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Saturday, September 22, 2012

Introduction to Economics: Bubbles and Crashes

With the recent world-wide economical crisis and discussions surrounding the crisis and possible political reactions to it, I have noticed that those discussions often fail because of very different understandings of the economics involved. This post is my attempt to write down my own understanding of the economical background of both the cause of economical crises as well as the possible reactions of politics to them.

Producer-Consumer Market

Market economies are based on the idea that, when goods are exchanged in public, supply and demand will work together to create sensible prices. The best example for this happens on direct producer-consumer markets, as they are the simplest.

Producers provide products on the market, consumers buy them. If consumers want more than producers can provide, prices rise until enough consumers have dropped out because they were unwilling to pay that price. Once consumers are unhappy to pay the prices of the producers, prices drop until enough producers drop out because they can’t produce at that price. This is also the main motivator for technological advances, as lowering production cost enables producers to stay in at lower prices.

This way, prices constantly go up and down and oscillate around the theoretical ideal price.

Investment Market

In capitalism, direct producer-consumer markets are overshadowed by much larger investment markets. Investment is based on the idea that someone provides money now in the hope of gaining more money back later.

For example, to start a business, someone needs to provide an initial amount of capital (money, tools, materials, etc.) with which the business can start off. Historically, most businesses were started with the capital of the owner only. This limits the possible business size drastically. In capitalist markets, businesses can get that money from investors in exchange for the promise of paying interest on the borrowed money later.

As investors can not look into the future, they have to base their investment choices on indicators that might or might not be true. Consequently, investors will not be able to actually tell whether their choice was good until after a certain time of investment. This time delay makes investment choices even more difficult.

Interest also follows the rules of supply and demand. The more obvious it is that a given investment chance will yield interest, the more investors are interested in providing capital, the lower the interest will be. The less obvious it is, the fewer investors are interested, the higher the possible interest. So investors are constantly balancing out risk vs. reward. In a sense, they are gambling.

The largest investors are banks. They provide capital to promising businesses in the form of credits. In turn, banks offer individuals the ability to invest their money into the bank for a net interest. The bank does the investment choices and cushions up the risk for the investors in the bank at the cost of lower interest rates for them.

Boom and Bust

Due to the time delay involved in figuring out if an investment is good or bad, the oscillating prices in investment markets tend to be stronger pronounced than in strict producer-consumer markets.

Additionally, one of the main indicators on whether a given investment opportunity is good or not is, ironically, purely social. If many other investors are investing in a given market, it’s highly likely that it’s a solid choice, even if you do not know why exactly. The chance of all of them being wrong is much lower than the chance of you having overlooked something. Conversely, if many other investors are pulling out for no apparent reason, the chance is high that there is a reason but you have simply not seen it.

This leads to boom and bust cycles in the investment market.

Investors start pouring money into a given market and prices rise. This causes other investors to gain trust in this market and join in. Prices keep going up in a positive feedback loop as more and more investment is made, attracting further investment. This is the boom phase.

At some point, this market will not be able to keep up the hopes of the investors anymore. Everyone knows that there is most definitely a limit. But no one knows when it is reached. If you pull out your money too early, you definitely lose money. If you stay, you might lose more money or even gain some.

At some point, usually above that theoretical ideal point, investors will slowly drop out and prices will go down. Other investors lose trust in this market and drop out as well, causing prices to go down further in a positive feedback loop as more and more investors drop out. This is the bust phase, more or less a complete mirror image of the boom phase. Everyone knows that there is a point where simply investing will yield good returns again, but no one knows when that point is reached.

Prices drop below the theoretical ideal point until some investors are willing to take the risk again. Others see this, join in, and the cycle is complete, the next boom phase begins.

Bubbles and Crashes

This is part of normal market activity. Investors know about boom and bust and can deal with them. Bust phases cause problems, but they usually can be dealt with normally.

Sometimes, though, things work slightly differently. The exact reasons for this are not yet known, and while there are some hypotheses on this, none seem to be fully correct.

As no one knows when the limit is reached, boom phases can keep growing and growing, causing prices to rise high above the theoretical level. This is called a bubble. At that point, prices are completely detached from the corresponding market. The only thing that keeps prices up are investors mutually ensuring each other that this is still profitable. The trust of investors slowly erodes as they lack any indication whatsoever outside of other investors about the market being sensible at this level.

At some point, enough investors will lose their nerve and pull out. This means they lose some money, but they save more money than those who stick around until what happens next. Once investors see others pulling out, their already eroded trust breaks and they pull out as well. As prices had been held up purely with investors, investors will drop out rapidly, causing prices to drop equally rapidly. The crash happens, and prices drop very fast and very low.

Normally, in a bust phase, some businesses go bankrupt, and some investors lose money. In a crash, this affects lots of businesses and lots of investors. As prices drop so much below the theoretical ideal level, a lot of businesses can’t sustain those prices at all, and many of them go bankrupt. And as investors had so much money invested in this bubble, all of which suddenly was gone, investors lose a lot of money, meaning even large investors can go bankrupt.

Additionally, no market is isolated. The businesses that went bankrupt here acted as producers and consumers in other markets. As so many businesses go bankrupt, this affects other markets, causing businesses in other markets to be dragged down as well.

And as investors are usually involved in various markets as well, an investor going bankrupt causes money to be missing in other markets. Banks going bankrupt cause other banks to have liquidity problems, meaning others will lose trust in those banks, pulling out money, and so on.

For very large bubbles and consequently large crashes, these ripple effects can travel across the whole globe, causing bust phases in various markets all across the world.

Political Intervention

Now, a market crashing on a purely financial level is bad for the involved businesses, but one could argue it’s their own fault for playing for risk. The problem is a business losing money or going bankrupt has very real effects on people. Businesses losing money or not getting loans anymore need to lay off workers. And workers in businesses going bankrupt necessarily lose their jobs. Bust phases on a smaller level and crashes on a large scale cause very high unemployment. Unemployment in turn means people need money from the state, as they are unlikely to find different jobs while the bust phase lasts and for a while after.

Politics has a few options to intervene here. It should be clear by now that the boom- and bust phases are not purely rational decisions, but greatly influenced by trust. The general approach for politics therefore is to try and re-establish trust. A very common way to do so is to increase investment in the failing markets, as that will hopefully return the trust of other investors and thus break the bust phase early. There are three basic ways to try and achieve that.

First, the central banks can pour out more money. This increases money supply for investors, thus making it more less risky for them to invest in the failing market and thus for the bust phase to end early. But the increased supply of money reduces the value of the money, causing inflation. A particularly nasty example of where this approach was used and went out of control was the hyperinflation in the Weimar Republic.

Second, politics can reduce taxes. Just like the first approach, this increases the available money for investors, again making it more likely for them to invest in the failing market and thus the bust phase to end early. It also avoids the inflation problem. But during bust phases, the state already has lower revenue levels due to a slower economy in addition to higher expenses due to higher levels of unemployment. Reducing taxes in such a situation will cause higher debt accumulation of the state.

In recent times, there have also been studies suggesting that the effects of tax cuts are greatly overestimated.

Both of these options have further problems. Simply providing more capital to investors does not guarantee it will be invested in the failing market. A proportion of it will be spent on other, more stable markets. This is an inherent inefficiency in these approaches. Also, there are theories that providing easier money to investors has a tendency to create stronger boom phases, making large bubbles together with the stronger bust phases more likely.

Hence, the third alternative, the state can act itself as an investor. The state can invest specifically in failing businesses with its very strong economic power, thus specifically targeting the market affected by the bust phase and reinvigorating the economy. This is much more targeted and thus more efficient than simply providing more money to investors, but it has its drawbacks. The main problem again is that the state already has less revenue due to the slow economy and higher expenses due to the higher unemployment rates, meaning debt goes up as well. Also, in this scenario, the state acts as an irrational market participant. This is far from a theoretical problem. For example, the state can misidentify a bust phase and try and prop up a market that is simply not sustainable at this level anymore. Such a market will not recover on its own, meaning the invested money is wasted or the market requiring permanent subsidies.

To have sufficient funds to employ the second and the third methods, the state needs to have a strong capital supply to last over the bust phase. Proponents of tax cuts usually prefer to save money with lower spending, while proponents of directed investment usually prefer higher taxes.

The latter has further consequences. Just as lowering taxes during a bust phase increases investment by increasing money supply, increasing taxes during a boom phase decreases investment by reducing available capital. Thus, the higher the taxes, the less pronounced both boom and bust phases will be.

As we have seen, all approaches politics can pick have their own drawbacks. All in all, this a form of pick your poison for politics. There is no clear choice. Usually, political ideologies and external factors influence this choice much more than actual conscious decision between these factors.

Do Nothing Money Creation Tax Reduction Direct Investment
Ends bust phase early Nope Yep Yep Yep
Keeps money value stable Yep Nope Yep Yep
Doesn’t increase sovereign debt Yep Yep Nope Nope
Doesn’t waste capital on other markets Yep Nope Nope Yep
Doesn’t increase chance of bubbles Yep Nope Nope Yep
Doesn’t interfere with market prices Yep Yep Yep Nope
Doesn’t dampen boom phases Yep Yep Yep Nope

Example: The Global Financial Crisis (2007 – ?)

The global financial crisis that started in 2007 began with a real estate bubble in the United States. House prices did rise higher and higher until they were not sustainable anymore. When this bubble did burst, the bust phase dragged down a number of investors, including many private people, but also a number of major banks. The crash in the housing market caused one of the largest investment banks, Lehman Brothers, to go brankrupt. The ripples from this crash and the bankruptcies that followed it raced across the globe, dragging down other banks with them.

Governments in the European Union tried to intervene and prop up their failing banks. Some countries overstretched themselves, and investors started to lose trust in those countries. Hence, the countries themselves needed to pay higher and higher interest rates on debt they accumulated, causing their debt problems to spiral out of control. The financial crisis led to a sovereign debt crisis.

As other countries are invested in them, this again caused trust to erode in those other countries, dragging the whole eurozone down. At the time of this writing, we’re still not over the crisis which started five years ago.


Small-scale boom and bust cycles are part of the normal operations of investment markets, and instrumental in the way supply and demand adjust prices there. At some points, though, something happens and the small waves go out of hand. These bubbles and associated crashes can have serious impact on all economies in a globalized world.

Trying to prevent them and deal with them when they happen is an important job of society as a whole, and thus for politics. There are three established ways of dealing with crashes (four, if you include “do nothing”), all of which have certain advantages and certain disadvantages.

Investigation into the causes of bubbles and associated crashes, and how to avoid them, is a major topic of contemporary economics.