to create a parsimonious model, they do sacrifice certain nuances that could greatly improve the efficacy of the bubble triangle framework.

Boom and Bust does several things well. To begin with, historically, economic literature has focused on explaining the causes behind specific historical episodes. Authors in the past have evaded formulating a more general theory explaining the inception of speculative bubbles and why they thrive. However, Quinn and Turner take a step further and provide a framework with the ‘bubble triangle’ that provides a more general theory for explaining the causes of bubbles. This approach has several positive connotations attached to it. For instance, a generalized framework would be incredibly useful in identifying upcoming speculative bubbles — for instance, the bitcoin and crypto bubble. The authors explore and apply this framework to several financial bubbles starting from the Mississippi crisis of 1720 in France to the Chinese stock market bubble of 2015. Quinn and Turner strengthen the validity of their claim by applying their framework over 300 years of financial and economic speculations to prove how it helps to identify the causes of these bubbles. Their approach is also worthwhile in doing the same. They do not look for new historical data but review existing scholarly literature and corroborate that in each instance the bubble triangle provides for formidable explanatory power.

In every speculative bubble, they found that the marketability of the commodity rises or is already high, credit or money is expanded, and speculation is at an all-time high. In terms of the Mississippi crisis of 1720, the Banque General went on a frenzy and printed paper money increasing the credit taking and giving capabilities vastly. There was also rampant speculation regarding the potential that the Company of the West and Company of the Indies possessed. The public thought that the two companies had the ability to generate massive profits by capitalizing on developing the lands of Mississippi. A very similar situation took hold in 2008, where the commodity in question was housing, and marketability was increasingly high. It was becoming considerably easier to buy houses due to the federal policies put in place by the ‘ownership society’ instituted by the Bush administration such as an all-time low-interest rate. This also had the effect of increasing credit in the economy since it became significantly easier to take loans. Speculation was also at an all-time high — the norm was that housing is a great investment. Robert Shiller, a renowned economist, showed ‘that inflation-adjusted U.S. home prices increased 0.4% per year from 1890 to 2004 and 0.7% per year from 1940 to 2004, whereas U.S. census data from 1940 to 2004 shows that the self-assessed value increased 2% per year.’(1) This rampant disconnect between actual versus speculative assessment of housing prices caused an era of ‘irrational exuberance’(2) wherein people were inherently way more optimistic than they should have been. However, unlike what Edelman contends, the roots of the crisis was not the irrational inflation of the real estate market, but the initial spark in all cases, much like the 2008 housing crisis during the ‘ownership society’ era, was government policies or innovation. Further, an interesting insight would be that fraud and ignorance often lead to speculative bubbles of greater magnitudes. For instance, the 2008 housing crisis had a major case of indecency and inaccurate reporting of ratings on the bonds market — Standard & Poor’s and Moody’s were heavily involved in bond credit rating misrepresentation. They were responsible for underestimating the credit risk of financial instruments like bonds and this caused the subprime mortgage crisis.

Quinn and Turner also contend that there could be varied effects of speculative bubbles based on their population exposure. The negative economic consequences of the Mississippi Bubble in France were far worse than the South Sea Bubble in the UK and the Dutch Windhandel in the Netherlands because of a couple of factors. The primary reason could be attributed to the degree of exposure. The entire French Population was exposed to John Law’s currency exploits and the French Banking system, Banque General, was much more instrumental during the inception of the Mississippi Bubble. This insight could be very useful for policymakers, investors, and theorists when determining a probable recourse to deal with speculative bubbles.

However, even though their book offers a groundbreaking framework for analyzing upcoming speculative bubbles, it does come riddled with a few issues. To begin with, the authors fail to apply their framework to the ongoing real-estate bubble in China and Hong Kong.(3) This works contrary to the claims of the book. By negating a very prominent recent bubble, the authors open doors to criticism in terms of arguments that their framework does not apply to more recent bubbles. In the case of the bubble in China and Hong Kong, the bubble-triangle framework works quite differently than the authors contend. Rather than the initial spark being government policies or technological innovation, the initial spark was provided by excess savings. In light of the COVID-19 pandemic, people began to save more and consume less in China. This inherently caused people to look for other avenues to invest their savings/money to make sure that it appreciates in value. This avenue, in China’s case, was real estate. Due to aggressive investments in real estate over the past few months, speculative demand has seen exponential growth. This is solely because people perceive real estate to be a much safer asset class than equity or any other overseas assets. By the end of 2020, 96% of China’s urban households owned at least one home.(4) However, given that people from all different backgrounds in China have such major equity in the real estate market, buyers have started to realize that the government will not let the real estate market tumble. The primary reason for this is that there are way too many stakeholders in this market. If the real estate market did crash, most citizens’ primary source of wealth would disappear and the government will risk a coup. Therefore, the Chinese real estate bubble is quite a challenger to the bubble-triangle framework since the initial spark was caused by excess savings and not government intervention. However, it is persisting because of government policies, which is a unique way of saying that there can also exist situations wherein the bubble triangle can be flipped on its head.

It is also useful to note that throughout the book, the authors emphasize that the ‘unhealthy’ relationship between the state and financiers is one of the primary sources of the bubble triangle framework that causes speculative bubbles.(5) Quinn and Turner do a very eloquent job of defining the cons of the same, however, in the process, they negate a more constructive argument that deals with defining the conditions required for a ‘healthy’ relationship and what is required to solidify a symbiotic relationship between the state and financiers.

Quinn and Turner also do not provide for any recourse to speculative bubbles. In fact, they go on to express their lack of faith in governments in dealing with bubbles. This is not helpful because the connotation this claim holds is that only the federal reserve has the ability and the competency to prevent and help a country out of a speculative bubble. Again, this is not helpful given that it does not give policymakers any direction or constructive input concerning handling crises. By not going into probable recourse actions for governments, they limit the scope of their book by only acting as a call to be vigil but not to act. The idea of the book then becomes only to further an idea for investors to be wary of any economic complications happening in the economy. They want investors to refer back to their bubble triangle framework and that is the extent of it.

It is also imperative to point out that isolating the true spark of a speculative bubble is exponentially harder than what the book lays out. A case in point is the Ownership Society Policy, which was mandated under the administration of George W. Bush. Back then the justifications provided for instituting a policy that made it substantially easy for people to secure loans to accumulate property/houses included inequality, insufficient retirement funds, and lack of healthcare. The timeline of the same is extremely important. The policy was instituted just two years after the dot-com bubble. At that point, the Federal Reserve also seemed to be keen on encouraging a boom in the real estate market because people were just recuperating from the losses of the dot-com bubble that ended in 2001 and were starting to invest their capital in a relatively safer asset — houses and real estate. Therefore, rather than what the book presents to be the reasons for the speculative bubble of 2008, which includes ‘irrational exuberance’, why not attribute the spark of the 2008 crisis to the multitude of ill-consequences brought about by the dot-com bubble and to the systemic roots of inequality? The larger idea is that it is incredibly hard to truly isolate the true spark of a speculative bubble.

Quinn and Turner also offer a contentious claim pertaining to the severity of the consequences of speculative bubbles. They assert that the magnitude of the consequences is contingent on two factors:

1. Leverage and Involvement: Levered exposures and involvement of banks heavily impact the severity. It is made worse by the participation of banks in that leverage.
2. Nature: The nature of the spark — innovation or political.

The authors contend that if a speculative bubble is caused by political factors, for instance, government policies, and the financial institutions are highly levered, the consequences of the speculative bubble would be extremely disastrous. However, this might not necessarily be true. One can strongly argue that the roots of the Mississippi bubble of France in 1720 and the 2008 Subprime Mortgage crisis are entrenched in financial innovation rather than government policy. In 1720, it was the printing of paper money rather than circulating gold and silver, which increased liquidity in the economy, and in 2008 it was the creation of complex financial products such as credit default swaps (CDS) and collateralized debt obligations (CDO). These financial innovations have more generally contributed to the worsening of the aforementioned speculative bubbles.

Even though the book has a few shortcomings, Quinn and Turner offer a fantastic framework to analyse the causes of past and upcoming bubbles. It is an easy read for a layman while also enlightening to experts. Its incredibly powerful explanatory and predictive capacity for multiple market participants across a broad spectrum is a merit that is too monumental to overlook.

Work Cited

1. Bouchet, M. (2018, August 04). Managing country risk in an age of globalization: A practical guide to overcoming challenges in a complex world. Retrieved April 11, 2021, from https://books.google.com/books?id=
2. Edelman, C. (n.d.). The 2008 housing crisis. Retrieved April 11, 2021, from https://www.americanprogress.org/issues/economy/reports/2017/04/13/430424/2008-housing-crisis/
3. Xie, S., & Bird, M. (2020, July 17). The $52 Trillion Bubble: CHINA grapples with Epic property boom. Retrieved April 11, 2021, from https://www.wsj.com/articles/china-property-real-estate-boom-covid-pandemic-bubble-11594908517
4. Xie, S. Y., & Bird, M. (2020, July 17). The $52 Trillion Bubble: China Grapples With Epic Property Boom. The Wall Street Journal. https://www.wsj.com/articles/china-property-real-estate-boom-covid-pandemic-bubble-11594908517.
5. Hung, J. (2020, October 13). How can Hong Kong weather the storm of plunging property prices? Retrieved April 11, 2021, from https://thediplomat.com/2020/10/how-can-hong-kong-weather-the-storm-of-plunging-property-prices/