Economic bubbles and cycles

By Ashfak Bokhari

Nobody knows for sure how long America’s financial crisis will persist and what kind of debris it will leave behind when it ends. Economic crises or bubbles are often of cyclic nature and keep revisiting the world every 10-15 or 50-60 years whenever there develops fault lines in the system.

The current turmoil which many economists saw coming and ultimately erupted in late September is seen to be much different from the previous ones. One reason, according to economist Branko Milanovic, is that this is the first crisis in the current era of globalisation. And since globalisation has already wired the entire globe into one single financial system, any crisis in its citadel would have a worldwide impact. So, all the advantages of financially-driven globalisation (speed and volume of transactions, geographical reach) have suddenly turned into disadvantages. That is why central banks in many countries have drawn up rescue packages for banks firms.

The term economic cycle refers to the fluctuations of economic activity around its long-term growth trend. Despite being called cycles, these fluctuations do not follow a predictable periodic pattern. The main types of these cycles have been named after those identifying their characteristics. They are: the Kitchin inventory cycle (3–5 years), Juglar fixed investment cycle (7–11 years), Kuznets infrastructural investment cycle (15–25 years), Kondratieff wave (45–60 years) and Forrester cycles (200 years). Which cycle the current crisis fits in is not clear. But it is said to the worst crisis since the Great Depression of 1930s.

Famous financier George Soros says the current crisis in the US has been caused by what he considers a “super-bubble” in the US economy which is bigger than just the recent housing crises, and this, in turn, has been caused by exotic financial instruments. These instruments were traded in very large volumes; some of them were rated AAA and institutions bought them, and a few months later they turned out to be valueless.

Major speculative bubbles have been known to have left behind disastrous effects on the economy. It is interesting to note that the first major speculative bubble in economic history revolved not around property or companies, but around tulip bulbs and came to be known as tulip mania. After tulips were introduced by Ottomans (modern-day Turkey) to Europe in the mid-1500s, the Dutch became much fond of them, seeing them as a status symbol.

Soon, the tulip became an object of speculation. To secure the fancy tulips in advance (they can take as long as 12 years to develop from seed to flower) a market came into being. Traders signed medieval futures contracts that guaranteed them tulips at the end of the season. In the 1630s, speculators, lured by tales of sudden riches, flooded the market. The Dutch government banned short selling of futures contracts to control the mania but failed.

Bulb prices kept climbing until early 1637 and then demand collapsed, causing a big drop in price. The futures trade stopped and the government permitted futures contracts to be voided with a 10 per cent fee. Hundreds of Dutch traders slipped into poverty.

Another historic bubble, called the Mississippi Bubble, occurred in the 18th century France. When the value of metallic currency began fluctuating wildly, John Law, an exiled gambler, was called back to help. He suggested the Banque Royale take deposits and issue banknotes payable in the value of the metallic currency. This introduced paper currency in France and his strategy helped create financial stability. In 1717, Law launched the Mississippi Company to which the French government gave a monopoly on trading rights with French colonies.

In 1719, he devised a scheme under which his company subsumed the entire French national debt. He promised 120 per cent profit for shareholders, and there were at least 300,000 applicants for the 50,000 shares offered. As the demand for shares continued to rise, the Banque Royale continued to print banknotes, resulting in severe inflation.

The bubble burst in May 1720 when a run on the bank forced the government to acknowledge that the amount of metallic currency in the country was not even equal to half the total amount of paper currency in circulation. By November, shares in the Mississippi Company were worthless. John Law had to flee the country. The ‘Panic of 1825’ occurred in London ten years after the end of the Napoleonic Wars. It refers to a stock market crash that started in the Bank of England arising in part out of speculative investments in Latin America including in the fabled imaginary country of Poyais. The crisis was felt most acutely in England where it led to the closure of six London banks and 60 country banks, but was also manifest in the markets of Europe, Latin America, and the United States. An infusion of gold reserves from Banque de France saved the Bank of England from complete collapse.

In the recent history, a major event was the Great Depression which happened when hundreds of thousands of investors contributed to a speculative bubble in the Wall Street. Many went into debt to purchase stock, resulting in more than $8.5 billion in debt which was more than the money in circulation at the time. When the market turned bearish on October 24, 1929, investors panicked, causing a massive sell-off that hit the stock markets and contributed to the Great Depression of the 1930s. To demonstrate confidence in the market, the Rockefeller family and the heads of major banks bought large quantities of stock but it did not stop the panic. By October 24, the market lost a total of $30 billion — an amount more than the US had spent on World War I. The crash caused business closures, massive lay-offs and a spate of bankruptcies. An international run on the dollar resulted in increased interest rates, driving out around 4,000 lenders.

After an investigation, Congress passed the Glass-Steagall Act of 1933 (repealed in 1999 to herald the era of regulation) which spelled out a separation between investment and commercial banks. This law was expected to stop future dramatic sale in the market but it could not when the Dow Jones index fell 22.6 per cent in 1987.

The Japanese asset price bubble occurred during1986-1990 period. After World War II, Japan’s domestic policies encouraged people to save money and the banks to advance easy credit. As a result, Japanese companies were able to produce and sell high-quality products at extremely competitive prices, becoming a major world economic power in the process. At the same time, people used easy credit to develop property and buy homes, contributing to a speculative real estate bubble. The Nikkei reached an all-time high of 38,957.44 in December, 1989. Then, in the early 1990s, the bubble burst, leading to Japan’s “lost decade” and many Japanese started investing abroad. Similarly, the dotcom bubble in the US, driven by technology, began developing in 1995 and burst in 2000.

When bubbles grow, they look wonderful in every way. Everybody makes easy profits. When they sink, they can set the economy back more than a decade.

In the cycles before World War II or that of the late 1990s in the United States, the growth periods usually ended with the failure of speculative investments built on a bubble of confidence. In these cycles, the periods of contraction and stagnation reflect a purging of unsuccessful enterprises as resources are transferred by market forces from less productive uses to more productive uses. Cycles between 1945 and the 1990s in the United States were generally more restrained.

Source: Daily Dawn, 27/10/2008

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