21 January 2021

If history is a guide, we are deep into financial bubble territory

By Joakim Book

Most assets look very bubbly these days: bonds, properties, rare art, gold, stocks – almost regardless of what investors have bought in the last few years, they have seen extraordinary returns. Last year alone, despite (or perhaps because) of the pandemic, shares in many  American tech firms soared by hundreds of percent. This is not normal. 

Take Tesla or Bitcoin’s meteoric explosions. After both had delivered eye-popping returns last year, Tesla shares gained another 25% only a few days into the new year, and Bitcoin rallied 43% from New Years’ Eve to a new all-time-high (both have fallen back somewhat in the days since).

Whatever your opinion of these assets, and whether governments’ financial and monetary pandemic support is making the issue worse, something seems off. Lots of people have invoked the “B-word”. 

Financial historians William Quinn and John Turner of Queen’s University, Belfast, have given the current bubbles some much-needed historical context with their handy yet comprehensive 222-page book, Boom and Bust: A Global History of Financial Bubbles.

With admirable clarity, Quinn and Turner detail ten previous financial bubbles to see what we can learn today. They identify three key ingredients for financial bubbles to form. In the same way as a fire requires fuel, oxygen, and heat, followed by a spark, a financial bubble needs “marketability, money and credit, and speculation”.

Marketability is the ease with which the assets may be bought and sold. Like oxygen, it is always around but remains a critical ingredient when bubbles form: trading becomes easier, cheaper, more readily available, or extended to new classes of people. From commission-free trading at most American brokerage firms to trading on apps like Revolut and Robinhood and the widespread use of fractional shares, marketability has exploded in recent years. In mere moments, with as little as a dollar or a pound, anyone can flip a (very small) piece of the most exciting assets in the world.

Money and Credit. Bubbles don’t get far unless there’s ample liquidity available, fuel for the bubble to inflate: loose monetary policy, banking systems flush with money or a strong desire to extend loans. With the lowest nominal and real interest rates seen in Britain and the US since the financial repression of the 1950s and 1960s ‒ already before the unprecedented monetary corona measures that have magnified this trend ‒ cheap credit is available to a degree probably never seen before. Today, getting your hands on insane amounts of leverage has never been easier, whether on highly-leveraged products freely available in the regulated markets, or through the shadow banks and various obscure cryptocurrency services. Not for nothing are claims about the “Everything Bubbleback in vogue.

Speculation is the least solid ingredients in the academics’ three-part story; as a never-ending charge against financial markets, it can mean pretty much anything. Nevertheless, bubble periods are associated with plenty of “novices becoming speculators” who buy bubbling assets when prices are rising and hope to offload them before they fall. Quinn and Turner write that 

“just as a fire produces its own heat once it starts, speculative investment is self-perpetuating: early speculators make large profits, attracting more speculative money, which in turn results in further price increases and higher returns to speculators.” 

A few minutes listening to devout fans of Elon Musk or reading the average cryptocurrency chat room is usually enough to conclude that speculative mania rules an uncomfortable number of people’s actions. School-age kids on TikTok scream “buy-the-f‒ing dip”; as the car-rental company Hertz declared bankruptcy in May, daring traders pocketed 5x on the heavy trading of its stock; the obscure penny stock Signal Advance increased 6,000% in two days after Musk tweeted “Use Signal” ‒ but he meant the non-profit messaging app, not the Texas technology manufacturer that trades under the ticker SIGL. This is a market in chaos. 

The Economist reported that the share of financial market volume coming from retail investors increased to 20% last year, up from 15% the year before. The hundreds of thousands of Robinhood traders roaming the financial seas are informed by nothing but Telegram groups and posts on r/wallstreetbets riddled with expletives.

The vast majority of the roughly 8,000 or so cryptocurrencies have more in common with the obscure Bicycle mania of the 1890s and fanciful dot-com projects a century later than they do with other asset classes. During the Bicycle mania, hundreds and hundreds of bicycle companies issued highly-leveraged shares according to a time-honoured pattern: “issue a prospectus full of unrealistic promises, pay influential figures to support the flotation and offer it to the public for a much higher price than you paid.”

Those involved in today’s get-rich-quick schemes share their maniac fervour with house-flipping Americans in the 2000s and speculators flipping Australian houses in the 1890s; promoters and speculators slinging railway shares in the 1840s; and savers, pension funds, and homeowners in Japan in the 1990s, US technology stocks later that decade, or Chinese stock markets in 2007 and 2015. 

“All these things will have a familiar feel to bubble watchers”, writes Merryn Somerset Webb sensibly in the Financial Times. Perhaps we can’t identify bubbles until after the fact, and nobody really knows in advance what it will take to prick them. But we can identify the necessary ingredients ‒ marketability, money and credit, speculation ‒ and there’s plenty of each at the moment.

Thankfully, it’s not all doom and gloom. Bubbles can be useful ‒ particularly when their spark is technological instead of political. The dot-com bubble, for all its overhyped narratives, laid the grounds for today’s flourishing tech sector: streaming, fintech, e-commerce. A bubble fuelled by grand hopes for a future technology, usually has something to show for it, while political bubbles leave behind nothing but havoc. When technology is the spark, write Quinn and Turner, “large sums of money [are] flowing into extremely innovative sectors of the economy, which might overwise have trouble attracting enough capital to get off the ground. As a result, they can be beneficial for society”.

One of the most well-supported conclusions in the literature on economic cycles is that recessions associated with financial crises are much deeper and take much longer to resolve than when banks and financial institutions are relatively insulated. Quinn and Turner point to banks as bubble magnifiers, as their lending inflates the bubbles; when they burst, the disruption spreads the crash across the real economy, often to banking customers who had nothing to do with the bubbling asset itself. A silver lining to today’s bubbles ‒ if, indeed, they are bubbles ‒ is that major banks are mostly unaffected. The fall-out from whatever crash may or may not happen ought, therefore, to be less painful. More like the mild late-19th century bubbles where “losses were still mostly borne by those who could afford them”, than the 2008 crisis that impoverished so many ordinary people.

Can we use history to predict bubbles? Well, no. And if these astute financial historians had uncovered a way to predict when bubbles would burst, they would have set up a hedge fund trading their secret knowledge rather than written a book about it. What is available to us from a particularly balanced summary of three centuries of financial bubbles is that all three necessary ingredients are available today to an astonishing degree. 

Judging from the bubbles of the past, we are now far into bubble territory. 

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Joakim Book is a researcher and freelance writer on banking, monetary policy and financial history.

Columns are the author's own opinion and do not necessarily reflect the views of CapX.