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:


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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?

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