Opinion Growth,bubble wrapped

Delusion,bubbles — those are strong words. However,they are the buzzwords now. Money is the root of all evil,to misquote from the Bible,justifying the economist’s lambasting of easy money. And to quote correctly from the Bible,the love of money is the root of all kinds of evil,justifying the economist’s lambasting of perverse incentives in the financial sector. Even better is the preceding quote from Timothy: “But those who want to get rich fall into temptation and a snare and many foolish and harmful desires which plunge men into ruin and destruction.”

Therefore,we must contain delusion and bubbles,so that never again in the field of economic development is so much ruin and destruction owed by so many to so few (from the financial sector). Bubble,especially an economic bubble,is a most intriguing expression. Many Indians will argue,independent of global shock,that there was a real estate cum housing bubble in India,a land price bubble,perhaps even a stock market bubble. Bubbles will eventually be pricked,causing pain and suffering. Therefore,to guard ourselves in the future,we must prevent bubble creation. In hindsight,a posteriori,many instances of price correction are described as bubbles.

But that’s not the point at all. To do something about bubbles and prevent bubble creation,we must know when there is a bubble a priori. Despite all analysis and theorising,we have never known,and will never know,in advance when there is a bubble. (Since asset prices are involved,perhaps we should say bauble.) There is a bubble when asset prices are significantly higher than intrinsic values. That sounds good,but is no more than tautology unless we can figure out what intrinsic values are. Let’s take a simple example. The intrinsic value of any asset is discounted present value of a future (net) revenue stream. Consequently,if interest rates drop (whether nominal or real makes no difference conceptually),intrinsic values of assets increase. People invest in those assets,reinforced by wealth effects,and giving this avaricious tendency an apparently dirty name like speculation gets nowhere. For most mortals,life is about avarice and speculation. To get semantics right,increase in intrinsic values doesn’t constitute a bubble. All we have established is interest rates,lending policies of banks and monetary policy influence intrinsic values and can make them volatile. However,notwithstanding measures of financial leverage,there is no a priori means of knowing the right interest rate.

The earliest documented so-called bubble was the Dutch tulip mania of 1637,described in Charles Mackay’s 1841 book Extraordinary Popular Delusions and the Madness of Crowds. Most people also quote Mackay for South Sea Bubble of 1720 or the Mississippi Company bubble of the same year and there have been several other “bubbles” after Mackay’s book,including dot com bubble and real estate bubbles in many countries in recent years. Mackay didn’t write only about economic bubbles,as the title of the book makes clear. He discussed alchemy,prophecies,fortune-telling,witch-hunts,haunted houses and crusades. In the apparent global consensus now emerging on financial peccadilloes,most people will agree Bernie Madoff should be condemned in the same breath as these anachronistic practices. What this ignores is what Mackay flagged in his book,madness of crowds,so-called herd mentality. Ponzi schemes work because of this. Positive feedback blows up both booms and busts disproportionately. It is incorrectly believed lemmings commit mass suicide. However,lemming populations fluctuate. That’s the commonality with human beings and economic business cycles.

Limited points about financial sector regulation,supervision and corporate governance are fine. But beyond that,no amount of regulation can neutralise human behaviour. Or ensure that if one set of human beings behave in one way,another set will behave in exactly the opposite way,so that amplitudes of cycles are reduced. Any regulation contrary to human behaviour is doomed. Stated differently,if we seek to curb busts,we have no option but to restrain booms too. Instead of booms and busts,boosts and bums is probably a better expression. Excessive regulation and state intervention will curb enterprise,initiative and innovation. We won’t get the boosts either and will be left with the bums. Rather oddly,discussions on global financial crisis often quote Walter de la Mare,“Life’s troubled bubble broken.” Or perhaps it is not that odd,since Walter de la Mare first worked for the statistics department of Standard Oil before writing psychological horror stories. The quote is from a poem titled,“The Song of the Mad Prince”,extremely appropriate if prince is interpreted as government and madness with excessive controls after September 2008.

That poem is believed to be a reference to Hamlet. To paraphrase Hamlet’s most quoted line,to control or not to control is not the question. Beyond some regulatory improvements,we should learn to live with business cycles,so-called bubbles,avarice and greed. If there is one austerity we need,that should be on government controls.

The writer is a Delhi-based economist

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