Investment Bubbles - Leading Indicators
Can we identify them and fix them before they burst?
After the Crash of 2008, many investment bankers, economists, and financial
planners said it was a fluke that nobody could have seen coming. Yet a few
economists were already discussing the housing bubble by 2002. Also, by
2004, I along with a few others discussed on-line evidence of a bubble.
So, how did most 'experts' miss it? Why did they not see it coming? More
importantly, what should we pay attention to from now on? And how can we
use this information to prevent future Investment bubbles?
Draft: July 2014
Part A: Indicators of an Investment Bubble
What economic data indicates the development of a bubble that will eventually
burst? Where can we find evidence that an investment bubble is developing,
even if we can't see specifically who is investing in the bubble or where
they are investing that money? We will list some empirical evidence from
Indicator 1: Wealth of the rich increases rapidly while employment and
working class wages stagnate
Indicator 2: Corporations increase their investments in zero-sum games
|This is the easiest to observe indicator. We saw it
throughout the George W. Bush administration. It was well documented
throughout the Coolidge administration.
It also follows logically. The rich invest most of their wealth. Consequently,
they acquire much of their income from investments. If the value of
investments are rising while wages and employment are stagnant, then
the wealth is more likely derived from an investment bubble than from
the production of wealth. Had economists and financial planners considered
this evidence during the first decade they would have been discussing
the investment bubble by 2004 and subsequently altering their investment
Increasing GINI may also be a cause of economic crashes. As the 1%
throw increasing amounts of wealth at capital investments, such as
real estate, the workers can no longer afford the costs those goods
or the risks of those investments. When the workers max out their
incomes the investment market will stall. All those who used debt
to buy in late will lose more than they gain.
|We see spikes in the wealth of the 1% right
before the crashes of 1987,
2000, and 2008.
Indicator 3: Investment component of GDP rises faster than consumption
|Corporate zero-sum games include mergers, stock buy-backs,
credit default swaps, and other risky transactions where large sums
of money get traded while nothing real gets produced and no jobs get
created. Even worse, mergers typically result in the elimination of
jobs, a drop in product diversity, a drop in competition, along with
other declines in real wealth. These changes lead to dropping wages
and dropping investment values. Huge sums are made by those who manage
corporate zero-sum games but the total real wealth frequently declines
as a result. Consequently, these actions would more accurately be
termed negative-sum games, where the acquisition of wealth by one
group requires a significant decline in real wealth for other groups.
|Corporate zero-sum games contribute to creation of economic
bubbles by extracting wealth from the productive sector of the economy
and using it to drive up the costs of investments and property. Even
data published by the practitioners, such as BAIN
clearly show that mergers, and other zero-sum games lead to economic
Indicator 4: Taxes on the rich are low
|A sign that expert economists should have seen in the
last few bubbles was the investment component of GDP rose significantly
faster than the consumption component. This strongly hints that investment
value was not rising as the result of increased productivity rather
investment value was being strongly inflated. This would be particularly
problematic if gross debt was also rising rapidly. It would indicate
that debt was inflating the bubble.
|We need to watch this pattern closely. If the investment
component of GDP is rising rapidly, we probably have a bubble. If
the investment component of GDP is large compared to the consumption
component we probably have a bubble. If debt has also risen rapidly
then the whole system is built on unsustainable debt and it will collapse
when the bubble bursts. When these patterns are observed extreme caution
is necessary. Intervention may be necessary.
|Taxes on the rich have varied significantly
over the last century. Investment bubbles in the midst of stagnant
wages occurred when taxes on the rich were
low. Growth occurred when taxes on the rich were relatively high.
Initially, this may seem counter-intuitive. We use tax cuts (unsuccessfully)
to stimulate the economy.
|This actually fits well with the other bubble indicators.
When taxes on the rich are low, the rich throw more money into investments.
The rapid flow of funds into investments inflates their value. People
fall for the rapidly rising "value" and throw more money
into the rapidly expanding bubble.
Taxes on the rich may be lowered directly through a drop in the tax
rate or indirectly through tax subsidies and drops in the capital
gains rate. The combination of these factors have actually allowed
the rich to pay lower tax rates than the middle class over the last
Related pages at this site
Part B: What should we do to prevent future Investment bubbles?
1. Pay attention to the indicators. If they are indicating a bubble make
choices that protect yourself from bubbles.
2. Ignore financial advisors who insist that trends will continue. All
trends are temporary. Some trends are the results of zero-sum games. Those
trends will end hard.
3. Support policies that resist the concentration of wealth into the hands
of a few, or into a few prized investments. Concentrated wealth almost
always ends badly. Remember tax policies can promote the formation of
bubbles (e.g.: tax subsidies to the rich) or resist the formation of bubbles
(e.g.: high tax rate on the rich.) Regulations can also promote bubbles
(e.g.: encouraging businesses to become too big to fail) or resist bubble
formation (e.g.: preventing concentrations of wealth and power.)
Part C: Blog: Are
we in a bubble now?