ECONOMIC BUSINESS BUBBLE: January 2011

Monday, January 31, 2011

How economic bubble builds up

November 2nd, 2008 by Kiyani
I got this nice story in email about how an economic bubble builds up. The story truly reflects current financial events around the world. It tries to answer the question “where does all the money go?”
A very simplistic explanation of how a “bubble” builds up.If you could read patiently and understand, it’s a great knowledge! Once there was a little island country.The land of this country was the tiny island itself. The total money in circulation was 2 dollars as there were only two pieces of 1 dollar coins circulating around.
1) There were 3 citizens living on this island country. A owned the land B and C each owned 1 dollar.
2) B decided to purchase the land from A for 1 dollar. So, now A and C own 1 dollar each while B owned a piece of land that is worth 1 dollar. The net asset of the country now = 3 dollars.
3) Now C thought that since there is only one piece of land in the country, and land is non producible asset, its value must definitely go up. So, he borrowed 1 dollar from A, and together with his own 1 dollar, he bought the land from B for 2 dollars. A has a loan to C of 1 dollar, so his net asset is 1 dollar. B sold his land and got 2 dollars, so his net asset is 2 dollars. C owned the piece of land worth 2 dollars but with his 1 dollar debt to A, his net residual asset is 1 dollar. Thus, the net asset of the country = 4 dollars.
4) A saw that the land he once owned has risen in value. He regretted having sold it. Luckily, he has a 1 dollar loan to C. He then borrowed 2 dollars from B and acquired the land back from C for 3 dollars. The payment is by 2 dollars cash (which he borrowed) and cancellation of the 1 dollar loan to C. As a result, A now owned a piece of land that is worth 3 dollars. But since he owed B 2 dollars, his net asset is 1 dollar. B loaned 2 dollars to A. So his net asset is 2 dollars. C now has the 2 coins. His net asset is also 2 dollars. The net asset of the country = 5 dollars. A bubble is building up.
(5) B saw that the value of land kept rising. He also wanted to own the land. So he bought the land from A for 4 dollars. The payment is by borrowing 2 dollars from C, and cancellation of his 2 dollars loan to A. As a result, A has got his debt cleared and he got the 2 coins. His net asset is 2 dollars. B owned a piece of land that is worth 4 dollars, but since he has a debt of 2 dollars with C, his net Asset is 2 dollars. C loaned 2 dollars to B, so his net asset is 2 dollars. The net asset of the country = 6 dollars; even though, the country has only one piece of land and 2 Dollars in circulation.
(6) Everybody has made money and everybody felt happy and prosperous.
(7) One day an evil wind blew, and an evil thought came to C’s mind. “Hey, what if the land price stop going up, how could B repay my loan. There is only 2 dollars in circulation, and, I think after all the land that B owns is worth at most only 1 dollar, and no more.
(8) A also thought the same way. Nobody wanted to buy land anymore. So, in the end, A owns the 2 dollar coins, his net asset is 2 dollars. B owed C 2 dollars and the land he owned which he thought worth 4 dollars is now 1 dollar. So his net asset is only 1 dollar. C has a loan of 2 dollars to B. But it is a bad debt. Although his net asset is still 2 dollars, his Heart is palpitating. The net asset of the country = 3 dollars again.
(10) So, who has stolen the 3 dollars from the country ? Of course, before the bubble burst B thought his land was worth 4 dollars. Actually, right before the collapse, the net asset of the country was 6 dollars on paper. B’s net asset is still 2 dollars, his heart is palpitating.
(11) B had no choice but to declare bankruptcy. C as to relinquish his 2 dollars bad debt to B, but in return he acquired the land which is worth 1 dollar now. A owns the 2 coins, his net asset is 2 dollars. B is bankrupt, his net asset is 0 dollar. ( he lost everything ). C got no choice but end up with a land worth only 1 dollar. The net asset of the country = 3 dollars.
************ **End of the story; BUT ************
There is however a redistribution of wealth. A is the winner, B is the loser, C is lucky that he is spared.
A few points worth noting.
1) When a bubble is building up, the debt of individuals to one another in a country is also building up.
2) This story of the island is a closed system whereby there is no other country and hence no foreign debt. The worth of the asset can only be calculated using the island’s own currency. Hence, there is no net loss.
3) An over-damped system is assumed when the bubble burst, meaning the land’s value did not go down to below 1 dollar.
4) When the bubble burst, the fellow with cash is the winner. The fellows having the land or extending loan to others are the losers. The asset could shrink or in worst case, they go bankrupt.
5) If there is another citizen D either holding a dollar or another piece of land but refrains from taking part in the game, he will neither win nor lose. But he will see the value of his money or land go up and dow like a see saw.
6) When the bubble was in the growing phase, everybody made money.
7) If you are smart and know that you are living in a growing bubble, it is worthwhile to borrow money (like A ) and take part in the game. But you must know when you should change everything back to cash.

As in the case of land, the above phenomenon applies to stocks as well.
9) The actual worth of land or stocks depend largely on psychology.
Credit: No idea from where this story came from since I got it in email. But who ever wrote it, explained in detail as to how bubble builds up. Two thumbs up to him or her

Sunday, January 30, 2011

More warnings about China's bubble economy

Following on from Yesterday's post on Jim Chanos' crusade against China, another two reports have come to light sounding the alarm bell on China's bubble economy.

The first article from Bloomberg quotes Richard Duncan from Blackhorse Asset Management, who claims that China's economy is the biggest bubble in history that may be headed for collapse.

A more than 50% surge in China’s money supply since 2008 helped fuel economic growth in excess of 9% per year, even as trading partners sank into recession. The expansion also saddled the country with factories that produce three times more goods than can be bought by China’s workers, 80% of whom make less than $5 a day, said Duncan.

“China has the greatest economic bubble in history...There’s a real risk it’s going to collapse in a Great Depression-style scenario.”

The pin that may prick China’s bubble, Duncan said, is a backlash against free trade among voters in the U.S., where unemployment last month rose to the highest since April. The U.S. House of Representatives in September enacted legislation that would let U.S. companies petition for duties on Chinese imports to compensate for the effect of an undervalued yuan. Protectionist sentiment could gather steam in the next two to three congressional election cycles, Duncan said.

Meanwhile, The Telegraph ran an article on a recently released report from the Chinese Academy of Social Sciences (CASS), which claims that China's housing bubble has grown so large that 85% of Chinese living in cities can no longer afford to purchase a home.

The Chinese Academy of Social Sciences (CASS) said in its annual Economic Blue Paper that a typical Chinese property now costs 8.8 years of average earnings.

In addition, CASS said that house prices are still rising far in excess of wages, putting property more and more beyond the reach of average Chinese.

CASS estimated that Chinese property prices had risen by 15% this year, although the rises in some cities have been far steeper.

By contrast, the UK's typical house costs five years of wages to buy, according to the Nationwide Building Society, and the UK's long-term average is four years of earnings.

"House prices have risen steadily for years," said Zhou Linhua, the co-author of the CASS report. "This has inflated investor expectations of a high return, which has brought more money flooding into the market, and fed the bubble"...

"Property prices are likely to remain high for a while," predicted Matthew Fang, an analyst at Guosen Securities, adding that demand was still strong and that inflation was rising.

Negative real interest rates have helped to persuade many Chinese to invest in bricks and mortar rather than leaving their money in the bank, and there is a continuing requirement for Chinese men to own their own property before they can get married.

Attempting to quantify the size of the property bubble, CASS calculated what it believed was a "real" house price in 35 large and medium-sized cities in September, using an index of eleven statistics, including per capita disposable income, saving deposits, number of doctors and university students, retail sales volumes and local capital investment levels.

According to its figures, new homes in seven out of the 35 cities were more than 50% over their fair value. Property prices in Fuzhou are 70% too expensive, while those in Hangzhou are 66% overpriced. New homes in Shanghai are 37% overpriced and those in Beijing are almost 50% overpriced.

The CASS' findings are similar to those of my China's Colossal Housing Bubble article from August 2010. And my conclusion then is just as relevant now:

A key reason why Australia was able to ride-out the GFC of 2008/09 was because of continued strong demand for commodities by China. China is Australia’s number one export destination, accounting for 22% of our exports. As such, Australia benefited directly from the massive building boom that emerged following the Chinese Government's 4 trillion yuan ($US590 billion) stimulus package, which led to sharp rises in the prices of commodities, including iron ore, aluminium and copper.

However, if a significant slowdown emerges, evident by a fall in China's infrastructure construction and/or apartment and home building, then demand for Australian commodities will fall sharply, leading to both lower commodity prices and decreased volumes being exported into China. The economic consequences for Australia from a sharp slowdown in China could, therefore, be enormous and would manifest itself through significantly lower economic growth, higher unemployment and falling asset prices.

What deeply concerns me is that while most of Australia's mainstream commentators are alive to the opportunities that stem from Australia's heavy exposure to China, they are completely unaware of the significant potential risks to China's (and by extension Australia's) economic outlook.

I hate to always be the bearer of bad news. But a slowdown of the Chinese economy is, in my view, the biggest threat to Australia's 'miracle' economy. Those banking on continuing record high commodity prices and perpetual economic sunshine could be in for a rude shock. Forewarned is forearmed...

Cheers Leith

Saturday, January 29, 2011

backlink for you

Friday, January 28, 2011

ECONOMIC BUBBLE in japan

The second largest market economy in the world, Japan has a per capita income that ranks third. In 1996, it registered a gross domestic product (GDP) of $4.63 trillion. Following the collapse of the "bubble economy" in the early 1990's, growth in the GDP has slowed. With the vision of creating a more efficient economy, Japan's government is currently promoting deregulation of numerous economic sectors.

HIGH-GROWTH ERA

Japan's postwar economy developed from the remnants of an industrial infrastructure that had suffered widespread destruction during World War II. In 1952, at the close of the Allied Occupation, Japan was a "less-developed country," with a per capita consumption roughly one fifth that of the United States. Over the next twenty years, Japan was able to become the first postwar-era country classified as "less-developed" to achieve "developed" status. In 1968, Japan's economy became the world's second largest, behind only that of the United States.

The percentage of Japanese living in cities almost doubled between 1950 and 1970, thus increasing demands for services. During the 60's, Japan's average for exports grew 18.4% per year. This economic growth accompanied tremendous changes in Japan's industrial structure. Whereas agriculture and light manufacturing used to be the mainstays of the economy, now it had shifted to heavy industry and services. Dominating the industrial sector were iron and steel, ship-building, machine tools, motor vehicles and electronics

Although high growth rates were predicted for the 1970's, double-digit inflation, the Middle East oil crisis, and other factors, caused a recession which lowered future growth expectations. This resulted in a reduction of private investment and economic growth slowed to an average of 3.6% from 1974-1979, a big drop from the 10% it had previously experienced. There was a slight increase in the 80's to 4.4%, but it was not until recently that a positive change has come about, due to many factors, including the "bubble economy."

In spite of the oil crisis and what happened, Japan's major export industries remained competitive by cutting costs and increasing efficiency. The energy demands were reduced and the automobile industry was able to improve it's position globally, by manufacturing lighter and more economical vehicles. The second oil crisis in 1979 created a shift in Japan's industrial structure from emphasis on heavy industry to development of new fields, such as the computer, semiconductor, along with other technology and information-intensive industries. This started a period of rapid growth

Sunday, January 23, 2011

Analysis: Housing bubble burst sending economy down

Wednesday, January 03, 2007

By Mark Weisbrot

WASHINGTON -- The big question for the U.S. economy now is whether we will make it through 2007 without a recession. Most of the top economic forecasters are predicting a "soft landing," which means the economy slows but not so sharply as to cause a recession.

But almost all of these same experts failed to forecast the last recession, and they missed the stock market bubble -- the largest financial asset bubble in history. And most of them also missed the housing bubble until it began to burst. So it would not be prudent to rely solely on their forecasts at this time

The timing of any downturn is not easy to predict. But a recession is likely, because of the enormity of the housing bubble and the impact of its collapse. Recall that our last recession in 2001 was caused by the bursting of a stock market bubble of about $7 trillion. The housing bubble is comparable in size -- about $5 trillion at peak. And the bubble wealth is much more widely distributed: Most Americans still have most of their assets in housing and little or nothing in stocks.

As this housing wealth disappears, people cut spending. We already have seen an enormous drop in the amount that people borrow on their homes, from $600 billion in 2005 to about $350 billion for 2006. It was this borrowing, enabled by soaring house prices that allowed people to borrow more against the value of their homes, that fueled the U.S. economic recovery since 2001.

Housing construction and sales also are a big sector of the economy, currently about 6 percent of GDP. If that falls 30 percent to 40 percent, as it has in previous downturns, that's a drop of about 2 percent of GDP.

The recession caused by the stock market bubble bursting, which lasted only from March to November 2001, would have been a lot worse if not for the enormous demand created by the housing bubble. So what will rescue the U.S. economy from the collapse of the housing bubble?

It's not easy to imagine what that would be. Personal savings rates are already negative, a phenomenon not seen since the Great Depression. How much can consumers borrow on their credit cards? A sustained surge of business investment is unlikely in the face of an economy that is already slowing: GDP growth was just 2 percent in the third quarter, down from 2.6 percent and 5.6 percent in the previous two quarters.

And there are downside risks from the global economy: Foreign central banks are keeping our long-term interest rates extremely low -- below short-term rates -- by accumulating 10-year U.S. treasury bonds. They could lose just some of their appetite for this debt at any time and send U.S. long-term rates upward. A decline in the dollar, which is inevitable given that we are borrowing more than 6 percent of GDP from other countries, poses similar risks -- although it will eventually help the U.S. economy by narrowing our trade deficit.

We possibly could get through the international imbalances for another year but the housing bubble collapse is already upon us, with November's housing starts down 25 percent over the last year, home sales plummeting, and home prices falling. This is something that our political leaders and policymakers should have warned people about, rather than encouraging the same kind of speculative excess that dominated our economy during the late 1990s stock market bubble

from - http://www.post-gazette.com/

Renewable energy: the next economic bubble?

Economic’, ‘market’ or ‘speculative bubbles’ have occurred throughout history with varied causes and impacts. One of the earliest examples in Europe was the Dutch ‘tulip mania’ of 1637, where tulip contracts were signed at 2000% of what they had been three months before. Bubbles typically develop in advanced capitalist economies, with highly sophisticated financial markets where capital is abundant compared to capital-scarce poor countries.

Playing bubble pop

Economists differ over what causes these bubbles. Some argue that it is the ‘herd behaviour’ – a group action without a direction - of investors. Others say that it is down to ‘excess liquidity’ – the loose lending of standards and low rates, or capital, or problems with forecasting market developments. What they do share is the strong diversion of asset prices from the intrinsic value of a good, be they tulip bulbs, houses or internet start-ups. Often it is the adoption of a new technology or a new market ‘fad’ that leads to a rapid surge in the valuation of asset prices, as investors pile into the new product in their search for higher yields

With the world facing the prospects of a drawn-out recession, looking for new economic bubbles might seem inexpedient. However, it is in times of economic downturns that investors are looking for new investment opportunities where capital could be placed, in the hope of reaping high returns. When trying to identify where a new bubble might be developing, the renewable energy sector seems a good candidate.

Heading towards a renewable energy bubble?

Currently, with oil prices plummeting to historic lows due to the decreased aggregate demand as a consequence of the recession, the world is nonetheless running out of fossil fuels. The drop in oil prices is not because there is increased supply. Actually, oil production might peak in the coming years. Once the economy recovers, energy prices will increase again. Supply will be even more limited if alternative sources are not developed any further.

In the US – the driving economy behind the last economic bubbles – the Obama administration has developed an ambitious plan to develop the renewable energy sector. It has promised to double the share of renewable energies (currently 7%) in its national energy mix over the next three years. It promises to create some 460, 000 new jobs in the energy sector. Under the current stimulus plan, it will invest $25 billion directly in the renewable energy sector. A new energy bill will slate additional funding for the sector. A nationwide emissions trading system will be introduced by 2012.

Will Obama’s ‘green revolution’ be the source of future US economic power?

While it was the internet revolution that propped up the US economy under Bill Clinton and the housing boom that fuelled economic growth under George W. Bush, will Obama’s ‘green revolution’ be the source of future US economic power? Widespread talk about ‘a global race for renewable energy leadership’ and the ‘green collar workers’ of the future already has markets pumping. A recent KPMG report identified a frenzy of mergers and acquisition in the renewables sector throughout 2007. It is likely that new government investments and global competition will further turn up the heat. Will the result be another speculative bubble in the renewables sector? As private investors struggle to find new profitable sectors to invest in a sinking economy while governments subsidise energy investments, it is possible that the foundations of a new bubble are being lay down on our watch, only to burst at the end of the next economic boom.

The risks are real. The damage could be high. A short boom and bust cycle could set back the development of feasible energy alternatives for decades. Setting an appropriate regulatory framework to curtail market exuberance should therefore be a priority for both US and European governments

from - http://www.cafebabel.co.uk/

Housing Bubble Analysis: Interview with Global Economic Trend Analysis (Mish)

is a no nonsense blog that features Mish's insights on everything from housing and the global economy to interest rates and policy decisions. Mish recently sat down with us to share his thoughts on the past, present, and future of housing.

Thanks for joining us Mish. When did you first become interested in the housing market?

I started watching housing as a bubble phenomenon in 2003 or so. Housing was clearly in a bubble already but that bubble soared exponentially in 2004 and 2005. I was lucky to have called the precise top in the summer of 2005. I did so on the basis of the cover of Time Magazine 'Home $weet Home'. The subtitle was 'Why we are gaga over real estate'
I looked at that and said 'That's it'. At the time people were camping out overnight in Florida for a chance to buy a condo. Prices were rising every day. That was another key signal. When things get that nuts there are no buyers left.
Here is an interesting picture that I created, overlaying my thoughts on top of a chart of Japanese land prices. Each arrow was put out real time. The hardest arrow was the first one. It seemed like a top was coming but it was not confirmed until much later although I was sure I was right that summer. I have not updated the chart for a while now

Home Sweet Home Time Cover

Have you ever seen a U.S. bubble that is comparable to this one?

There has never been a housing bubble in the US as big as this one, on a national scale. Perhaps some international bubbles have been as big. Vancouver Canada is going to implode like Florida did. Spain and the UK are huge problem areas right now. The bubble in Japan was arguably bigger and it took 18 years to unwind.

What are the three biggest reasons why we ended up in this mess, and is there anything we can do to reverse the damage that has been done?

We ended up in this mess because of bad policies from Congress, bad policies from this administration, and bad policies from the Fed, all compounded by consumer greed. That is a toxic mix. Starting with Congress we have had policies that encouraged housing via tax breaks. That is a violation of sound free market policies. We had the creation of Fannie Mae. There were 300 some odd programs to make housing affordable.
Well, guess what happens when you go pushing houses on everyone and handing out tax breaks? Prices go up. The more programs that were created to make housing affordable the higher prices went. Illinois Governor Rod Blagojevich went off the deep end with a program guaranteeing mortgage loans for illegal aliens. The peak of insanity was when Alphonso Jackson, Housing and Urban Development Secretary actually went so far as to send this message to private sub-prime lenders: 'I am absolutely emphatic about winning back our share of the market that has slipped away to subprime lenders.' Look at the insanity. Government was talking about winning market share from the private sector on housing.
Then of course we have Bush's Ownership Policy making renters feel like second class citizens. Government has no business promoting one form of housing over another. The Fed's role in this was slashing interest rates to 1 percent in an inane attempt to prevent deflation in the aftermath of the last recession. At the same time Greenspan openly endorsed ARMs right at the bottom of interest rate yields. Greenspan is a man who was wrong at every major turn. History will not treat him kindly. The role of consumer greed should be obvious.

How long will it be before housing finally hits bottom? And where will prices decline the most?

It took Japan 18 years to hit bottom. I suspect it will take at least 5 to 7 here and 5 is very optimistic. It could easily take 10 years or more. My best guess is 7 but it all depends on what the Fed does to fight it. Ironically enough, the more the Fed fights it the longer it will take. That is what happened in Japan and it will likely happen here. Prices will decline most in the bubble areas: California, Florida, Phoenix, Las Vegas, Boston. Some of the rust belt states where masses of jobs were lost will also get hit hard. The process has already started. Florida is a disaster already: ground zero of bubble busting.

Could states like California and Florida be pushed into a recession because of the price drops?

Of course. The entire country is headed into a recession. Here is a chart I put together on housing and recessions
The thing to keep in mind is that housing permits lead housing starts. Housing starts provide jobs. The rest of the economy is showing severe signs of stress already with the latest GDP at 0.6 percent. Look at all the jobs associated with housing: carpenters, brick layers, appliance manufacturing, shipping, lighting, grass seed, trucking of everything to the new house, furniture, etc. How can it not have an impact?

You mentioned in a recent interview that the peak for sub-prime ARMS re-setting is going to be in November of this year. How do you think that will affect foreclosure rates, and in turn, the housing market?

Yes. Treasury rates have barely budged. In fact they are inching up. It is already too late for 430,000 people. That is how many foreclosures we have had in the first quarter alone according to RealtyTrac. Also remember that credit standards are getting tighter on top of this all. And finally some will be unable to refinance because they are too far underwater. When banks take bank property in foreclosures they will dump those houses on the market. That will further depress prices.

What do you think about the proposed sub-prime bailouts? Will they help or cost more money than they are worth?

Government intervention is one of the causes of the housing bubble. It is axiomatic that the problem cannot be the solution. Note that Congress acted too late anyway.
Government always does. The market already imposed its solution to runaway credit and ridiculous lending standards: the market's solution was a subprime lending blowup and forced tightening of lending standards. If the free market is given a chance to work it will. Bear in mind some will say the free market caused this reckless expansion of credit in the first place and government is needed to clean it up. That is ass backwards. Remember my answer to what caused the problem? It was government intervention compounded by the Fed that allowed subprime lenders to wreck havoc.

What else could the government do to ease the pain of the market correction?

The best thing for Congress to do at this point is nothing. They will only make the problem worse.

Do you have any advice for investors and would be buyers hoping to make a buck off the housing debacle?

Well it's obviously too late to short many of the subprime lenders that have now gone bankrupt. I think the best advice here is to not get too cute. We are still relatively early in the debacle. There are no tremendous bargains out there (especially for novices) to be thinking of snatching properties at foreclosure auctions. The people that buy now looking for bargains are simply too early. Inventory is still building, the economy is slowing, and we are headed into a recession. I would caution the real estate buyer to be patient. Better opportunities will come down the road

from - http://efinancedirectory.com/

Financial & Economic Crisis

An economic bubble, often referred to as a speculative bubble, a market bubble, a price bubble, a financial bubble, or a speculative mania, is “trade in high volumes at prices that are considerably at variance with intrinsic values”.

While some economists deny that bubbles occur, the cause of bubbles remains a challenge to those who are convinced that asset prices often deviate strongly from intrinsic values. While many explanations have been suggested, it has been recently shown that bubbles appear even without uncertainty, speculation, or bounded rationality. Most recently, it has been suggested that bubbles might ultimately be caused by processes of price coordination or emerging social norms. Because it is often difficult to observe intrinsic values in real-life markets, bubbles are often identified only in retrospect, when a sudden drop in prices appears. Such a drop is known as a crash or a bubble burst. Both the boom and the bust phases of the bubble are examples of a positive feedback mechanism, in contrast to the negative feedback mechanism that determines the equilibrium price under normal market circumstances. Prices in an economic bubble can fluctuate erratically, and become impossible to predict from supply and demand alone.

Possible causes

It has been variously suggested that bubbles may be rational, intrinsic, and contagious. To date, there is no widely accepted theory to explain their occurrence.

Puzzlingly, bubbles occur even in highly predictable experimental markets, where uncertainty is eliminated and market participants should be able to calculate the intrinsic value of the assets simply by examining the expected stream of dividends. Nevertheless, bubbles have been observed repeatedly in experimental markets, even with participants such as business students, managers, and professional traders. Experimental bubbles have proven robust to a variety of conditions, including short-selling, margin buying, and insider trading.

While it is not clear what causes bubbles, there is evidence to suggest that they are not caused by bounded rationality or assumptions about the irrationality of others, as assumed by greater fool theory. It has also been shown that bubbles appear even when market participants are well-capable of pricing assets correctly. Further, it has been shown that bubbles appear even when speculation is not possible or when over-confidence is absent.

Greater fool theory

Popular among laymen but not fully confirmed by empirical research, greater fool theory portrays bubbles as driven by the behaviour of a perennially optimistic market participants (the fools) who buy overvalued assets in anticipation of selling it to other rapacious speculators (the greater fools) at a much higher price. According to this unsupported explanation, the bubbles continue as long as the fools can find greater fools to pay up for the overvalued asset. The bubbles will end only when the greater fool becomes the greatest fool who pays the top price for the overvalued asset and can no longer find another buyer to pay for it at a higher price.

Greed

A related explanation is that economic bubbles are favoured by the greed and irrational exuberance of overly bullish investors. The argument is that investors tend to extrapolate past extraordinary returns on investment of certain assets into the future, causing them to overbid those risky assets in order to attempt to continue to capture those same rates of return. Overbidding on certain assets will at some point result in uneconomic rates of return for investors; only then the asset price deflation will begin. When investors feel that they are no longer well compensated for holding those risky assets, they will start to demand higher rates of return on their investments.

Herd behaviour

Another related explanation used in behavioural finance lies in herd behaviour, the fact that investors tend to buy or sell in the direction of the market trend. This is sometimes helped by technical analysis that tries precisely to detect those trends and follow them, which creates a self-fulfilling prophecy.

Liquidity

Others argue that the cause of bubbles is excessive monetary liquidity in the financial system, inducing lax or inappropriate lending standards by the banks, which then causes asset markets to be vulnerable to volatile hyperinflation caused by short-term, leveraged speculation. According to the explanation, excessive monetary liquidity (easy credit, large disposable incomes) potentially occurs while fractional reserve banks are implementing expansionary monetary policy (i.e. lowering of interest rates and flushing the financial system with money supply). When interest rates are going down, investors tend to avoid putting their capital into savings accounts. Instead, investors tend to leverage their capital by borrowing from banks and invest the leveraged capital in financial assets such as equities and real estate.

Simply put, economic bubbles often occur when too much money is chasing too few assets, causing both good assets and bad assets to appreciate excessively beyond their fundamentals to an unsustainable level. The bubbles will burst only when the central bank reverses its monetary accommodation policy and soaks up the liquidity in the financial system. The removal of monetary accommodation policy is commonly known as a contractionary monetary policy. When the central bank raises interest rates, investors tend to become risk averse and thus avoid leveraged capital because the costs of borrowing may become too expensive.

Other possible causes

Some regard bubbles as related to inflation and thus believe that the causes of inflation are also the causes of bubbles. Others take the view that there is a "fundamental value" to an asset, and that bubbles represent a rise over that fundamental value, which must eventually return to that fundamental value. There are chaotic theories of bubbles which assert that bubbles come from particular "critical" states in the market based on the communication of economic factors. Finally, others regard bubbles as necessary consequences of irrationally valuing assets solely based upon their returns in the recent past without resorting to a rigorous analysis based on their underlying "fundamentals".

Effects of an economic bubble

Economic bubbles are generally considered to have a negative impact on the economy because they tend to cause misallocation of resources into non-optimal uses. In addition, the crash which usually follows an economic bubble can destroy a large amount of wealth and cause continuing economic malaise. A protracted period of low risk premiums can simply prolong the downturn in asset price deflation as was the case of the Great Depression in the 1930s for much of the world and the 1990s for Japan. Not only can the aftermath of a crash devastate the economy of a nation, but its effects can also reverberate beyond its borders.

Another important aspect of economic bubbles is their impact on spending habits. Market participants with overvalued assets tend to spend more because they "feel" richer (the wealth effect). Many observers quote the housing market in the United Kingdom, Australia, Spain and parts of the United States in recent times, as an example of this effect. When the bubble inevitably bursts, those who hold on to these overvalued assets usually experience a feeling of poorness and tend to cut discretionary spending at the same time, hindering economic growth or, worse, exacerbating the economic slowdown. Therefore, it is imperative for the central bank to keep its eyes on asset price appreciation and take measures to curb high levels of speculative activity in financial assets. This is usually done by increasing the interest rate - the cost of borrowing money.

Examples of economic bubbles include:

Tulip mania (1637), The South Sea Company (1720), Mississippi Company (1720), Railway Mania (1840s), Florida speculative building bubble (1926), The Nifty Fifty American stocks of the late 1960s and early 1970s, Poseidon bubble (1970), Sports cards and comic books in the 1980s and early 1990s, TY Beanie Babies (1996), The Dot-com bubble (circa 1995–2001), Japanese asset price bubble (1980s), 1997 Asian Financial Crisis (1997), Real estate bubble, British property bubble (as of 2006), Irish property bubble (as of 2006), United States housing bubble (as of 2007), (The former Florida swampland real estate bubble), Spanish property bubble (as of 2006), Romanian property bubble (as of 2008), Exotic Livestock production in North America (i.e. llamas, white tail deer, elk, wild boar, and to a lesser extent bison). Some other goods which have produced bubbles include postage stamps and coin collecting

from - http://www.world-crisis.net/

Can Data Mining With Complexity Analysis Predict Economic Bubbles?

In the brilliant book by Eric Beinhocker of McKinsey Global Institute titled "The Origin of Wealth", there is a very powerful and dramatic statement which attempts to explain wealth creation, thus: "All wealth is created by thermodynamically irreversible, entropy-lowering processes". We could not agree more! If everything in this universe must subscribe to and abide by the laws of thermodynamics, so must the economy.
People usually glaze over when words like entropy are thrown around. Making conceptual connections between social phenomenon like the economy to a physical phenomenon like a steam engine might sound absurd. But hey, we didn't make the rules (of nature)! We simply have to follow them, if not there will be consequences to pay. That is the whole point. In the last several years, we have let entropy run amok in the US economy and we are now feeling the effects.
Business intelligence tools which can help with data mining for economists must be required to have means to compute the entropy of the economy. We believe that such tools can at least explain, if not predict the trajectory of the economy. What follows is a brief history of the entropic economy, from 2001 to present day.
But first the good news - if wealth is created by lowering entropy, we can pat ourselves on the back. Since 2001 Q1, the entropy of the US economy has reduced by nearly 20%! Indeed if we compare the US economy in current dollar terms, the economy has grown from $10T in 2001 to more than $14T today in market dollar terms. The only problem is that in between the economy has taken some nasty detours which have affected so many people adversely (and a few people very beneficially).

We have analyzed the data from http://www.bea.gov/ for the last 40 quarters. This data includes all major macroeconomic factors: Imports, exports, capital investments, government spending, personal consumption, unemployment, inflation, interest rates... the works.

There are essentially three states to the economy: bubble, normal activity, bust. We find that sustained changes in entropy over two quarters has a strong influence on which of these states the economy ends up in the following quarter. In case you are wondering whats happening right now: entropy has been dropping since 2009 Q4 up until the last quarter. BEA data states that GDP growth has been positive since then. So there seems to be some good news after all!

Bala "BR" Deshpande, is the President of Ontonix USA, a boutique consulting firm with a unique technology to measure complexity and apply it in two main areas: innovative risk management and supply chain complexity reduction. Most businesses assume it is very difficult to measure something as intuitive or maybe as abstract as "Complexity". But it is actually quite practical and extremely valuable in providing early warnings to crises and giving managers a health-check of their business. Try a free evaluation of the tools using your own data here

from - http://ezinearticles.com/

How economic bubble builds up

I got this nice story in email about how an economic bubble builds up. The story truly reflects current financial events around the world. It tries to answer the question “where does all the money go?”
A very simplistic explanation of how a “bubble” builds up.If you could read patiently and understand, it’s a great knowledge! Once there was a little island country.The land of this country was the tiny island itself. The total money in circulation was 2 dollars as there were only two pieces of 1 dollar coins circulating around.
1) There were 3 citizens living on this island country. A owned the land B and C each owned 1 dollar.
2) B decided to purchase the land from A for 1 dollar. So, now A and C own 1 dollar each while B owned a piece of land that is worth 1 dollar. The net asset of the country now = 3 dollars.
3) Now C thought that since there is only one piece of land in the country, and land is non producible asset, its value must definitely go up. So, he borrowed 1 dollar from A, and together with his own 1 dollar, he bought the land from B for 2 dollars. A has a loan to C of 1 dollar, so his net asset is 1 dollar. B sold his land and got 2 dollars, so his net asset is 2 dollars. C owned the piece of land worth 2 dollars but with his 1 dollar debt to A, his net residual asset is 1 dollar. Thus, the net asset of the country = 4 dollars.
4) A saw that the land he once owned has risen in value. He regretted having sold it. Luckily, he has a 1 dollar loan to C. He then borrowed 2 dollars from B and acquired the land back from C for 3 dollars. The payment is by 2 dollars cash (which he borrowed) and cancellation of the 1 dollar loan to C. As a result, A now owned a piece of land that is worth 3 dollars. But since he owed B 2 dollars, his net asset is 1 dollar. B loaned 2 dollars to A. So his net asset is 2 dollars. C now has the 2 coins. His net asset is also 2 dollars. The net asset of the country = 5 dollars. A bubble is building up.
(5) B saw that the value of land kept rising. He also wanted to own the land. So he bought the land from A for 4 dollars. The payment is by borrowing 2 dollars from C, and cancellation of his 2 dollars loan to A. As a result, A has got his debt cleared and he got the 2 coins. His net asset is 2 dollars. B owned a piece of land that is worth 4 dollars, but since he has a debt of 2 dollars with C, his net Asset is 2 dollars. C loaned 2 dollars to B, so his net asset is 2 dollars. The net asset of the country = 6 dollars; even though, the country has only one piece of land and 2 Dollars in circulation.
(6) Everybody has made money and everybody felt happy and prosperous.
(7) One day an evil wind blew, and an evil thought came to C’s mind. “Hey, what if the land price stop going up, how could B repay my loan. There is only 2 dollars in circulation, and, I think after all the land that B owns is worth at most only 1 dollar, and no more.
(8) A also thought the same way. Nobody wanted to buy land anymore. So, in the end, A owns the 2 dollar coins, his net asset is 2 dollars. B owed C 2 dollars and the land he owned which he thought worth 4 dollars is now 1 dollar. So his net asset is only 1 dollar. C has a loan of 2 dollars to B. But it is a bad debt. Although his net asset is still 2 dollars, his Heart is palpitating. The net asset of the country = 3 dollars again.
(10) So, who has stolen the 3 dollars from the country ? Of course, before the bubble burst B thought his land was worth 4 dollars. Actually, right before the collapse, the net asset of the country was 6 dollars on paper. B’s net asset is still 2 dollars, his heart is palpitating.
(11) B had no choice but to declare bankruptcy. C as to relinquish his 2 dollars bad debt to B, but in return he acquired the land which is worth 1 dollar now. A owns the 2 coins, his net asset is 2 dollars. B is bankrupt, his net asset is 0 dollar. ( he lost everything ). C got no choice but end up with a land worth only 1 dollar. The net asset of the country = 3 dollars.
************ **End of the story; BUT ************
There is however a redistribution of wealth. A is the winner, B is the loser, C is lucky that he is spared.
A few points worth noting.
1) When a bubble is building up, the debt of individuals to one another in a country is also building up.
2) This story of the island is a closed system whereby there is no other country and hence no foreign debt. The worth of the asset can only be calculated using the island’s own currency. Hence, there is no net loss.
3) An over-damped system is assumed when the bubble burst, meaning the land’s value did not go down to below 1 dollar.
4) When the bubble burst, the fellow with cash is the winner. The fellows having the land or extending loan to others are the losers. The asset could shrink or in worst case, they go bankrupt.
5) If there is another citizen D either holding a dollar or another piece of land but refrains from taking part in the game, he will neither win nor lose. But he will see the value of his money or land go up and dow like a see saw.
6) When the bubble was in the growing phase, everybody made money.
7) If you are smart and know that you are living in a growing bubble, it is worthwhile to borrow money (like A ) and take part in the game. But you must know when you should change everything back to cash.
As in the case of land, the above phenomenon applies to stocks as well.
9) The actual worth of land or stocks depend largely on psychology.
Credit: No idea from where this story came from since I got it in email. But who ever wrote it, explained in detail as to how bubble builds up. Two thumbs up to him or her!

from - intology.com

The China Bubble

Gady Epstein, 12.10.09, 06:00 PM EST
Forbes Magazine dated December 28, 2009
China's economy is humming along in high gear, thanks to a fast-growing pile of dicey debt. Such booms tend to end badly

China's economy is the envy of the world. As developed nations struggle to eke out a bit of growth and to get unemployment rates out of double digits, Chinese output gallops ahead at an 8% annual rate. This $4.7 trillion economy, it seems, is the world's dynamo and the prototype for the future.

Take a close look, however, and you may come away thinking China resembles nothing so much as Japan shortly before its stock and property markets melted down two decades ago. A speculative frenzy of borrowing and bidding up is at work. If and when prices crash, there will be hell to pay.
Signs of the times: government bureaucracies funding themselves by foisting debt on state-owned business enterprises; local governments raising capital by selling land at sky-high prices to corporations they own; and a People's Bank of China lavishing liquidity on the entire system in a way that makes Federal Reserve Chairman Ben Bernanke look downright stingy.
"It's a Ponzi scheme whose head is the central bank, and it can print money," says Victor Shih, a China expert at Northwestern University.
The U.S. government's $7.2 trillion in debt at the end of June represented 50% of gross domestic product. The Chinese government's officially disclosed $840 billion in public debt represents less than 20% of GDP. But the People's Bank of China and the treasury are also on the hook for potentially $1.5 trillion in off-balance-sheet debt owed by cities and provinces and entities they control. They're also implicitly obliged to backstop $1 trillion, both in loans that "policy banks" were directed to issue, even when they made no economic sense, and nonperforming loans that the government removed from the books of state-owned commercial banks over the past decade.
Add it up and the national government is responsible for debt equal to over 70% of 2009 GDP. That doesn't count any loans generated this year that might go sour amid a 30% increase in debt balances nationwide. (The U.S. government, in addition to its direct debt equal to 50% of GDP, is responsible for cosigning of mortgage borrowers' obligations equal to another 18% of GDP.)