BOOK REVIEW: FRANK DILLIONreviews When Bubbles Burst: Surviving the Financial Falloutby John Calverley; Nicholas Brealey Publishing, 248pp; £12.99
ECONOMIC HISTORY teaches us that every so often, investors get caught up in a bubble. The Tulip mania in Holland in the 1630s, the South Sea Bubble in 1720 and the Wall Street Crash are just three of the better known examples of this phenomenon, while the dotcom crash took the phenomenon into the 21st century.
In bubbles, a belief takes hold that we are in a new paradigm or golden era where prices for assets such as equities, technologies, commodities and, in the modern era, houses, can only move in one direction. When the bubble bursts, it has a nasty tendency to overshoot, pushing asset prices below the consensus view of their true worth, often with catastrophic consequences for those who are over-geared in their investments. For a whole variety of reasons, investors tend to forget this and we are living through the pain of the unravelling of the latest global bubble, with its origins in the US housing market.
In this engaging book, bank economist John Calverley explores the psychology of bubbles and tries to predict how the latest one will play out. The author can claim form here, having signalled many of the dangers in a 2004 title, Bubbles and How to Survive Them.
Bubbles have a classic anatomy, he explains. They start with some form of displacement, a trend or development that changes the investment landscape and which appears to open up new opportunities. This can be the end of a war, a technological innovation – canals, railways and the internet have played their roles – or a change in the financial environment such as access to cheap credit through low interest rates. Excitement is generated and banks fuel the boom, pushing up prices. The boom reaches a mania where expectations reach fever pitch. Traditional valuations are thrown out the window and earnings potentials are extrapolated forward endlessly, as occurred in the dotcom mania.
Eventually the market slows as the smart money takes its profits. Sometimes there is a period of calm before an event or a series of events burst the bubble. This could be a war, a rise in interest rates, a slowdown in the economy as new investments come on stream. The trigger, Calverley notes, does not have to be one major event – sometimes it is simply a case of a straw breaking the camel’s back.
Generally business confidence evaporates and everybody wants to wait and see before committing to recruitment or new investment. Consumers tune in to this mood, putting off big ticket purchases such as trading up their homes or buying new cars. In some cases there is a panic phase when investors try to cut their losses ahead of the crowd. As one observer of the latest crisis advised recently: “Don’t panic but if you do panic, panic early.”
The final phase is one where prices reach their floor and investors begin to see value, starting the slow process of recovery. Alternatively, governments intervene with “lender of last resort” actions to restore confidence. However, as Calverley notes, it is rare to escape this phase without a serious recession or slowdown at least.
Charting a bubble in reverse is a relatively easy exercise, but how do you spot one in its development phase so you can avoid it? Calverley has drawn up a helpful checklist.
Apart from the obvious ones concerning overvaluation compared to historical averages and the subjective paradigm shift, he cites falling savings rates, immigration driving housing demand, subdued inflation, a widening of the investment community and high levels of popular and media interest as clear danger signals.
Media play a role by emphasising the “wow” factor of overnight business success. In the case of housing markets, where the majority of readers will be gainers, the emotional hook may be glee at the good news. A subtext, he argues, may be that “you can get rich too” and stories provide a form of reader-service guidance on how to join the party.
Calverley is critical of the role of central bankers, whom he says are often terrified of drawing too much attention to bubbles. Federal Reserve chairman Alan Greenspan’s speech about “irrational exuberance” in 1996, when the SP index stood at 650, resulted in no policy change or even further warnings as the index galloped towards 1,500.
Governments have even less interest in identifying bubbles, he adds, as it is easier to win elections during bubble periods because voters feel prosperous.
One practical suggestion the author makes is his call for the establishment of independent asset valuation committee. This would comprise of an experienced group of financial experts to study fundamental trends in stock and property prices to identify reasonable long-term valuation ranges.
This could include a mix of central bankers, academics and practitioners. If and when this group judged that asset prices were moving significantly outside their normal range, they would issue public warnings for investors, lenders and policymakers.
One potential downside, however, he acknowledges is that the warnings might be rubbished. A committee warning of a stock market bubble from 1997 onwards would have lost all credibility by 2000 – even though it would be proven right in the long run.
Calverley is pessimistic about the recovery timeframe to the downturn. He worries about the effects of deflation and analyses the severity and length of Japan’s recession. The policy bias towards creating inflation to lift asset prices and shrink debt is a dangerous one and could backfire.
But the history of bubbles will continue, he believes, with evidence suggesting they tend to occur in cycles of 18 years. The issue now is to put robust institutional frameworks in place to limit the next one, as by then this crisis will be but a memory.
Calverley has produced a well-researched and thoughtful analysis of the current recession with detailed pathologies of previous bubbles to support his arguments.
Frank Dillon is a freelance business journalist
