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.