All economic cycles, particularly the long-term — say more than 5 years — have a great propensity to generate bubbles in one or several kinds of assets, depending on the variety of circumstances. However, price bubbles will never be very uniform or predictable, either in scope or duration. The biggest misunderstanding about price bubbles is precisely the reason for their existence. The reason is embarrassingly simple: human imperfection. There are three elements involved:
- Human society has made substantial progress throughout the centuries.
- Economics and financial knowledge are in essence also advanced.
- Excesses are still well beyond the human capacity to overcome.
The not inconsiderable mechanisms, checks, and balances that have been developed through the ages to prevent drastic imbalances are easily overwhelmed by numerous factors:
- The genuine human desire to progress, to always go further. Mankind has never adequately practiced the concept of limits. We tend to go overboard quite easily. This phenomena is particularly acute where credit-line management is concerned.
- The greed that inevitably grows as a boom progresses — or fear, in the opposite extreme.
- The lack of effective checks and balances to fight the many conflicts of interest, inevitable in any human process.
For instance, let’s expand on the last point. During the 2008-2009 sub-prime crisis, this kind of multiple conflicts had many actors: builders, sellers, middlemen, buyers, government, and rating agencies, to name a few. They all contributed, though at different levels, to creation and nurturing of the humongous credit bubble that created so much chaos and ruin when it burst.
Of course, the three previous factors are not mutually exclusive; they usually interact and reinforce each other, magnifying the situation. While no substantial progress is made in these three areas, it is virtually impossible to expect that bubbles will not happen again. At best, the expectation would be to create less inflated bubbles, if possible is to achieve a better understanding of economic cycles and to make substantial progress in risk-management. For that purpose: the following assumptions are important:
- At the very minimum, to avoid serious damage when the inevitable breakdown occurs.
- In a much better scenario, to benefit from the bubble’s creation and its rupture as much as possible. However, this requires great skill in handling the tools for this purpose. The complexity of this approach begins by defining and selecting which tools to use and weighing the options, as well as the corresponding hierarchy when the frequency mixed signals appear. Both efforts, although many more in the second case, require commitment, research, and experience of two basic types:
- technical competence, and
- emotional management.