Bubble Behaviour

It is rare these days that I read a book from cover to cover in one fell swoop and, rather like the best essays from my pupils, either a book grabs me from the start or it all too easily finds its way onto the dusty shelves of my departmental library. John Calverley’s latest book ‘When Bubbles Burst, surviving the Financial Fallout’ has survived my in-built impatience and I recommend it to colleagues as one of the best books on the dramatic ending of the Great Stability and how the unravelling of financial and economic excess will affect our lives in the years to come.

The financial crisis is already spawning a new genre of grizzly and deeply pessimistic books that have hit the bookshelves with an almost indecent haste as markets have subsided and the outlook for the real economy deteriorates by the hour. Publishers are clearly keen to make some money by rushing out assessments of harsh economic winter that risks engulfing rich and emerging nation alike and through the process of globalisation into reverse.

John’s first book ‘Bubbles and how to survive them’ came out in 2004 and in it he gave prescient warnings of much of what was to come, notably the unsustainable growth of real house prices in the United States, the UK and a number of Euro Area countries together with the risks of eye-wateringly large amounts of borrowing and debt that were linked to the rapid growth of property prices. I must admit here that his earlier tome does indeed have a resting place on my departmental shelves! I remember at the time thinking that it was too dry for my students to absorb and needed to be made more accessible to the intelligent general reader. Happily his new book easily meets these requirements – and more – for it is a lucid, succinct and eminently digestible piece of work which provides a steady flow of non-technical and timely insight and analysis. There is plenty in here to stretch a talented young sixth-form student of economics who wants to really get behind the nature of bubbles in financial and commodity markets (the distinction between the two has become blurred!). I have added it to my reading list for students wanting to take economics or finance courses at university.

When Bubbles Burst is divided into three main sections: In the first John Calverley dissects previous bubbles ranging from the Great Depression through the Japan’s lost decade after the abrupt ending of her asset price boom of the late 1980s and taking us through the stock market bubbles in the USA and UK as the twentieth century reached a conclusion. He offers a checklist of the typical characteristics of a bubble giving heavy emphasis to the importance of price expectations, the dangers of loose monetary or fiscal policies and also the impact that a new element can have on the perceptions of investors – be it emerging technologies and their effect on stock market valuations or the effects of large scale immigration or a decisive shift to a low interest rate environment to the attractiveness of property.

The second section focuses on the housing bubble and is highly recommended for any teaching colleague who wants to brush up on the many links between house prices and real economic activity. Bubbles and crashes occur when asset prices move pathologically out of line with fundamentals and Calverley makes a persuasive case for demonstrating just how far out of line property prices had moved both here and in the United States.

Pathology and Bubble Behaviour

The third cluster of chapters dip into behavioural finance as an explanation for the causes of bubbles and offers some policy prescriptions for getting us out of what might prove to be a lengthy and painful transition from an economy hooked on debt to one where the real wealth that comes from people making the most of their biggest asset – their own abilities and ingenuity is given more prominence.

Behavioural finance and neuro-economics is providing some important insights into our attitudes to risk, the impact that framing and anchoring has on our expectations together with the natural biases in behaviour of all economic agents, especially those that are new to financial markets and whose experience of previous bubbles is all but non-existent. John Calverley leads us through a brief but accessible look at ideas drawn from prospect theory, theories of rational bubbles and critical state theory where power laws of herding mean that one small event can tip the balance and create huge amounts of volatility in asset pricess.

Given how fast economic events are moving at the moment, many of Calverley’s policy suggestions remain remarkably topical – ranging from the lure of quantitative easing (one of my students asked me last week if QE stood for ‘quite easy’ ways out of a depression!) to reforms to bank lending including counter-cyclical deposit to loan ratios. He floats the idea of an independent Asset Valuation Committee whose job would be to improve the flow of financial information available to stock market and property investors, alerting us to when asset prices were either dangerously over-valued or under-priced in the market and perhaps giving people a stronger base on which to reallocate their portfolios and achieve better long term returns. An Asset Valuation Committee might act as a set of Wise Elders to the herd many of whom have spent much of the last two decades stampeding from one asset class to another – from internet shares to buy-to-let property – without stopping to calculate in the cold light of day the risks of the decisions they have taken.

The tap of finance has run dry and pathological caution will be the order of the day among lenders until the financial system is repaired. The risks of debt deflation are strong and the consequences for jobs will be severe. But there is an opportunity here for a better architecture for macroeconomic policy making that should not be ignored. John Calverley’s book makes a tremendous contribution to the debate.

John Calverley is Head of Research, North America, Standard Chartered Bank