February 15, 2009
Can Governments have 'Bubbles'?
Dagny D'Anconia has proposed that governments, like commodities or companies, can be victims of "bubble" collapses. For those unfamiliar with her earlier articles, the following brief anatomy of bubbles may help readers to appreciate her perceptiveness.
A "bubble" is traditionally defined as a boom-bust catastrophe caused by the expansion of a financial or social entity to an unsustainably high value, followed by a rapid and catastrophic collapse when the overvaluation is perceived. As Rick Moran and Thomas Lifson pointed out, last year's petroleum bubble was a classic example.
The force causing the overvaluation can be euphoria, recklessness, overconfidence, overoptimistic expectations, greed, fraud, desperation, coercion, and/or ignorance.
The collapse can be spontaneously caused by loss of public confidence as result of excessive overvaluation (the last straw), new information, the exposure of fraud, a realistic re-evaluation, and/or panic. It can also be triggered, at a specific time, by managed news (true or false) or by planted rumors.
Bubbles are usually classified by the type of entity involved. Commodity bubbles are usually caused by a perceived threat of future shortage of a constantly needed commodity, as with the petroleum bubble of 2008. Real estate bubbles are caused by (1) a temporary shortage of housing due to major migrations (e.g. urban housing during WWII), (2) the unfulfilled expectation of future development of a major urban or recreational area (e.g. the Florida land boom), (3) unwise government intervention, or (4) media hype.
Investment bubbles are a common occurrence in the stock and commodity markets. Some are started by the hyped announcements of corporations (e.g. a new drug) followed by refutation (e.g. failure of clinical trials). In other cases, speculators spread false rumors to create a bubble, which collapses when the rumor is proved false. In the fraudulent Ponzi or pyramid bubble, extravagant promises of a high return are made to seem real when the first round of investors reap their profits -- because the perpetrator is using the money from later investors to pay back the first group. Mr. Bernie Madoff has graciously provided us with a fresh example of this type.
But all these are examples of only one type of financial bubble, wherein the inflating factor is public opinion. In the physical world, a bubble can be formed in at least three ways:
A. by pumping external gas into a small blob of pliable material until it expands to the point of rupture,
B. by generating gas within the blob, or
C. by starting with a sphere of material and eating out its insides until it is a hollow shell.
Each has a financial counterpart. The bubbles described above correspond to type A. Types B and C are not usually appreciated to be bubbles because the force for overvaluation lies within the entity. Here the valuation is often initially valid and based on years of solid performance. However, the managers of the entity, because of overconfidence, greed, or some other motive, either overextend (type B) or siphon off (type C) the assets of the organization until it is no longer stable and collapses. The collapse is usually triggered by revelations that cause the organization's creditors and/or the public to lose confidence in its ability to pay off its debts or promises.
In the corporate world, Enron is an example of type B. In type C, the company's stock is watered or assets are liquidated and the profits diverted into the pockets of the perpetrators.
Mechanisms of bubble formation can be combined. The perpetrators of an internal bubble may try to augment (or cover up) their chicanery by instigating a type A bubble at the same time. The ultimate catastrophe is augmented because in all cases, the collapse of a bubble involves a loss of public confidence.
Internal bubbles have often caused the collapse of governments. In type B collapses, the government extends its activities (e.g. warfare or welfare) beyond its expectable revenues. This tactic is feasible for periods of several years or even decades but will sooner or later cause collapse. In type C bubbles, the government "waters its stock" by creating money and causing inflation. Numerous examples of both types are recorded on our history books.
With these definitions in mind, read Mme, D'Anconia's article, consider the bailout and the stimulus package, and prepare to be afraid.
On the other hand, there's some consolation in the knowledge that individual politicians can be bubbles too.