Bubblenomics

If someone asked you to name the country you most associated with tulips, you’d immediately say, “The Netherlands!” Interestingly enough though tulips aren’t in fact an indigenous Dutch flower, having been introduced from Turkey in 1593. The Dutch quickly fell in love with them though and over the following decades they became highly prized as status symbols among the Dutch social elite.

One of the things that helped them achieve such status was the fact that the supply of tulip bulbs was quite limited, (a flowering bulb takes seven years to grow from seed) and so, as demand increased, prices did too. As prices began to take off, flower sellers bought up as many bulbs as they could in order to get them before their prices increased further. This led to a further drop in supply and a further hike in prices. It wasn’t just the flower sellers though – traders had noticed the seemingly ever-increasing price of tulip bulbs and saw a new way to make money. They started buying them, not to plant in their gardens – they were buying them in order to sell them on later at a profit.

Flower sellers and traders alike were buying bulbs now because they expected them to be more expensive later on. That is, they had an expectation that prices would keep rising and that made them want to buy them now.

If you think by talking about tulip bulbs in the 1600s, I have completely lost the plot, then let me tell you what happened next. In the winter of 1636 – 1637, the already inflated price of tulip bulbs increased by one thousand percent in just three months. Bulbs of rare varieties sold for the same price as an average house and many people mortgaged or sold their properties in order to get in on a seemingly guaranteed profit.

But then something happened. There are different theories to what the event was, or if there even was a particular event that triggered it but one day, prices stopped going up. Panicked investors saw that the peak of the market had been reached and started selling. As supply increased and demand decreased the price started to drop. Soon everyone was trying to offload their tulip bulbs before it was too late but… it was already too late. The price of tulip bulbs plummeted spectacularly until soon they were back at the price that someone might want to pay to have a nice flower in their garden. Such was the shock that the entire Dutch economy collapsed and entered a depression.

While it is easy to look back at this event and conclude that the Dutch simply went mental, almost 400 years later we still experience economic “bubbles” and the effects are every bit as severe today as they were to the Dutch people of the 17th century. So what are bubbles? How to do they form? How do they grow? Why do they burst?

We’ll answer all of this and more in my five rules of Bubblenomics.

The 1st Rule of Bubblenomics

In order for a bubble to have a chance of starting you need lots of people to really want to buy something – in fact you need more than that. What you really need is for lots of people to really want to buy something more than they did last month. Bubbles are not formed off the back of high demand, they are formed off the back of increasing demand. As we saw in 17th century Amsterdam, the tulip bubble was built on the demand for tulip bulbs increasing… and increasing… and increasing. If the demand had doubled and then stopped there would have been no bubble (just more expensive tulips) and so the first rule of Bubblenomics is simply:

In order to create a bubble, the asset must experience a sustained increase in demand.

Easy enough. I’ll make it clear now though, a sustained increase in demand is not the definition of a bubble and it is not, on its own, enough to create a bubble. To understand how a bubble forms we need a few more rules, which I’ll come on to next.

The 2nd Rule of Bubblenomics

There are many different examples of bubbles in many different areas of the economy. Recent examples are the dot com bubble, which inflated during the late 1990s and burst in the year 2000 and the recent housing bubble, which caused the current global financial crisis.

As well as a sustained increase in demand, all of these bubbles have something else in common – a limitation on supply. Let me explain what I mean by that.

Suppose Mars Bars suddenly become really trendy and the demand for Mars Bars goes through the roof. Mars would quickly respond to this by making more Mars Bars. The increased demand would be met with increased supply, the price would quickly stabilise and no bubble would ensue.

Bubbles only form on something of which there is some kind of limitation on supply, such as the number of shares in a dot com company, tulip bulbs in 17th Century Amsterdam or houses.

Therefore the second rule of Bubblenomics is:

In order to experience a price bubble, the supply of an asset must have a limitation such that increases in demand cannot be easily met by an equivalent increase in supply.

You might be asking why, given the second rule, housing is a good candidate for bubble creation. If demand goes up, we should just build more houses, right? Sadly is isn’t that easy.

Demand for houses is volatile and increasing the supply of houses takes time. Suppose that one year the demand for houses in central London is 5% higher than it was in the previous year – you can’t just quickly meet supply by suddenly building 5% more houses in central London. There is the lack of space, the planning regulations and of course, the fact that it takes a long time to build a house. Because of those things, that increased demand just translates into an increased price.

The 3rd Rule of Bubblenomics

A price increase alone isn’t a bubble though and to understand how a bubble forms we need to look at the third rule. Basic microeconomics tells us that when the price of something goes up, we should expect demand for that something to drop and in most situations that is true. In bubble situations however, the opposite happens. Let’s stick with housing to explain this.

When house prices start to increase, potential buyers see that prices are going up and start piling in order to buy something before prices go up even more, thereby further reducing demand. More people are buying, not because the current price is low – it isn’t – but because they expect it to be higher in the future and although now is expensive, now is still cheap compared with what they expect next month might be. That means that more people want to buy now and current prices increase.

This is what the third rule covers:

The expectation of future price increases fuels current demand

Another way of putting it would be, “Aaarrgh! House prices are going up and up! I need to buy now, before they’re even more expensive! Aaargrh!”

I did make that sound a bit panicky but how many times during the decade before the financial crisis did you hear people talk about having to get on the property ladder before it became unaffordable? If you hear logic like that, it is a clear sign of a bubble in progress.

If you take the first three laws together you can begin to see how a cycle might form – demand keeps going up and with supply constrained, prices increase and as the price increases become sustained, demand goes up further because buying now is better than buying later. Together those three explain a lot but in order to really understand bubbles there are two more laws we need to cover.

The 4th Rule of Bubblenomics

As I mentioned, there are different theories of what caused the Dutch tulip bubble to pop but I suspect it had something to do with the availability of funds. That is, people simply ran out of things to sell  in order to buy tulip bulbs – after all, once you’ve sold your house, you’re pretty much done.

The equivalent in a housing bubble is how much someone is willing to lend you in order to buy a house. A bubble can only keep inflating when buyers have the access to funds to sustain that inflation. The housing bubble that caused the recent, global financial crisis is a perfect example. As prices increased, banks just responded by lending more money.  If the banks had said, “We’ll only lend 80% of a home’s value and that lending can be at max, three times your income”, the bubble would never have happened. They didn’t though. As prices increased, bank lending just increased to further inflate the bubble.

This is the fourth rule of Bubblenomics:

Inflation of a bubble requires someone to keep providing the air

The 5th Rule of Bubblenomics

Don’t worry, this is the last one and it is the simplest one of the lot. The first four rules dealt with how bubbles form and grow but they don’t explain how they burst. What I am calling the 5th rule of Bubblenomics is known in economic circles as Stein’s Law, after the late American economist, Herbert Stein. It says simply this:

If something can’t go on forever, it will stop.

Bubbles see prices increase dramatically and as we have seen, the price increases are self-sustaining for a while. The reality though, is that the price of something can’t go on increasing faster than people’s income forever. At some point, people either won’t want to buy it, don’t have enough money to buy it or can’t borrow enough money to buy it. That much is inevitable – if something can’t go on forever, it will stop.

As the Dutch saw in 1637 and the world saw in 2008, when a bubble stops the result can be catastrophic. So, it should be obvious to everyone that we want to prevent bubbles, right? Right. It should but clearly it isn’t. Just look at the UK government’s “Help to Buy” scheme, which even Vince Cable pointed out would do little more than create a new housing bubble.

He was of course quickly silenced by George Osborne but let’s remember that Vince is an extremely well-qualified economist and George has an undergraduate degree in history.

Apparently a degree in history that didn’t cover the Dutch Tulip Bubble of 1637.

RedEaredRabbit