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 the past.

Indicator 1: Wealth of the rich increases rapidly while employment and working class wages stagnate
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 strategies.
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 2: Corporations increase their investments in zero-sum games
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 crashes.
Indicator 3: Investment component of GDP rises faster than consumption
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.
Indicator 4: Taxes on the rich are low
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 few decades.

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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?

 
 

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