Financial bubbles

Financial bubbles Guillermo Lalmolda The objective of this paper is to help people properly understand what causes financial bubbles.

San Jorge University A-23, km299, 50830 Villanueva de Gállego, Zaragoza, Spain 976 060 100 976 077 584 17/04/2014

Index INTRODUCTION .................................................................................................................................. 2 SECTION 1: UNDERSTANDING ECONOMIC VALUE, RATIONALITY AND BUBBLES. ......... 4 1.1

Economic value ....................................................................................................................... 4

1.2

Rationality and Nash Equilibrium........................................................................................... 7

1.3

Bubbles ................................................................................................................................... 9

SECTION 2: BUBBLE THEORIES..................................................................................................... 11 2.1 Animal spirits .............................................................................................................................. 11 2.2 Keynesian beauty contest and Nash equilibrium ........................................................................ 12 2.3 Bubble theories ........................................................................................................................... 13 2.3.1 The greater fool theory ........................................................................................................ 13 2.3.2 Herding theory ..................................................................................................................... 14 2.3.3 Extrapolation theory ............................................................................................................ 14 2.3.4 Moral hazard theory ............................................................................................................ 14 2.4 Austrian cycle business theory.................................................................................................... 14 SECTION 3: CONCLUSION ............................................................................................................... 16 BIBLIOGRAPHY ................................................................................................................................. 17

ABSTRACT Economic bubbles are and have always been one of the most important facts in economy, and one of the main causes of economic depressions and recessions. Last decades we have suffered two of the most important bubbles in history: the .com bubble and the securitization bubble. Understanding economic bubbles requires previous understanding of what economic value and rationality is, apart from knowing where the term bubble comes from and also a brief summary of its history, which will only be addressed in the introduction. Afterwards, the paper explains the different theories which can explain economic bubbles and concludes with a personal opinion of the author. This paper differentiates from others explaining a non-mainstream theory that has been ignored for decades and can perfectly help us understand economic bubbles: the Austrian business cycle theory. The main purpose of this paper is to make people understand what is a bubble, how to identify a bubble, what causes it and, finally, make people conscious about the existence of several theories and not only the mainstream theories that, by several reasons, can be the most popular and not necessarily the ones which better explain them, or not the only ones which explain them.

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INTRODUCTION The first definition of bubble was not exactly the one we have today. The first definition established for a bubble was a situation where the price of a product or an asset increased above its usual price. As the economic science developed, the new term used in place of usual price was fundamental value. This phenomenon was called a mania on its origins, rather than a bubble as we define it nowadays, because of the tulip-mania which occurred in Holland 1637. The price of the tulips was so high that some of them ended up being worth the same as a house. As today’s bubbles, people purchased tulips expecting their price to soar, even though many people probably knew that they were overpriced, given the fact that their expectation were to sell that tulip at that inflated price. And precisely as today’s bubbles, it burst when the markets realized the price would not keep increasing as before and, as a consequence, they started selling the tulips. The word mania described the behavior of the markets, which obviously was rather irrational if we assume that we should never acquire an overpriced asset or product because purchasing an underpriced asset or product would be the best option. But on the contrary, we could also say people acted in a rational way because they expected to sell that overpriced product or asset for a higher price which could maybe be more profitable than purchasing an underpriced asset or product. Theories such as the greater fool theory or herding theory explain such behavior of the agents and why that behavior could be perfectly rational -or not-, depending on the agent. All this theories are based in what John Maynard Keynes (1935) called Animal Spirits. The previous explanations, which will be explained further in detail, are known as Psychological theories of bubbles and are based on human social factors, behaviors and expectations. Bubbles can appear anywhere and in any market: there have been bubbles in China, the United States, Argentina, Holland, Spain, Australia, Japan, Romania, Ireland, Zimbabwe and many other countries. It has affected several different commodities and assets, such as tulips, shares, real estate, uranium, rhodium, wheat, ostrich eggs, etc. Bubbles can emerge both in recession, depression or expansion cycles. Apart from Psychological theories, there are other theories which explain how bubbles can be encouraged and caused by certain policies, especially monetary policies. This paper will not only focus on the mainstream theories, but also on one theory which is especially important to explain economic cycles and, thus, bubbles: the Austrian business cycle theory. Austrian business cycle theory explains how business cycles occur as the consequence of the credit expansion caused by the monopoly of fractional reserve banking and Central Banks, which is the organism in charge of creating new money and regulating the whole financial system changing, for instance, interest rates or minimum reserves required. This affects the whole market and encourages malinvestment and, thus, bubbles. As a consequence, the

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solution according to this theory is a free banking system without central banks, with the requirement of 100% reserve on deposits and gold standard. This theory has been rejected by mainstream economists and the mainstream schools of economic thought they belong to –especially Keynesianism and Monetarism-, even though both ideologies have failed to solve many economic crisis such as the Japanese crisis. As of 2014 and after years of expansive policies, both monetary and fiscal, and especially after ‘Abenomics’,1 the result is a stagnant economy, the highest public debt in the world –as of 2013/2014 it accounted for 226.1% of the GDP-, a budget deficit around 9% of GDP, a low growth rate of 1.5%, -instead of 3% as specialists forecasted- and a record annual trade deficit of $ 112 billion in 2013/2014, a 65.3% jump from a year ago, given that import costs outpaced exports receipts: exports rose by 9.5 % in 2013-even though export volumes fell 1.5%- but, on the other hand, imports rose by 25% and Japanese currency fell more than 20% against the US dollar between January and December 2013. There are many other examples which can prove how these theories have failed to solve different economic crisis: for instance, Spain’s fiscal stimulus package ‘Plan E’, which spent around € 12.11 billion. All this empirical data should definitely make us question mainstream economics and look for new theories which can better solve economic crisis and help us better understand bubbles, which are one of the main causes of economic crisis, as the Austrian business cycle theory does. According to Topol (1991), the common partial assumptions for bubble formations are weak financial policy and excessive monetary liquidity in the financial system, which implies low interest rates and excessive leverage. This explanation is somehow similar to Austrian business cycle theory. This paper is structured in two sections, each one explaining different necessary aspects in order to understand economic bubbles. In Section 1, economic value and rationality will be explained to better understand the concept of bubble, which will be explained in the same section too. In Section 2 the different bubble theories will be explained, both psychological and the Austrian business cycle theory. Finally, the author will analyze the whole paper and give and opinion about the different sections addressed in the paper.

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Abenomics refers to the economic policies advocated by Shinzō Abe since the December 2012 general election, which elected Abe to his second term as Prime Minister of Japan.

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SECTION 1: UNDERSTANDING ECONOMIC VALUE, RATIONALITY AND BUBBLES. 1.1 Economic value There have been several definitions of value along history, and this paper will address them but, to start, the most commonplace definition of value is the one which follows: it is how much a good or service is worth for an economic agent, the amount of money, goods or services which is considered to be a fair equivalent of that good or service. It is important to understand that economic value is the maximum amount an economic agent is willing to pay for an item, and does not have to be the same as the price, which is the amount of money at which the product tries to be sold in the market –and if no one wants to pay that price it may not be sold at that price-. Price is set by supply and demand in perfectly competitive markets –auctions or agriculture could be an example- and by the producers in monopolistic competitive markets, where produces are ‘price makers’, and not ‘price takers’ as in perfectly competitive markets. Prices can also be influenced by the state, which can fix them –controlling prices or owning a company- or increase them with taxes. An economic agent can consider the price is higher than its economic value and, as a consequence, not purchase it. On the contrary, the economic agent can also consider the price is inferior to the economic value and –maybe- purchase it. David Ricardo (1817) argued there was not a theory with such a large number of different opinions as the theory of value. We can mainly distinguish between two schools of thought. In the first place, we can find the objective theories, where the value of a commodity is related with all or some of the factors of production (labour, capital and land) and, in the second place, the subjective theories, which assume that value is related with its utility. The objective theory comprises two main theories: The labour theory of value and the cost of production theory value. The labour theory of value argues that the value of a commodity is only determined by the labour needed to produce that commodity, whereas the cost-ofproduction theory of value says that the value is determined by any of the factors or production, either labour, capital or land, and taxation, even If the last one is not a fact of production. Adam Smith, David Ricardo and Karl Marx were supporters of the labour theory of value, while Jean-Baptiste Say, Senior and John Stuart Mill were supporters of the cost-ofproduction theory, among others Objective theory supporters argued that there were two different kinds of values: value in use and value in exchange. On the one hand, value in use determines how useful one commodity

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is, its utility. On the other hand, value in exchange is the quantified worth of one commodity in terms of the worth of another commodity or commodities. There are many goods and services which are not useful whatsoever but, on the other hand, are highly valued, as Adam Smith (1776) illustrated: “The word value, it is to be observed, has two different meanings, and sometimes expresses the utility of some particular object, and sometimes the power of purchasing other goods which the possession of that object conveys. The one may be called 'value in use;' the other, 'value in exchange.' The things which have the greatest value in use have frequently little or no value in exchange; and on the contrary, those which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful than water: but it will purchase scarce anything; scarce anything can be had in exchange for it. A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it.” He also explained how value in exchange is calculated: “The value of any commodity, ... to the person who possesses it, and who means not to use or consume it himself, but to exchange it for other commodities, is equal to the quantity of labour which it enables him to purchase or command. Labour, therefore, is the real measure of the exchangeable value of all commodities”. (Smith, op.cit) If value in exchange is determined by labour or any of the three factors of production, the assumption is that any commodity2 has an intrinsic value3 which can’t be subjective. As a consequence, classical economists could not solve the water and diamonds paradox without dividing value into value in use and value in exchange. The explanation for the discrepancy between value in use and value in exchange remained a mystery because the classical economists were unable of solving it. The paradox, which was conceived by Adam Smith, has been summarized in this way: Why is it that “water, which has so much value in use, has no value in exchange, while diamonds, which have practically no value in use, are exchanged at high prices”. (Ekelund and Hébert 1997, 294) The previous was unsolved until William Stanley Jevons used a marginal utility analysis to so solve it in his book Theory of Political Economy (1871). The marginalists -Jevons, Menger and Walras, among others- who supported subjective theories, argued that there were two different kinds of utilities: total utility and marginal utility. Total utility measures the satisfaction you obtain from consuming a good, like water. Consuming water is essential for life, we cannot live without water. In fact, it is far more essential than diamonds. We also use it to keep us clean taking a shower, brushing our teeth, to produce energy, etc. By contrast, the utility obtained from diamonds is substantially less.

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A commodity is a marketable item produced to satisfy wants or needs. Therefore, items like a stone, which are neither produced nor marketable, have no intrinsic value whatsoever. 3 The inherent value of a product, the objective value of the item itself, measured by the costs involved in producing it, for instance.

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They are not necessary for being alive as water and they still manage to be far more valued than it. Marginal utility measures the extra satisfaction of wants and needs obtained from consuming one additional unit of a good. Following the previous example, the marginal utility is the satisfaction obtained by the very last glass or drop of water. As a consequence we can deduce that the total utility of water is far greater than the utility of diamonds, whereas the marginal utility of water is normally much smaller. For instance, the first unit of water will be used to prevent you from dying of thirst. The second one may be used for personal hygiene. The third unit might be used to nourish your pet. The fourth unit might be used to water your plants and your fifth unit in a decorative fountain outside of your house. But like water is abundant, you possess so many units of it that the marginal utility of each additional unit is relatively insignificant. You might drop a glass of water on the floor and you will not be worried at all, but if you lose a diamond, you will probably be quite worried indeed. Why? Because diamonds are rare and less plentiful. As a result, their marginal utility is high. Given the fact that, luckily, most people don’t die of thirst and we can shower every day, we value more diamonds than water, even if water is essential for life and diamonds are not. Another example is the following: even if we are dying of thirst, just imagine we are next to a shop with plenty of potable water we can drink, but we don’t have the money to purchase it. There is no other place in 100km around where we can buy any water whatsoever, and there are no available means of transport. We have thirty seconds left before we die. One glass of water will not be enough to cure us, because we have been several days without drinking. There is no one or nothing around us but the shop and the vendor, no one will come in thirty seconds time and safe us. One glass will just keep us alive a few hours more. Suddenly, one man magically appears in front of us, and lets us choose one of the following; a diamond or a glass of water. We assume the vendor will not give us water for free –even though we are dying- and that we are in no position of stealing him because he has a gun and we do not. We also know the shop vendor will accept a diamond in exchange for water, and that he will give us plenty of water for one diamond, enough to walk to the next town 100km away, where there is free water and food and we will easily survive. Still, we know that while the water will allow us to live few hours more. We could think the marginal utility of the diamond is now lower than the marginal utility of the glass of water, but it is not because now, the marginal utility of that water equals plenty of water which will allow us to survive; the marginal utility of the diamond is now its exchange value and not ornamental as it normally is, so we must be careful and detect when things such as this can make the marginal utility change. On the contrary, if we were in the same situation, but the shop was full of diamonds, and the man came and offered us the glass of water and the diamond, we would have chosen the glass of water, because its marginal utility –surviving few hours more- would be better. Hopefully, someone could come to the shop within a few hours to buy a diamond and give us some water and/or take us to the town we wanted to go, or we could walk and see if we happen to

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find someone around. In this case, like there is only one unit of water available and we can’t purchase more with the diamond, the water marginal utility is much higher for that man, but not for those people living in that town with plenty of water, because those people can purchase a large number of commodities with one diamond. Marginalists solved the water and diamond paradox this way, using marginal utility. Marginal utility is not objective, it is subjective. For example, some person may think that the marginal utility of his second car is less than the price he will get selling it, 10.000€ in cash. As a consequence, that person will sell the car. On the other hand, we have a person who has two cars, and his second car is the same as the first person second car, but he considers that the marginal utility of his car is more than 10.000€ -the price he would get selling it- and, as a result, he does not sell the car. Why can this happen? This can happen for several subjective reasons we cannot address. The first person may have discovered a new car he can buy and he wants to buy it quickly, and for him it is more valuable to buy the new car immediately with that 10.000€ and sell it. The other person, even in the same situation, may be more patient and wait to get another buyer who can offer 11.000€, and then buy the new car. Maybe one of them needs cash for other reason and values cash more than the other and, as a consequence, wants to sell the car for 10.000€ and the other one does not. Maybe the first person does not enjoy driving as much as before and has enough with one car, or maybe he just thinks his car is rubbish and no one should pay more than 10.000€ because that would mean being a cruel capitalist, and he is a nice person. Whatever, there can be hundreds of reasons why one person values things differently. The Austrian School of Economics would argue that the value is determined by the importance an acting individual places on a good for the achievement of their desired ends, as we have previously proved. The subjective theory of value assumes that if value is subjective there is not a defined intrinsic value in commodities whatsoever. Let’s take a painting as an example. Artists such as Vincent Van Gogh were poor and their paintings were only valuated after he was death. The labour and/or factors used to produce the painting were the same when before and after his death and still, his paintings have been valued differently as the time passed. Has the intrinsic value of his paintings changed? No, because there was never an intrinsic value because that paintings belonged to Van Gogh. Individuals, subjectively, valued the paintings themselves.

1.2 Rationality and Nash Equilibrium Rationality is a decision-making process where the agents take the best possible decision out of all the possible decisions. Rational choice theory is a very important concept in today’s economics and its use is widely spread. Keynes beauty contest, which explains the behavior of the stock markets, is explained by rationality and Nash equilibrium.

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Nash equilibrium is a method used to predict the outcome of a strategic interaction –which we call a game- in the social sciences. A game comprises a set of players, a set of actions available to each player and a payoff function for each player. In order to obtain Nash equilibrium, a rational player will choose an action profile –a list of actions- with the property that no single player can obtain a higher payoff or utility by unilaterally changing his action profile –his strategy-. Nash equilibrium assumes certain rational hypothesis, which will allow us to reach Nash Equilibrium:      

The players will do their best to maximize their payoff or utility. The players do not make mistakes while executing their tactics. The players are intelligent enough to determine their private equilibriums The players know the planned equilibriums of all the other players. The players know that changing their own strategy will not cause the other players to change theirs. All the players know that the rest of the players meet these conditions, including this one. There is common knowledge.

Prisioner’s dilemma is the most used coordination game to explain Nash equilibrium. Nash equilibrium, when most players maximize their payoff, is when both choose to confess. The question is, why do not both players decide to cooperate? The answer is simple: given the fact the other players are all rational and know the planned equilibriums of other players –the strategy- , it would be possible to improve your own result by betraying and not cooperating. If you betray the other player, you would be free and, therefore, it is a better strategy than cooperating with him, it is not a strategy which maximizes your payoff. Still, this situation is not possible to happen unless one of the players is not rational –something that does not happen in Nash equilibrium-, because if they are rational they will know that if they choose to cooperate with you, you will betray them.

Player A Do not confess (Player B) Confess (Player B)

Do not confess A: 1 year B: 1 year A: free B: 12 years

Confess A: 12 years B: free A: 3 years B: 3 years

Understanding Nash equilibrium will allow to later understanding the Keynesian beauty contest and its relation with stock markets.

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1.3 Bubbles Understanding the different theories value will let us understand what fundamental value is and, as a consequence, understand what a bubble is. The fundamental value of a commodity should be the price that commodity should have in a theoretical equilibrium model without market frictions4 and rational agents. This is related with the objective theories of value and the belief in the existence of an intrinsic value. To better understand how fundamental value is calculated, we will explain how fundamental value is calculated for shares rather than in other commodities. In the case of a share, the fundamental value is the present value based on predictions of the future cash flows and profitability of the business or share. Two of the most used methods to calculate fundamental value are dividend discount model – for shares- and discounted cash flow for several commodities. Discounted cash flow is necessary to better understand Austrian business cycle theory.

Dividend discount model is a method which values the price of a share using future – forecasted- dividends and discounting them back to present value. If the value we obtain is higher than the share current price, then the stock is undervalued, and vice versa.

Discounted rate is the constant cost of equity capital for that company and the dividend growth rate is the constant growth rate expected for the dividends. Discounted cash flow is a method which values investment opportunities and commodities. It uses the future cash flow forecasts and discounts them back to present value. If the obtained value is higher than the cost of the investment or the commodity, we have an investment opportunity and we may want to invest.

Weighted average cost of capital –WACC- is the same as the discount rate and it measures the cost of capital in which each category of capital –both equity and debt- is proportionally weighted. 4

Trading environment where costs and restraints related with transactions do not exist.

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Where: Re = cost of equity Rd = cost of debt E = market value of the firm's equity D = market value of the firm's debt V=E+D E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc = corporate tax rate

A bubble exists in an asset when its market price is superior to its fundamental value. Bubbles are not easily detected because there is disagreement over the fundamental value of the assets and, of course, there are different methods to calculate it. If we mention fundamental analysis, we must also mention technical analysis. Technical analysis does not try to estimate the value of a share, for instance. Technical analysis is interested in the price movements in the market. It studies supply and demand in order to forecast the trend the share price will have. Given the fact that investors do not invest always trying to calculate the fundamental value but trying to forecast the behavior of the others, technical analysis is more related with subjective theories of value. For instance, if someone accrues 100% profitability, he is very likely to disinvest even if the future perspectives of the company are very good. Subjectivity and the marginal utility of the investment matters again. Maybe the investor needs cash, or does not trust or know when the other people will start disinvesting and the price share will start to fall. There can be hundreds of reasons. The phases of a bubble according to Minsky (1975) are the following: 1. 2. 3. 4. 5.

Trigger: An exogenous event, for instance a new technology. Boom: new opportunities for investing let profits rise Credit expansion: banks are transforming short term deposits into long term deposits. Destabilising speculation: price bubbles, herding, overinvestment. Crash: profits do not live up to previous expectations, banks write off part of the outstanding debt. 6. Reversal of capital flow: depositors try to withdraw. 7. Panic: panic sales cause rapid decline in asset prices. The bubble bursts. 8. Liquidity squeeze: banks compete for scarce liquidity and are in need of refinancing.

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9. Liquidity spirals: banks sell long term assets, and asset prices may fall below fundamental value. More banks go bust. To conclude this section, it is fundamental to understand when bubbles burst, what simple fact, causes the burst. With perfect information, bubbles crash soon after market price exceeds fundamental value according to Abreu & Brunnermeier (Ecmta.2003), Brunnermeier & Morgan (2005) and Cheung & Friedman (2006) even though, as we will later see, this is not necessarily true. In the real world where agents are not always rational and, as we will see later, being rational does not imply analyzing fundamental value, things change. With rising uncertainty about fundamental value –if it exists- and closing date, bubbles tend to persist longer.

Thus, bubbles crash if sufficiently many traders sell and the share price shrinks.

SECTION 2: BUBBLE THEORIES 2.1 Animal spirits Animal spirits (Keynes, op.cit) is the base of the bubble theories. Keynes thought that investors were motivated by ‘animal spirits’. Keynes referred not to psychological factors which make investors reluctant to invest, but those which make them invest at all, under deep uncertainty. He thought that in the face of deep uncertainty, only a manic, driven, strongwilled person would put capital at risk, and therefore, demand would fall and the economy

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would fall into recession. By contrast, when animal spirits are strong, investment is sufficient to maintain aggregate demand, he affirmed. This is how Keynes explained business cycles. "Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits – a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.". (Keynes, op.cit). What Keynes meant with the previous quote is that taking into account only economic data was inadequate. Profits and cash flows can be high, but if businessman fear a recession because of any cause –a war, for example- then they are likely to disinvest. Like people expect a recession, savings would rise and the government would have to step in and boost aggregate demand with expansive fiscal policies. Keynes believed that actions induced by animal spirits were totally irrational.

2.2 Keynesian beauty contest and Nash equilibrium Keynes also conceived ‘the Keynesian beauty contest’ which illustrates that much of investment is driven by the expectations of the average expectations of other investments. Keynes observed that investment strategies were similar to those used in a London newspaper of his day that featured pictures of around a hundred young women. The person who submitted a list of the top five women would win the prize. That person did not have to select the 5 women he thought were the most beautiful in his eyes, but the objectively most beautiful women, those that most clearly matched the consensus of all other contestants. The first ‘level’ of contestant would rely on his own concepts of beauty to establish rankings. The second level of contestant would try to guess the beauty concepts of the first level of contestant; the third level of contestant would try to guess what the second level of contestant guesses about first level contestant concepts of beauty… and son on. The result is that investment is volatile because investors do not try to know fundamental value, but what the market will do. People value shares as they think everyone else thinks their value is. As a consequence, investors are either lucky or masters at understanding people’s psychology. The relation between Nash equilibrium is better understood understanding the game ‘guess 2/3 of the average’. Each contestant must choose a number from 0 to 100, and the winner is the one who guesses the number closest to two-thirds of the average of all the other numbers. This kind of competition granted John Nash the Nobel Prize. According to the Nash Equilibrium, that assumes all the contestants are rational, intelligent, and that every contestant knows that the other contestants are rational and intelligent, the solution is zero. But these assumptions don’t apply to the real world.

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If there are enough players and you assume your rivals will guess randomly, the average number will be 50, and you should choose 33.3, or two thirds of 50. Assuming that other contestants will assume that the rest of the contestants will choose randomly, you should choose 22.2, or two thirds of 33.3. Taking another step up, you should choose 14.8, or two thirds of 22.2. If you keep climbing, you will reach zero in the infinitum- the Nash Equilibrium. In real life, people tend to stop at about two or three levels. The winning number is almost always between 14.8 and 22.2. We can see the contestants use the same logic in this game as in the Keynesian beauty contest; they tend to guess the average of what other people think, or even the next step which Keynes perfectly described: "It is not a case of choosing those faces that, to the best of one's judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”. (Keynes, op.cit). These will obviously cause share prices not to reflect fundamental value and to be sometimes overvalued. Thus, this human behavior causes bubbles.

2.3 Bubble theories These psychological theories are probably based on animal spirits. According to Keynes, the general crowd was supposed to be too ignorant to form reliable estimates of present values. “Their ignorance leads to short-term trading, „speculation‟, rather than long-term trading, „enterprise‟. And this short-run perspective often makes for instability”. (Koppl, 1991). All in all, as animal spirits described, agents may act under irrationality causing overvalued or undervalued asset prices and instability as a consequence. As a result, the following theories were conceived: 2.3.1 The greater fool theory People may believe that buying a commodity at a very high price should still give them a profit, even though it may be overvalued and there may be a bubble going on. The thing is that they may be right because there is always a bigger ‘fool’ who is willing to buy the commodity for a greater deal of money. Eventually, the last ‘fool’ will not be able to sell its commodity for a higher price or for the same price, and will lose money. When economic bubbles occur, the greater fool theory seems to work just as described. Bubbles create overvalued commodities and, as long as investors are in a purchasing frenzy, they are willing to purchase an overvalued commodity. The problem is that, eventually, the bubble will burst when there are no more fools willing to buy the commodity, and it will affect the investor who was depending on the greater fool theory.

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2.3.2 Herding theory Individuals usually imitate the actions of a larger group in a rational or irrational way, both. This behavior can perfectly be represented by the investor’s crowd buying and selling in the direction of the market. Technical analysis is based on this concept, given that its objective is to detect market trends and follow them, something that encourages even more to reinforce the herd behavior. This behavior is not only found in individuals, but also in institutional investors like mutual funds. Why? Because investment managers are evaluated in comparison to their competitors, and if their competitors enter into a bubble, the incentive for the rest is to enter as well since their fund’s performance are going to be assessed relative to others. Therefore, in a mid-term or long-term bubble like, for instance, Spanish housing bubble, institutional investors may rationally participate in it, since the opportunity cost of not participating is bigger than participating. The problem is to quit the bubble before it bursts.

2.3.3 Extrapolation theory This theory is probably present in most bubbles. Extrapolation theory argues that investors tend to project historical data into the future and believe that what happened in the past will repeat in the future under the same context and, thus, prices will continue increasing. Investors tend to associate past returns with future returns, overbidding some risky assets trying to keep and get the same past yields. But there is a point when returns are no longer positive when considering all costs, and the bubble bursts.

2.3.4 Moral hazard theory Recently we have seen how many banks have been bailed out all over the world because of their bad praxis. This does not come without a cost –apart from monetary cost-. Moral hazard theory explains us what happens when the risk return relationship is altered. This happens when an agent has protection from the government –for example- and is bailed out. From then on, that agent has a terrible incentive to undertake a level of risk above his control or not equivalent to the risk that agent would assume if he were fully personally exposed to the risk.

2.4 Austrian cycle business theory Austrian business cycle theory explains how business cycles occur as the consequence of credit expansion. To understand how that credit expansion occurs, we must understand what the monetary base, the money supply, the reserve ratio and the money multiplier are:

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

   

The monetary base is part of the overall money supply and it refers to that part of the money supply which is highly liquid, including commercial bank deposits with the Central Bank, notes and coins. The reserve ratio is the percentage of deposits that banks maintain in liquid reserves. That percentage set a minimum reserve ratio in order to control supply of money. The money supply is the total amount of money in the economy –at least in this case-. The money multiplier measures how many times commercial banks can increase the supply of money in an economy. The money multiplier can be calculated with the following formula: Increase in money supply / Increase in monetary base that caused it. For instance, if a commercial banks gain deposits of €2 million and this leads to a money supply of €20 million, the money multiplier will end up being 10.

Another way of calculating the money multiplier is the inverse of the reserve ratio. M = 1/w where M is the money multiplier and w is the reserve ratio. In the previous example, M was 10, so the reserve ratio was 10% (1/1%=10). This ratio can multiply the money supply by 10. As a consequence of not having 100% reserve on deposits –this means a 100% reserve ratiosavings, and the money supply increase of the Central Banks, loan supply increases over the real level of saving, because if one agent saves 1000€ and the money multiplier is 10. The money that can be lent is almost 10 times the real savings the economy has. This is called artificial credit expansion. The Central Bank, which controls the interest rate at which commercial banks borrow money, can lower the interest rates. The increase in money supply caused by the fractional reserve -this means not having 100% reserve on deposits- and the low interests that may be set by the Central Bank cause the interest rates of loans to plummet: companies can finance their investments at a very low cost. This causes the entrepreneurs to invest like if the savings of the society were increasing, while consumers are not reducing their consumption and, as a consequence, they are not saving money. Projects that before artificial credit expansion were not profitable at all are now very profitable indeed, thanks to low interest rates. Malinvestment growth gets higher and higher as time passes, and bubbles start to appear. We can use discounted cash flow as an example of how malinvestment happens when interest rates are artificially lowered. Let’s assume our cash flow is € 10000 each year and the WACC IS 3%. The project will last for 5 years. If we apply the formula we will get the following: x=10000/(1+0,03)+10000/(1+0,03)^2+10000/(1+0,03)^3+10000/(1+0,03)^4+10000/(1+0,03)^5 x = 45797.1

X is the discounted cash flow value, which is the present value of the cash flows that this business will generate. The cost of the project is € 41000 and the profitability is 6.50%. In the end, like the real savings in the economy are not as high as the interest rates indicated because they have been manipulated by the Central Banks and the fractional reserve and, as a consequence, the investment projects do not generate the expected cash flows because there

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is no demand for those products because there are not enough savings, and even if they generate those cash flows, the interest rates are not the same as before, because the inflation is higher and the risk premium of the interest rates has soared. Now WACC, for example, has increased from 3% to 7%. The first two years WACC was still 3%, but the following years it rose to 7%. x=10000/(1+0,03)+10000/(1+0,03)^2+10000/(1+0,07)^3+10000/(1+0,07)^4+10000/(1+0,07)^5 x = 42056.48

Now the project is not profitable anymore, even assuming the same cash flows. Moreover, the value of our assets decreases as interest rate soars. This affects the whole market and encourages malinvestment and, thus, bubbles. As a consequence, the solution according to this theory is a free banking system without central banks, with the requirement of 100% reserve on deposits and gold standard. 100% reserve on deposits would prevent artificial credit expansion as long as the free banking system or the Central Banks –if there was one- do not issue unsupported paper currency like they do nowadays. That is the purpose of gold or a similar asset, to limit the previous.

SECTION 3: CONCLUSION Bubbles cannot be avoided whatsoever, but they definitely can stop being encouraged by government policies or monetary policies. Bubbles are clearly are unavoidable, because there are psychological factors like the ones explained in section two that conceive them sooner or later. Still, if bubbles are not encouraged, their impact on the economy can be diminished and we will not suffer the enormous bubbles we have suffered until today. There are bubbles going everywhere at every time, but many of them are unknown and do not have a big impact. We only hear about bubbles which cause recessions and depressions. But there are thousands of commodities which probably are rather overvalued all over the world. Inflation, for example, does not take into account the price of assets such as real state or the stock markets. If inflation took into account real state, inflation in Spain would have been much higher these previous years. The way to stop encouraging bubbles and prevent most recessions is taking into account Austrian cycle business theory, which has been ignored by most economists. Bubbles such as the securitization bubble or the Spanish housing bubble could have been prevented. Still, having been ignored for decades is not a sufficient reason for assuming the theory is incorrect, moreover after what has happened. When few people argued the Earth was round, most scientists defined them as crazy. Still, many people believe that expansive monetary and fiscal policies are the solution to our problems, even knowing they have miserably failed in countries like Japan, but they always find an excuse to justify the failure –one common argument is that the fiscal/monetary stimulus was not big enough-. Sadly, lobbies, especially

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the banking sector, will do whatever they can to stop 100% reserve on deposits, gold standard and a free banking system, because this would harm their privileges and their profits.

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