Wednesday, March 24, 2010

Do You Know How I Know You Are A Bubble?

We often hear that speculative bubbles are impossible to forecast until after they have popped. Naked Capitalism points to Edward Chancellor's "10 Sign Posts of Manias and financial Crises" to make the argument that (1) you can identify bubbles and (2) if you want to see a live bubble in action, look to China (you should really click through to see the supporting links): Top 10 Reasons You Know China Has A Financial Bubble On Its Hands
  1. "Great investment debacles generally start out with a compelling growth story."
  2. "Blind faith in the competence of the authorities."
  3. "A general increase in investment is another leading indicator of financial distress. Capital is generally misspent during periods of euphoria. Only during the bust does the extent of the misallocation become clear."
  4. "Great booms are invariably accompanied by a surge in corruption."
  5. "Strong growth in the money supply is another robust leading indicator of financial fragility. Easy money lies behind all great episodes of speculation from the Tulip Mania of the 1630s – which was funded with IOUs – onward."
  6. "Fixed currency regimes often produce inappropriately low interest rates, which are liable to feed booms and end in busts."
  7. "Crises generally follow a period of rampant credit growth."
  8. "Moral hazard is another common feature of great speculative manias. Credit booms are often taken to extremes due to a prevailing belief that the authorities won’t let bad things happen to the financial system. Irresponsibility is condoned."
  9. "A rising stock of debt is not the only cause for concern. The economist Hyman Minsky observed that during periods of prosperity, financial structures become precarious."
  10. "Dodgy loans are generally secured against collateral, most commonly real estate."
Now some of these ("a surge in corruption") are simply part of the human condition, bubble or not. I would also add an 11th item to the Top 10: growing opacity in budgeting and accounting. The acceptance of Enron-style accounting methods in America's public and private financing should have been a warning that no one had any idea as to the solvency of the overall system. That should go double for China, which doesn't even bother to follow generally accepted accounting principles, but simply tosses out numbers that China bulls/acolytes accept without question (a level of blind faith they would never grant to their own countries, btw).

It's always dangerous to make any predictions about China because the only constant there has been the persistence of poverty and roiling social change. Right now, China looks like the wave the future. But, 20 years ago, it was a pariah because it was shooting student protesters. 20 years before that, it was in the throes of the Cultural Revolution, and was as isolated as North Korea is today. And 20 years before that it emerging from 20 years worth of civil war and foreign invasion. The popping of a speculative bubble may be the least of China's problems.

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