Felix Salmon

How financial innovation causes bubbles

By Felix Salmon
February 4, 2010

Stephen Gandel has a good, thought-provoking interview with Roy Smith, a former Goldman banker whose book is available in the UK. His way of looking at both bubbles and busts as being driven by liquidity I think has a lot to be said for it:

There is now about $140 trillion in market capitalization in the word’s financial markets looking for investments. That money can now move around very easily. But even if a relatively small portion of that money goes after something — say, mortgages — it can quickly cause a bubble and a crisis. So all this good work we have done in the past few years to make our capital markets more efficient and open has also made them very hazardous, and we haven’t done anything yet to address that problem.

Here’s Smith’s verdict on the history of Wall Street:

The net result has been a positive for users of capital markets, which can be accessed more cheaply than ever before. But the success of the market has resulted in a vast accumulation of capital in tradable form that is now capable of wrecking whole economies. In 2000 and 2007, financial bubbles did great damage, and the monster is still out there.

Up until now, I’ve thought that the harmfulness of financial innovation was largely a function of its role in enabling regulatory arbitrage. But Smith’s idea I think is stronger. Financial innovation, on this view, is in large part the art of turning illiquid assets into liquid assets. And once an asset is liquid, it’s susceptible to highly-dangerous booms and busts.

The point is that it’s pretty much impossible to have a bubble in something which doesn’t have a liquid asset class supporting it. There’s a good reason that the very concept of a bubble is associated with stocks: stocks are one of the most liquid asset classes in the world. The carry trade is essentially the art of creating bubbles in liquid currency markets. The invention of the mortgage-backed security allowed trillions of dollars to flow into the housing market, where a huge bubble formed. There was a veritable frenzy of trading in Dutch tulips, when they were in a bubble. (Can someone help me out with the Japanese property bubble of the 1980s? What was the driving force behind that?)

It’s not like you can’t lose money where there isn’t a speculative frenzy, of course: banks and insurance companies have been going bust for centuries, after misjudging creditworthiness or losing a gamble when some tail event finally happened. And a lack of liquidity can be just as bad as a surplus of it: if a country has exchange controls and high interest rates, a huge proportion of the money in that country eventually ends up being lent in some form or another to the sovereign, which when it eventually defaults can cause massive economic devastation.

But as Smith says, a world with over $100 trillion in liquidity is by its nature a world prone to bubbles: a tiny slosh of that money in a certain direction can cause massively destabilizing effects in formerly-sleepy corners of the market. And the explosive growth of ETFs, which can turn all manner of fixed-income, commodity, and currency asset classes into liquid and bubble-prone stocks, only makes matters worse.

The monster is still out there — and the monster is growing, as sovereigns with trillions of dollars of disposable wealth at their disposal look for asset classes to invest that wealth in, and as Wall Street continues to extoll its ability to corral multi-billion-dollar financing deals by doing clever things in the capital markets. What’s more, it’s far from clear that regulators even have the ability to identify bubbles, let alone to prevent them growing to destabilizing levels. George Soros said in Davos that he loves identifying bubbles and then jumping on the bandwagon and making lots of money. Can anybody hope to stop him?

19 comments so far | RSS Comments RSS

Does this mean Tobin tax or any sort of transaction tax should be looked at as it would likely reduce liquidity?
For Japan, wasn’t it exporters’ cash that fuelled the property bubble? The riches earned abroad from Japan’s relentless international expansion were recycled at home in the real estate part of the keiretsu.

Posted by fxtrader14 | Report as abusive

On Japan see the book by Christopher Wood: The Bubble Economy: Japan’s Extraordinary Speculative Boom of the ’80s and the Dramatic Bust of the ’90s

Posted by david3 | Report as abusive

Felix – property by itself is not a particularly liquid asset, but the instruments created in this instance enabled agents to make it more liquid.

I think this is along the same lines as what Buttonwood has referred to in the Economist a number of times: In recent years there has been very little real wealth creation, but a lot of creation of claims on wealth.

Posted by edepicier | Report as abusive

Oh yeah, the Japanese real estate bubble back in the ’80s. What drove it I haven’t a clue, but I do recall two notable occurences from it: 1) at one point, a square mile of property in Tokyo was worth more than ALL the real estate in America, which sounds fantastic and 2) property buyers were taking out multi-generational mortgages. Fancy that, paying off a mortgage your grandfather incurred! Talk about serfdom.

Posted by Gotthardbahn | Report as abusive

Increasing the liquidity of the rest of the economy is the whole point of banking.

The fundamental rule of banking is borrow short, lend long. The banking sector is fundamentally illiquid. The rest of the economy, then, becomes fundamentally more liquid with a banking sector.

Unfortunately, as noted, with liquidity come new risks. This is one reason good regulations and regulators are a necessary component of capitalism.

Posted by wcw | Report as abusive

the other problem, Felix, is ONE SIDED liquidity – it is difficult to get short real estate – which fuels the bubble

Posted by KidDynamite | Report as abusive

Volker is right – the only financial innovation has been the ATM (ok, on-line banking, too). Everything else is just re-packaging of risk so that it becomes unrecognizable. Risk doesn’t disappear just because it is chopped up into tiny little pieces and spread outlike manure in a filed, it just becomes harder to track, which makes it easier for people to profit from the ones who are unable to recognize the risk.

What causes the bubbles is when enough people believe the risk has disappeared or has been reduced, and asset values are distorted. The “innovation” actually leads to increased instability, as bets are made using inaccurate information (e.g., believing the companies that rated debt).

What people refer to as financial innovation is innovative only for the select few who are able to profit from it, but for the rest of the world, those “innovators” are just parasites who have extracted value from the system while weakening it.


Posted by OnTheTimes | Report as abusive

“There’s a good reason that the very concept of a bubble is associated with stocks: stocks are one of the most liquid asset classes in the world.”

Bubbles can be associated with anything from oil (recently as last year) to housing (does anyone remember?), tulip bulbs, and so forth.

Posted by yr2009 | Report as abusive

What is the definition of a bubble? How do I measure a bubble?

Posted by Boabdil | Report as abusive

You measure a bubble when credit is plentiful, hyperinflation in demand swamps supply. The exact timing of the peak is unknown but is characterized by hyperinflation in quantity supplied swamping demand and coincides with an eerie silence followed by a stampede for the exit followed by what we are experiencing now…deflation.

Posted by csodak | Report as abusive

Was Enron “financial innovation”? Is it “financial innovation” for dishonorable bankers to whisk up a bunch of toxic and in some cases fictitious mortgages, bury them amongst a load of other fluff, re-rate them as though they possessed real worth, then leverage their aggregate face value ten times over, hawking them as though they were lighting in a bottle to see who the last man standing might be?

Is that even legal? Not really, when you cut to the chase.

Burying in fancy language what these “sovereigns” have been up to, even dignifying an ungentlemanly rigged game with taxpayer dollars as markers as “capitalism” is an inflation of language. Referring to what came out their back ends a “bubble” is yet another euphemism, when it’s more like an explosion with countless civilian wounded.

I don’t want to see what moves they might pull next, or what new names they have for the game. It’s time these self-infatuated playas called it quits, without parole.

Posted by HBC | Report as abusive

Felix — After the Plaza Accord in 1985, Japan began running a loose monetary policy, which fed into the asset markets. Here’s a quick summary:

http://en.wikipedia.org/wiki/Plaza_Accor d

Posted by DavidMerkel | Report as abusive

The one thing that bubbles are always associated with is leveraged debt, even going back to the tulips, and that requires someone convincing someone else that it is going to be worth enough in the future to cover your cost of cash.

I disagree with the position that we haven’t created wealth recently, we have created enormous wealth in the form of extra years of life, even since 1970 the life expectancy of a 65 year old has increased almost four years.

A higher percentage have gone to school and are carrying around knowledge which is theirs for life, even if jobs are tough right now that is gained for good.

Maybe free time needs to be calculated into the GDP as a positive contribution, there are a lot of ways to look at wealth and maybe as we pass through these hard times we need to re-evaluate and decide what kind of a country we want to live in.

Posted by jstaf | Report as abusive

Someone, maybe the housing industry lobby, the mortgage industry lobby etc,. managed to convince the top lawmakers in this country the ‘home ownership’ was an important American value, and that it had huge social benefits.
This notion prompted law makers to subsidize the housing industry through twisting the taxation system.
Bankers saw the opportunity to leverage on this ‘value’, and make a ton of money for themselves, and the rest is history, that’s written by the winners –
but who are they in this case?

Posted by yr2009 | Report as abusive

You are forgetting the major innovaion of adding to the liquid funds by de-regulating pension funds and such, now the average Joe has a stake in Wall Street and will tolerate government bailouts. With all the insider trading and instant trading, we all know the game is rigged, but we all have to play anyways.
I want an investment bankers job so I can reap huge bonuses for doing as well as the market during good times, and huge bonuses during bad times to keep my great talent on tap.

Posted by Potatoe1 | Report as abusive

“There’s a good reason that the very concept of a bubble is associated with stocks: stocks are one of the most liquid asset classes in the world.”

Um, not exactly. Bubbles are associated with the stock market because stocks are very risky. The stock market may have an average return of about 6% over the last 100 years, but it also has a standard deviation of about 20%, indicating incredibly high volatility. What that means is very simple–we will never see constant 5-8% returns year in and year out. Instead, it will always be down 10%, up 28%, up %12, down 24%, etc.

Such is life. Human nature is such that we are constantly driven to succeed. We always want more, always. And we always want more than our neighbors.

And such is how it will always be. Was reading the other day about how Olympians who win silver medals are usually not happy, despite being the one of the best in the entire world and his/her respective sport.

Posted by stevenstevo | Report as abusive

OnTheTimes: great insights.

Boabdil, are you from Zimbabwe ? It is when the underlying pot overheats, the problem is when all the pots on one stove/oven overheat at the same time, like a can of condensed milk in a pressure cooker that doesn’t make the flan but the ceiling.

Anyway, it amazes me how people see financial instruments in pixles, but at the same time jump from one to the other as if they magically connect, i.s.o. explaining the (inverse) relationships. Inflation devours nominal returns and spits out real returns for all instruments. More liquidity has a different effect on instruments, depending on the state of the whole market at a specific point in time, with all its lags and HFT’s.

Financial innovation exist because of in-house actuaries, lawyers, traders, portfolio managers and our favourite, the (chartered) accountants, yes a private arbitrage (boys) club.

Posted by Ghandiolfini | Report as abusive

You write: “Financial innovation, on this view, is in large part the art of turning illiquid assets into liquid assets. And once an asset is liquid, it’s susceptible to highly-dangerous booms and busts.” Accepting that view of financial innovation, I wonder what your complaint is. When an asset is illiquid, its value can still go up or down; it’s just hard to find out how much you could sell it for, or how much you’d have to pay to buy it. With a liquid market participants have more flexibility, and the price information is more readily available. That seems good; but evidently you believe that, with a liquid market, fluctuations in value are likely to be wider. (That *seems to be* what you are suggesting. But why think so?) And you regard these supposed wide fluctuations in value/price “highly-dangerous”–but *to whom*? What “destabilizing effects” beyond mere fluctuations in price do you have in mind?

“[A] lack of liquidity can be just as bad as a surplus of it . . . .” You *are* hard to please!

“[I]t’s far from clear that regulators even have the ability to identify bubbles . . . .” Of course, they can’t! It’s so hard, *investors* can’t do it consistently; it’s silly to expect more from *regulators*.

Posted by Philon | Report as abusive

Here is a simple, personal way to think about what causes financial bubbles:

http://actualanarchy.blogspot.com/2011/0 4/easier-way-to-think-about-bubbles.html

Posted by ActualAnarchy | Report as abusive

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