Is a bubble burbling in financial markets?

November 4, 2009

JaneFoley.JPG-Jane Foley is research director at Forex.com. The opinions expressed are her own.-

The discrediting of the efficient markets theory in the aftermath of the financial crisis appears to have been accompanied with growing support for the view that rather than efficient in nature, financial markets are predisposed towards the formation of bubbles.

A bubble can simply be defined as an occurrence that begins when the price of an asset has been driven significantly above it “fair” value. According to the efficient markets theory this would not happen.

If bubbles are a natural outcome of financial market activity it is relevant to ask whether the very loose fiscal and monetary policies of many central banks and governments are presently sowing the seeds of the next bubble.

Even though the real economies of the U.S., UK, Eurozone and Japan continue to be defined by expectations of rising unemployment and falling real wages, access to cheap money has already helped restore the profitability of many investment banks.

In turn, this has fed risk appetite which is evident in the rally in stocks since the spring, increased demand for “risky” currencies and a recovery in commodities prices. Brent oil has rallied by 128 percent from its 2009 low. The ability of oil to rally despite the existence of oil supplies well above the seasonal average suggests there is already speculative element in this market which could be in danger of driving prices above their fair value.

This week’s meetings of the Federal Reserve, the Bank of England and the European Central Bank have focussed attention not so much on rates, but on the extraordinary policy decisions taken by these central banks in the wake of the financial crisis and whether conditions are ripening in favour of a gradual withdrawal of some of these policies.

The Fed last week ended its $300 billion treasury bond purchasing plan, though it will carry on buying mortgage backed securities. The Bank of Japan last week announced that it will stop buying corporate bonds at year end. The Reserve Bank of India also removed emergency support measures last week.

This week there is speculation that the ECB could announce that it will hold no more 12-month cash tenders next year. By contrast the Bank of England is expected to increase quantitative easing at the November 5, Monetary Policy Committee meeting. Supporters of quantitative easing continue to stress that the lack of clear inflation pressures suggests there is room for these plans to be extended.

However, the lack of response in either money supply or inflation indices could equally be illustrating that these plans are not having a significant impact on the real economy and are therefore no longer appropriate. The paring back of these plans are likely to have an impact on the ability of some banks to turn an easy profit and thus should rein in risk appetite and limit speculative and “bubble” forming activity.

Unfortunately, a bubble can only be truly confirmed after it has burst; a characteristic with clear destabilising consequences. If bubbles are natural phenomena within financial markets, the need for tighter regulation and ongoing reviews of processes that oversee the financial system are absolutely necessary.

This conclusion, while in complete contrast to the implications of the efficient markets theory, ties in very well with the political desire to reform the banking regulatory framework in order to protect the tax payer from future hefty bank bail-out costs. The banking landscape, while already vastly different from just two years ago could continue its transformation for years.

researchEMEA@forrex.com

Comments

If bubbles are a natural outcome, then the most that tighter regulation can do is choose where the next one will or will not occur.

 

Exactly how was the “efficient markets theory” discredited after the financial crisis? Are we supposed to pretend that the Department of Housing and Urban Development regulations imposed in the mid-1990s requiring Fannie and Freddy to increase the share of loans extended to low and moderate income households wasn’t a factor in the collapse of the housing sector? Should we ignore the consequences of modifications to the CRA in 1995 which required lenders to meet a numeric quota based on the minority population in the area, thus forcing banks in some areas to lower their lending standards in order to comply? Does an artificially low interest rate policy from the Fed have no effect at creating an incentive structure such that many borrowers choose ARMs instead of FRMs?

I’m not saying that banks are completely innocent, but there’s plenty of blame to go around, and the perverse incentive structure created by idiotic regulation did have a significant contribution to the collapse of the financial sector. Maybe banks shouldn’t have extended loans to risky borrowers, but it’s a little hard to compete when the bank across the street is offering artificially low rates and is dumping the risky loans on “Fannie Mac”.

No, the recent financial crisis does not discredit the free market system, and it doesn’t prove that bubbles are natural phenomena within financial markets (though they can happen, this isn’t evidence of it). If the financial market was truly deregulated, then we wouldn’t expect for banks to go to great lengths to extend loans to anyone who walked in the door. Irresponsible banks may try it, but come a recession they would just go out of business with no taxpayer funded bailout. Believe it or not, the threat of going under is actually a reasonably effective incentive for banks to pursue responsible lending policies–no regulation required.

Of course this isn’t to say that stricter regulation wouldn’t be effective at stabilizing the financial sector. Regulation can be made to work, and intelligent reform does have the potential to achieve the popular goal of minimizing the risk for (or damage from) a future collapse. However, we shouldn’t misplace blame to the alternatives in order to advance this agenda. The problem isn’t deregulation, but rather incomplete and idiotic regulation. We can improve by going either way: both more regulation and less regulation would be effective at avoiding a similar situation next time. The big question is do we trust Congress to come up with a rational plan devoid of specific loopholes which can potentially be exploited by certain special interests in the banking sector?

Posted by Nick | Report as abusive
 

Jane, since you assert that the demand for crude was flat while the price was rising, a plausible explanation would be that the whole production curve has been elevated to compensate the loss in US$ value. I think that conditions for spotting a bubble formation stages should be investigated in correlation with the level of affordability for the end consumer. The housing bubble was predicted 2 years in advance, based on this kind of approach.

However, in repeated statements, Middle East suppliers were not shy spelling out that their comfort zone prices were between US$75 and US$80 when the barrel was hovering around US$60. In very short time, prices on the market have been elevated to a plateau of US$80, with no apparent changes in observable factors concurring in price formation. Therefore, what is the mechanism of translating a statement of desire into effective pricing in a market deemed free?

Posted by M | Report as abusive
 

Futures and Options create the “bubble-bust” cycle.When people who do not really need certain commodities at all,indulge in manipulating the price/s,of the same,due to sheer financial muscle,this will be the result.But the pity is,the legitimate users of these commodities suffer.In a way,the whole SYSTEM is flawed and needs urgent correction,by way of banning unwanted and illogical, (for the legitimate users,of commodities)instruments,and that includes the Derivatives Trading,too.Otherwise the creation and busting of bubbles,which is the “bread and butter”
,of many professionals, will be the order of the day.

 

The CFTC was responsible for regulating trades in commodities such as Oil, Wheat, Corn and so on. This regulatory body was created to stabilize prices for producers and consumers.
However, this has been perverted by ‘waivers’ that allow big money players (Yes I’m talking to you G$) to skirt the rules while the normal producers and consumers are pounded by inflated, volitile commodity prices. This is criminal in the case of food coomodities as people around the world begin to starve to death because they cannot afford staples like corn, wheat, and rice.
Bubbles are caused by speculators. Speculators are increasingly trading perceived values in derivatives. The OTC derivatives market, which the CFTC tried to enforce their regulatory power over in the ’90′s (re: Brooksley Born) was squashed by the big money interests bribing congress to defang the CFTC by passing legislation.
Insiders are now the only force in the bubble market because the FIRE sector now owns the government. Anyone who wants to put any measurable blame on poor simple folk (who were often unsavvy victims of predatory lenders re: WAMU, CitiBank aka SHITTYBank) and the HUD who sold their legally mandated constituents to the wolves really needs to be taken down a notch.
Rich, greedy people who have an OCD to become ever richer and feel money and power are the only things that matter in the world are the blame pure and simple. Our government in the U.S. and most governments around the world are no more than a pack of high priced whores. The people in shiny striped suits with manicured nails are little more than common theives. The only thing that sets these parasites apart from common street criminals is their crimes are on a massive scale and they get away with it in broad daylight.

Posted by J | Report as abusive
 

Free markets reflect human emotions and rational thought…the former follows the latter in time but oscillates at a much higher amplitude/degree. That is why Ayn Rand is wrong and there is an abundance of historical artifacts which can be found as evidence proving that her and her followers are naive at best… the broken bodies laying at the foot of the skyscrapers that house wall street offices, neckties used as a hangmans rope, broken tulips and popped southsea bubbles.
It is a bit tiring to here the drone of the free marketers crying “please, just let us reign because we are rational humans”. What is rational is recognizing when rational that the human mind can and will take on states of irrationality and we need to protect ourselves from ourselves. Regulation created with rational minds protects all of us from the time when we are collectively dilusional.

Posted by csodak | Report as abusive
 

csodak,

…if only we had rational regulators above the influence of human emotion and personal greed.

Posted by etotheipi | Report as abusive
 

Asset Bubbles are idea not a natural occurence.Mr Darling is presently trying to tell us that the world will have to watch out for future bubbles.Yet what he is presently doing is supporting the previous set of bubbles.
Mr darling take away your printing pounds, 1% interest rates and buying worthless pieces of paper and what would you have. ASSET PRICES AT THEIR CORRECT LEVELS! Oh and a few of Mr Darlings friends filing for insolvency.Keep up the good work Mr Darling

Posted by gd | Report as abusive
 

I think government should be providing better regulations, the banks preyed on the general public offering lending products that were irresponsible. The irony is overwhelming, the same people who were the victims of not only these lending products but also the crash that followed were asked to bail out the banks. I still can’t believe that Chuck Prince hasn’t been arrested for his part while running Citi. Regardless of the external fundamental factors, that usually server has a catalyst, the emotions of the investors that trade are what really drives the market. This ‘recovery’ of the market defies logic. The S&P500 was at 666 in March and it hit or almost hit 1100. All this on declining volume. This is a classic bear market bounce. The unemployment numbers in many states are still double digits. We haven’t seen the bottom yet and it will be deeper than 666. Pouring more money is just delaying the inevitable. Th greed that has often fueled capitalism will be it’s undoing. It’s time that the ‘old boys club’ be broken up and more Women CEO’s be instituted.

 

I think the markets are very risky to be invested in currently. And while I don’t think now is a great time to be buying gold, I am still very bullish on the gold price and gold mining stocks in the long term. I believe it’s one of the few sectors in which investors can protect themselves from the misguided policies of the govt. And with regard to particular gold mining companies, one I like a lot is San Gold, which recently announced the discovery of a new high grade gold zone at its Rice Lake Mine in Canada. I saw several good articles on the company at http://www.goldalert.com/goldmining/sang old including one that discusses how it is increasing production and reducing costs. There are many unintended consequences of the huge deficits the govt is running up, and I think the gold price reaching new highs is a strong sign of the currency debasement and money printing that are going on.

Posted by mthomas | Report as abusive
 

The problem is that the declining Greenback plus the low interest rate are creating bubbles in Asia. Many people are borrowing heavily to bet on Asia stock markets and forex.
It’s hard for the governments in Asia to control the inflow of foreign capital, even knowing that part of the money is held by speculators.

 
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