It is generally accepted that when a developing economy reaches a certain level of complexity, it experiences an economic crisis as we saw happen to several countries in Latin America and Asia during the last part of the Twentieth Century. And the reason why such crises happen has been attributed to the view that when the economy begins to advance, the developing nations tend to live beyond their means even as a large portion of the population does not share in the fruits of the progress but lives in poverty.
It is also generally accepted that the economic crisis through which the whole world is now struggling began with the fact that cheap goods and cheaper services were made available to the consumers of the advanced economies by the working poor of the emerging ones and that cheap credit was extended to the rich nations by the leaders of the poor ones. And the question is whether or not the two economic crises were due to one and the same set of causes. If the answer is yes, the next question to ask is whether or not the causes are also behind the cyclical booms and busts that hit the developed economies every so often.
To answer these questions we begin with a simple definition of what makes a market. We say there is a market when at least two individuals conduct a transaction where something is exchanged for another. The transaction can be a barter where goods or services are exchanged for other goods or services. Or the transaction can be a more sophisticated commercial exchange where goods or services are exchanged for a commonly accepted currency that can later be exchanged for other goods or services with someone else somewhere else.
We must also note that anyone who participates in an economic system is both a buyer and a seller. In fact, the individuals who work for an enterprise sell their labor for currency which they later use to buy goods and services. And the enterprises sell their goods or services for currency which they later use to buy labor as well as other goods and services. The important point here is that for any of these transactions to take place, the participating entities must communicate and must reach out to each other in some fashion which means they interface.
It is safe to say that inside even the smallest of jurisdictions, numerous interfaces take place every day among the various entities. But we can group these entities into one of two classifications. One group is called the supply side and it comprises the makers and sellers of goods or services. And the other group is called the demand side and it comprises the consumers of those goods and services. The utility in making this classification is that we can now visualize a single interfacing window where the transactions take place between the supply side of the economy and the demand side.
So then, how can this set-up go wrong and cause crises when implemented in the developing nations? The answer is that the problem begins at the interface and spreads from there. What often happens is that the institutions that grant the loans to the developing nations stipulate that the latter must export the goods or services they intend to produce so as to earn enough in the currencies of the developed economies to pay back the loans. What results is not a two-sided equation with a single interface linking the two parties but a three-sided contraption with two interfaces tying together the three parties in what often becomes a difficult relationship. The difficulty arises not because there exists the intention to take colonialism back to the poor nations but that the lenders want to make sure the loans they gave out will be paid in full with interest as agreed upon.
In this set-up, things develop in such a way that instead of having a labor force being paid enough to buy and to consume the products and services it makes, we have a labor force that produces goods and services for export. Where there used to be a system calibrating the work done with the wages paid so as to balance the two sides of the equation, there is now a contraption where the workers are expected to produce but their role as consumers is supplanted by the wealthy foreigners who gave out the loans.
In short, the twosome has become a threesome and where there used to be one interface for bargain and for the exchange of ideas between the workers and their employers, there is now a second interface linking the employers with their foreign bankrollers who are also their customers, advisors and counselors. And it does not take too much imagination to figure out which advice and which counsel the employers will take more often.
But that is not all because there is here a hidden fault line that is a time bomb. As long as the business owners have a foreign market where they can sell their goods and services at a relatively high price, they will not reduce their prices to match the purchasing power of the local population. Nor will they pay their workers higher wages to make them afford the goods and services they produce. And what contributes in part to the making of such decisions is that the business owners discover they still do not make enough money to live the extravagant life they crave and pay back the loans they took from the foreign entities. Instead, they discover that it is the foreign middlemen who make most of the profit on the goods and services they produce in their enterprises using the cheap labor of their poor countrymen.
Only then do the nouveau riche of the developing countries realize they have two problems on their hand; one problem having to do with a disgruntled work force at home and one problem having to do with anxious lenders abroad. So what do they do? They aggravate the situation even more by spiriting what money they can lay their hands on outside the country and stash it in secret accounts far away from home. This done, they prepare themselves to take flight at a moment’s notice when the day of reckoning comes knocking at their door.
This type of scenario played itself out more often in Latin America than in Asia but something close happened there too. And shortly after these scenarios were played out in some Asian countries such as the Philippines, it so happened that mainland China was ready to show itself as the emerging industrial power with the muscle to turn the table. What the leaders of China did was use their country’s interface with the developed world to conduct a different kind of bargain with their counterparts there.
What came out of this encounter was that instead of creating a loop where products and services went from China to the developed world in exchange for payments going in China’s direction, the Chinese managers of the economy asked their wealthy customers to keep the money, consider it a loan and pay interest on it. In doing this, the Chinese made it so that their customers never became their bankrollers, advisors or counselors. And the consequence has been that the crises which used to hit the developing countries now hit the developed ones instead. And we are living the aftermath of this reversal.
And so, to answer the earlier question, yes, there are similarities between the causes that usually trigger the crises in the developing countries and those that triggered the world crisis we are facing today. What remains to be verified is the question relating to the periodic booms and busts that plague the developed economies: Do the similarities extend to them as well? Again, we must look at the interface between the supply side and the demand side of the equation to see what kind of relationship exists there.
To help us in this regard, we first visualize a society living in a primitive economy based on barter alone as it used to be eons ago. Everyone produces something, some of which they keep and some they exchange for other things with their neighbors. The more that a family or a clan produces, the more they get to consume or to exchange for other things. But if for some reason one clan produces less than they will need during the upcoming season, they will make do with less. In a society like this all that is produced by the members is consumed by them which is what keeps the two sides of the equation in balance and prevents a mismatch from developing at the interface.
Fast forward to a complex society in modern times where consumerism is rampant and most of what is produced is sold on credit; from a house to a pair of socks, from a car tune-up to a family vacation; from a toy to a college education. Of course, the consumers pay for the privilege of receiving something now and paying later. This is to say that credit has its cost. How expensive the cost will be depends on the interest rate and the duration of the loan. But on average, the consumers get to dish out more than twice the price of a residential unit before they pay for it in full, at least twice the price of a car before they get to own it, and one and a half times the price of everything they charge to their lines of credit.
But despite these mind boggling arrangements, the system functions more or less well most of the time except for the inconvenience of having to put up with a mild form of boom and bust once in a while. However, things can develop in such a way as to turn the mild boom and bust into its more exaggerated form known as the bubble. Looking at what transpires in such cases will shed light on the mechanism by which all forms of boom and bust happen.
To see this, imagine a set of twins who are separated at birth and who grow up with neither of them knowing he has a twin brother. They do the same kind of work, marry the same kind of girls and buy the same kind of homes at the opposite ends of the same town. One day, chance brings them together and they realize who they are. They discuss their lives and discover how closely paralleled they have been except for one thing; one twin has no money and the other has a million dollars in the bank. How did this happen?
The story of the twins is told in part 3 of the series.
Thursday, July 30, 2009
Friday, July 24, 2009
Financial Mismatch At The Interface (1 of 4)
It used to be that when the economy of a developing nation reached a certain level of complexity the nation found itself mired in an economic crisis, and the people who lived at the lower end of the food chain were the ones to suffer the most. These people protested their lot and were joined by many throughout the world who blamed the process by which the crisis happened on the International Monetary Fund (IMF) and the World Bank. All these people regarded the two international bodies as being most responsible for the resulting misery, and they demonstrated against them when and where their representatives met.
The demonstrators believed that the IMF and the World Bank forced the governments of the developing nations that borrowed the money to adopt policies favoring the nouveau riche in the poor countries and their associates in the rich countries. They considered the nouveau riche and the old rich to be the modern expression of a new wave of colonialism that seeks to dominate the poor countries economically. But then the rich nations were hit by what looked like a similar sort of crisis in the year 2008, and the process by which this came about seemed to defy logic when viewed through the lens of the colonial theory. And so everyone developed an opinion as to how the crisis of the rich nations began but it was clear that the participants based their conclusions on premises rooted in long held ideologies.
And now that most economies have been affected, everyone has a view as to how they should be jumpstarted and made to run on all cylinders so as to reach a healthy rate of growth once again. But when all is said and done, those views boil down to two major categories. There is the trickle down category which is espoused by those who identify themselves with the political Right, and there is the trickle up category which is espoused by those who identify themselves with the political Left. Here again we see that the opinions are rooted in the same old ideologies.
The trickle down theorists say that when you give incentive to the people at the upper end of the food chain, they set-up the businesses that create the jobs that employ the people at the lower end of the food chain and thus trickle down the benefits of the incentives. By contrast, the trickle up theorists say that when you give financial breaks to those at the lower end of the food chain, you give them the means to spend on the goods and services produced by the enterprises of the upper enders and thus trickle up the benefits of the breaks.
Both groups have convincing examples they can cite and powerful arguments they can field to bolster their respective positions. And when you look closely at what they say, you find that both are correct but only because each group makes a set of assumptions that reflects an economy at a different stage of its cycle. You then realize that what may work under one set of assumptions may not work under the other set.
For example, if you have an economy where ideas for new products and new services abound but there is not enough capacity to produce them even though the public is clamoring for them, it makes no sense to give breaks to the consumers and leave the potential producers starved for funds. A better approach would be to give incentives to those at the upper end of the food chain who constitute the supply side of the equation so that they may upgrade their means of production and hire the people that will produce enough goods and services to fill the orders coming from the demand side. The result will be that the benefits of the incentives will trickle down and lift those at the lower end of the food chain.
On the other hand, if you have an economy that has a great deal of spare capacity and high unemployment, it makes no sense to give incentive to those who would add still more to the capacity to produce while a high percentage of the population has little or no earnings to buy the products and services that may not even be essential at this time. A better approach would be to give the breaks to those who are at the lower end of the food chain so that they may buy what they need and thus reward the producers who deliver value for the money that is paid to them. The result will be that the benefits of the breaks will trickle up and strengthen the deserving hand at the upper end of the food chain.
At first glance these examples seem to stand at the two extremes of some economic spectrum but in reality, they are both mainstream because they reflect the two sides of the same coin. In fact, they represent one and the same economic cycle, and they take place all the time in all sorts of economies. And the reason why they take place at all is because no one has yet repealed the economic cycle as we have been reminded by events over and over again.
But what stands alone as an extreme case is what we are experiencing these days in the wake of the financial crisis that hit the world a few months ago. What we have now is a situation where everyone is hurting. Those upstairs who own enterprises have a spare capacity but also a debt load that is crushing them while those downstairs have fewer jobs to go to and also a debt load that is crushing them. Clearly then, we have a multi-layered problem that does not lend itself to easy solutions, and the question is this: Can anything be done to alleviate the problem in the short run while making sure that we shall never again be hit with a situation as extreme as this in the long run?
It looks like the short term concerns have been successfully addressed by the intervention of the central banks and the treasuries of the major powers, and only time will tell how durable the measures they took will be. As to the question regarding the long term situation, it requires that we first identify the two pillars upon which stands an economy:
First, there is the physical plants and the infrastructures that go with them. These are everything constructed inside an economic jurisdiction ranging from the factory that stands in an industrial park to the hospital that dominates a commercial district to the apartment building that rises in a residential zone. And the infrastructures that go with these edifices are the streets, bridges, tunnels, water pipes, sewer systems, power and communication grids and so on.
Second, there is the human resources and the infrastructures that go with them. They are the people who have the knowledge, skills and experience to make the physical plants and their infrastructures work, and the people who maintain these constructions on an ongoing basis. To function well the human resources themselves need infrastructures of their own, and these are the teachers, trainers, books, manuals, teaching aids and so on that keep upgrading the human resources with new ideas and new discoveries on an ongoing basis.
Now, in a jurisdiction where no war or natural catastrophe has happened, nothing is destroyed or severely damaged and no one is killed. Thus, the two pillars of the economy remain intact and the slowdown, if and when it occurs, can only be attributed to the natural cycle of the economy. In fact, a slowdown is something that happens periodically in a mild form once every few years, and happens in a more severe form once every few decades. And as noted above, there seems to be nothing we can do to prevent the slowdowns from happening or to repeal the economic cycle that causes them. But what we should be able to do is prevent the slowdowns from becoming so severe as to threaten the entire economic system such as we are experiencing at this time.
The good news is that in the absence of war or a natural catastrophe the problem is one of organization, pure and simple. The bad news is that we have not figured a way to organize the economic system such that it can work harmoniously with our human nature. We tried all sorts of ideologies spanning the political spectrum from the far Left to the far Right, and not one of them has spawned a system that proved to be reliable and effective under all conditions.
And so an interesting question comes to mind at this juncture: Are the forces acting on the developing economies that experience growing pains the same forces that act on the advanced economies as they experience cyclical crises? This question is important because if the answer is yes, we can look forward to formulating one solution that will solve both problems.
The demonstrators believed that the IMF and the World Bank forced the governments of the developing nations that borrowed the money to adopt policies favoring the nouveau riche in the poor countries and their associates in the rich countries. They considered the nouveau riche and the old rich to be the modern expression of a new wave of colonialism that seeks to dominate the poor countries economically. But then the rich nations were hit by what looked like a similar sort of crisis in the year 2008, and the process by which this came about seemed to defy logic when viewed through the lens of the colonial theory. And so everyone developed an opinion as to how the crisis of the rich nations began but it was clear that the participants based their conclusions on premises rooted in long held ideologies.
And now that most economies have been affected, everyone has a view as to how they should be jumpstarted and made to run on all cylinders so as to reach a healthy rate of growth once again. But when all is said and done, those views boil down to two major categories. There is the trickle down category which is espoused by those who identify themselves with the political Right, and there is the trickle up category which is espoused by those who identify themselves with the political Left. Here again we see that the opinions are rooted in the same old ideologies.
The trickle down theorists say that when you give incentive to the people at the upper end of the food chain, they set-up the businesses that create the jobs that employ the people at the lower end of the food chain and thus trickle down the benefits of the incentives. By contrast, the trickle up theorists say that when you give financial breaks to those at the lower end of the food chain, you give them the means to spend on the goods and services produced by the enterprises of the upper enders and thus trickle up the benefits of the breaks.
Both groups have convincing examples they can cite and powerful arguments they can field to bolster their respective positions. And when you look closely at what they say, you find that both are correct but only because each group makes a set of assumptions that reflects an economy at a different stage of its cycle. You then realize that what may work under one set of assumptions may not work under the other set.
For example, if you have an economy where ideas for new products and new services abound but there is not enough capacity to produce them even though the public is clamoring for them, it makes no sense to give breaks to the consumers and leave the potential producers starved for funds. A better approach would be to give incentives to those at the upper end of the food chain who constitute the supply side of the equation so that they may upgrade their means of production and hire the people that will produce enough goods and services to fill the orders coming from the demand side. The result will be that the benefits of the incentives will trickle down and lift those at the lower end of the food chain.
On the other hand, if you have an economy that has a great deal of spare capacity and high unemployment, it makes no sense to give incentive to those who would add still more to the capacity to produce while a high percentage of the population has little or no earnings to buy the products and services that may not even be essential at this time. A better approach would be to give the breaks to those who are at the lower end of the food chain so that they may buy what they need and thus reward the producers who deliver value for the money that is paid to them. The result will be that the benefits of the breaks will trickle up and strengthen the deserving hand at the upper end of the food chain.
At first glance these examples seem to stand at the two extremes of some economic spectrum but in reality, they are both mainstream because they reflect the two sides of the same coin. In fact, they represent one and the same economic cycle, and they take place all the time in all sorts of economies. And the reason why they take place at all is because no one has yet repealed the economic cycle as we have been reminded by events over and over again.
But what stands alone as an extreme case is what we are experiencing these days in the wake of the financial crisis that hit the world a few months ago. What we have now is a situation where everyone is hurting. Those upstairs who own enterprises have a spare capacity but also a debt load that is crushing them while those downstairs have fewer jobs to go to and also a debt load that is crushing them. Clearly then, we have a multi-layered problem that does not lend itself to easy solutions, and the question is this: Can anything be done to alleviate the problem in the short run while making sure that we shall never again be hit with a situation as extreme as this in the long run?
It looks like the short term concerns have been successfully addressed by the intervention of the central banks and the treasuries of the major powers, and only time will tell how durable the measures they took will be. As to the question regarding the long term situation, it requires that we first identify the two pillars upon which stands an economy:
First, there is the physical plants and the infrastructures that go with them. These are everything constructed inside an economic jurisdiction ranging from the factory that stands in an industrial park to the hospital that dominates a commercial district to the apartment building that rises in a residential zone. And the infrastructures that go with these edifices are the streets, bridges, tunnels, water pipes, sewer systems, power and communication grids and so on.
Second, there is the human resources and the infrastructures that go with them. They are the people who have the knowledge, skills and experience to make the physical plants and their infrastructures work, and the people who maintain these constructions on an ongoing basis. To function well the human resources themselves need infrastructures of their own, and these are the teachers, trainers, books, manuals, teaching aids and so on that keep upgrading the human resources with new ideas and new discoveries on an ongoing basis.
Now, in a jurisdiction where no war or natural catastrophe has happened, nothing is destroyed or severely damaged and no one is killed. Thus, the two pillars of the economy remain intact and the slowdown, if and when it occurs, can only be attributed to the natural cycle of the economy. In fact, a slowdown is something that happens periodically in a mild form once every few years, and happens in a more severe form once every few decades. And as noted above, there seems to be nothing we can do to prevent the slowdowns from happening or to repeal the economic cycle that causes them. But what we should be able to do is prevent the slowdowns from becoming so severe as to threaten the entire economic system such as we are experiencing at this time.
The good news is that in the absence of war or a natural catastrophe the problem is one of organization, pure and simple. The bad news is that we have not figured a way to organize the economic system such that it can work harmoniously with our human nature. We tried all sorts of ideologies spanning the political spectrum from the far Left to the far Right, and not one of them has spawned a system that proved to be reliable and effective under all conditions.
And so an interesting question comes to mind at this juncture: Are the forces acting on the developing economies that experience growing pains the same forces that act on the advanced economies as they experience cyclical crises? This question is important because if the answer is yes, we can look forward to formulating one solution that will solve both problems.
Wednesday, July 1, 2009
Tiptoeing Through The Golden Tulips
For the markets to be regarded as behaving the way they should, they must regulate themselves which is what they do when they are healthy. However, markets also have a mind of their own and they sometimes go off in the wrong direction, a move that culminates in their failure to behave as expected. When this happens, the lives of all of us can be disrupted because as citizens, we depend on the smooth functioning of the marketplace irrespective of the economic jurisdiction where we find ourselves, whether or not we own a business, whether or not we have an investment plan. And so I ask: Why do markets fail to regulate themselves sometimes?
To answer this question requires that we develop a sense of what makes a market in the first place. Well, there are two ways to make a market. One way leads to the built-in mechanism for self-regulation that forms naturally in a healthy market, and the other leads to the formation of a bubble which is the ingredient most responsible for causing the failure of markets. The way to prevent the latter situation from developing into a serious problem is to detect the bubble before it becomes so large as to be unmanageable; to then sound the alarm and to take the steps that will avoid having a catastrophic failure.
A saying was coined not long ago that aptly expresses why the bubbles begin to form in the first place. It is this: "Someone forgot to take the punch bowl away." Well, the bubbles in the punch of the marketplace are not the tiny bubbles in the wine of Don Ho or Connie Francis; they are large financial bubbles that can seriously hurt a great many people when the time comes for them to burst. And the trick is not to wait till the last moment to take the punch bowl away; it is never to let the bubbles make anyone so happy as to feel fine doing bad business. But this may be a difficult thing to do because different people feel happy for different reasons; some for doing good business and some for doing bad business, and you can never tell which is which.
In any case, we must recognize that competition is the mechanism that regulates a market and keeps it healthy. Competition is initiated when two or more operators, be they manufacturers, wholesalers or retailers, sell the same product in the same market. Unless there is illegal price fixing among the participants, they will keep each other honest by serving their customers the best way they know how. In the meantime, they will be operating in the open as much as possible so as to win the trust of their customers and to maintain that trust for as long as they can.
Also, when bulk buyers go out to buy the same product, the more of them compete to buy the thing, the higher the price of the product. But as the price rises, the number of people still willing to bid for the product keeps shrinking. Eventually the pool of buyers dries up and the last one left bidding will have established the optimum price for the product. This whole operation is called price discovery, and the price thus established for a product is called the market price in some instances or the fair value in other instances.
As can be seen, therefore, the various operators in the marketplace, be they buyers or be they sellers, each will look after themselves. They will do so by competing against each other both as they buy and as they sell. In the end, the sum total of their activities will look like they are pulling the market in every direction which is the effect that keeps it healthy. Without this multiplicity of pulls and in the absence of competition, the marketplace keeps the same orientation and develops what I call a market malignancy.
When greed and lightheadedness affect a large number of participants is when they all start to push in the same direction rather than compete by pulling in different directions. The malignancy develops at this point and turns into a bubble that affects the marketplace at the local level. The bubble then metastasizes and spreads through one sector of the economy, and if not arrested in time, goes on to threaten the entire economy.
Bubbles form when the buyers and the sellers are the same people and they operate on a stage that flips from being a buyer’s market into a seller’s market and vice versa in a short period of time. This encourages them to all buy at the same time and to sell at the same time. Prices swing wildly as a result and the normal operation of the marketplace becomes distorted. The number of bidders does not dwindle as prices go higher, and the sellers stop lowering their prices to compete against each other. Thus, the bidders keep on bidding at ever higher prices and the bubble keeps on getting ever larger with every transaction.
What keeps the bids going indefinitely instead of letting the number of bidders dwindle are two occurrences happening at the same time. First, money is made available at a low interest rate. Second, the expectation is that someone will come tomorrow and pay a higher price for a product that is already trading at a high price today. These occurrences prevent the price discovery from taking place and prevent the bidding process from coming to an end.
Thus, instead of competing and eliminating each other by pulling in different directions, the majority of the participants stay in the game and push in the same direction, towards a higher price. This is how the participants reinforce each other and keep inflating the bubble to make everyone feel fine by feeling wealthier. However, the punch bowl remains there, the big bubble comes around the corner and gets ready to burst. And when this happens, the "golden moon and the sea to toast you and me" promised by Don Ho and Connie Francis become just a song to be recalled as the participants sip on a wine where the bubbles have fizzled out of existence.
Of course, in a climate such as this, not everyone is savvy enough to realize what is going on. And when the time comes for the bubble to burst, those who do not understand how the game is played and do not know how to tiptoe their way through the maze of financial instruments whizzing around and about them are left holding the bag. This is what has been happening ever since the first documented event of this kind took place in Seventeenth Century Holland where the people went crazy trading in tulips.
The same thing happened on a few other occasions when gold was coveted by the many and they all rushed to hoard it like piranhas going after a single prey. In fact, some authors argue that the situation with gold and the other precious metals preceded the Tulip Craze of Holland; other authors even trace the craze all the way back to antiquity. In any case, the Industrial Revolution came along and changed a few things because it brought with it new technologies, each of which had a profound effect on the economy.
What happened was that ever since that time, each technological innovation triggered a rush on its equity that inflated, that grew into a bubble and that culminated in the inevitable burst. There were, for example, the railway bubble, those of housing, that of the dot com and so on. In each case, the participants chased the dream of instant wealth, the dream of hoarding gold to sell at a higher price whatever the name of the new gold and whatever its appearance, be it a tulip, a railway certificate, a house or even a dot com certificate with no product to back it.
Everyone of those crazes hurt the gullible who got into the game not knowing what they were doing. They were the many who got fleeced by the few who got wealthy overnight. And the fleecing handful went on to build palaces for themselves complete with gardens full of tulips and cellars full of bottled wine packed with tiny bubbles. Each of those crazes also affected the entire economy and hurt the people who did not participate in the game. For these reasons, we must do something to guard against such occurrences happening again. But what should that be?
Well, since the problem begins with the loss of competition among the participants in their rush to buy and sell something, the answer seems to be that we ought to probe the anti-competitive activities of the participants as they flip the products at a high frequency. But this approach is fraught with danger because buying and selling is the bread and butter of the capitalist system and when you interfere with that, you stand a chance to cause more damage than solve problems. Thus, we must proceed carefully to protect the system while we try to catch the operators whose intention is to get rich quickly at the expense of everyone else.
We should take a tip from Tiny Tim and tiptoe our way through the tulips in the garden of the marketplace to see what thorny tulips there are which merit being taken out and separate them from the golden tulips which merit being saved. But if it proves that there are more golden tulips in the shadow of the willow tree than there are thorny ones, we must leave the garden alone and let it operate as it has done for ages while we educate the public on the issue of bubble formation the best way that we can.
Anyway, it is summertime in the northern hemisphere where I live, and the time has come to sip on some red fluid and the tiny bubbles that come with it as I tiptoe my way through natural tulips and some other vegetation. See you when I get back from vacation.
To answer this question requires that we develop a sense of what makes a market in the first place. Well, there are two ways to make a market. One way leads to the built-in mechanism for self-regulation that forms naturally in a healthy market, and the other leads to the formation of a bubble which is the ingredient most responsible for causing the failure of markets. The way to prevent the latter situation from developing into a serious problem is to detect the bubble before it becomes so large as to be unmanageable; to then sound the alarm and to take the steps that will avoid having a catastrophic failure.
A saying was coined not long ago that aptly expresses why the bubbles begin to form in the first place. It is this: "Someone forgot to take the punch bowl away." Well, the bubbles in the punch of the marketplace are not the tiny bubbles in the wine of Don Ho or Connie Francis; they are large financial bubbles that can seriously hurt a great many people when the time comes for them to burst. And the trick is not to wait till the last moment to take the punch bowl away; it is never to let the bubbles make anyone so happy as to feel fine doing bad business. But this may be a difficult thing to do because different people feel happy for different reasons; some for doing good business and some for doing bad business, and you can never tell which is which.
In any case, we must recognize that competition is the mechanism that regulates a market and keeps it healthy. Competition is initiated when two or more operators, be they manufacturers, wholesalers or retailers, sell the same product in the same market. Unless there is illegal price fixing among the participants, they will keep each other honest by serving their customers the best way they know how. In the meantime, they will be operating in the open as much as possible so as to win the trust of their customers and to maintain that trust for as long as they can.
Also, when bulk buyers go out to buy the same product, the more of them compete to buy the thing, the higher the price of the product. But as the price rises, the number of people still willing to bid for the product keeps shrinking. Eventually the pool of buyers dries up and the last one left bidding will have established the optimum price for the product. This whole operation is called price discovery, and the price thus established for a product is called the market price in some instances or the fair value in other instances.
As can be seen, therefore, the various operators in the marketplace, be they buyers or be they sellers, each will look after themselves. They will do so by competing against each other both as they buy and as they sell. In the end, the sum total of their activities will look like they are pulling the market in every direction which is the effect that keeps it healthy. Without this multiplicity of pulls and in the absence of competition, the marketplace keeps the same orientation and develops what I call a market malignancy.
When greed and lightheadedness affect a large number of participants is when they all start to push in the same direction rather than compete by pulling in different directions. The malignancy develops at this point and turns into a bubble that affects the marketplace at the local level. The bubble then metastasizes and spreads through one sector of the economy, and if not arrested in time, goes on to threaten the entire economy.
Bubbles form when the buyers and the sellers are the same people and they operate on a stage that flips from being a buyer’s market into a seller’s market and vice versa in a short period of time. This encourages them to all buy at the same time and to sell at the same time. Prices swing wildly as a result and the normal operation of the marketplace becomes distorted. The number of bidders does not dwindle as prices go higher, and the sellers stop lowering their prices to compete against each other. Thus, the bidders keep on bidding at ever higher prices and the bubble keeps on getting ever larger with every transaction.
What keeps the bids going indefinitely instead of letting the number of bidders dwindle are two occurrences happening at the same time. First, money is made available at a low interest rate. Second, the expectation is that someone will come tomorrow and pay a higher price for a product that is already trading at a high price today. These occurrences prevent the price discovery from taking place and prevent the bidding process from coming to an end.
Thus, instead of competing and eliminating each other by pulling in different directions, the majority of the participants stay in the game and push in the same direction, towards a higher price. This is how the participants reinforce each other and keep inflating the bubble to make everyone feel fine by feeling wealthier. However, the punch bowl remains there, the big bubble comes around the corner and gets ready to burst. And when this happens, the "golden moon and the sea to toast you and me" promised by Don Ho and Connie Francis become just a song to be recalled as the participants sip on a wine where the bubbles have fizzled out of existence.
Of course, in a climate such as this, not everyone is savvy enough to realize what is going on. And when the time comes for the bubble to burst, those who do not understand how the game is played and do not know how to tiptoe their way through the maze of financial instruments whizzing around and about them are left holding the bag. This is what has been happening ever since the first documented event of this kind took place in Seventeenth Century Holland where the people went crazy trading in tulips.
The same thing happened on a few other occasions when gold was coveted by the many and they all rushed to hoard it like piranhas going after a single prey. In fact, some authors argue that the situation with gold and the other precious metals preceded the Tulip Craze of Holland; other authors even trace the craze all the way back to antiquity. In any case, the Industrial Revolution came along and changed a few things because it brought with it new technologies, each of which had a profound effect on the economy.
What happened was that ever since that time, each technological innovation triggered a rush on its equity that inflated, that grew into a bubble and that culminated in the inevitable burst. There were, for example, the railway bubble, those of housing, that of the dot com and so on. In each case, the participants chased the dream of instant wealth, the dream of hoarding gold to sell at a higher price whatever the name of the new gold and whatever its appearance, be it a tulip, a railway certificate, a house or even a dot com certificate with no product to back it.
Everyone of those crazes hurt the gullible who got into the game not knowing what they were doing. They were the many who got fleeced by the few who got wealthy overnight. And the fleecing handful went on to build palaces for themselves complete with gardens full of tulips and cellars full of bottled wine packed with tiny bubbles. Each of those crazes also affected the entire economy and hurt the people who did not participate in the game. For these reasons, we must do something to guard against such occurrences happening again. But what should that be?
Well, since the problem begins with the loss of competition among the participants in their rush to buy and sell something, the answer seems to be that we ought to probe the anti-competitive activities of the participants as they flip the products at a high frequency. But this approach is fraught with danger because buying and selling is the bread and butter of the capitalist system and when you interfere with that, you stand a chance to cause more damage than solve problems. Thus, we must proceed carefully to protect the system while we try to catch the operators whose intention is to get rich quickly at the expense of everyone else.
We should take a tip from Tiny Tim and tiptoe our way through the tulips in the garden of the marketplace to see what thorny tulips there are which merit being taken out and separate them from the golden tulips which merit being saved. But if it proves that there are more golden tulips in the shadow of the willow tree than there are thorny ones, we must leave the garden alone and let it operate as it has done for ages while we educate the public on the issue of bubble formation the best way that we can.
Anyway, it is summertime in the northern hemisphere where I live, and the time has come to sip on some red fluid and the tiny bubbles that come with it as I tiptoe my way through natural tulips and some other vegetation. See you when I get back from vacation.
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