Architecture of Financial Bubbles

The world financial system, for the last few years, has been suffering under a grievous economic collapse caused by an excessive asset speculative bubble fueled by largely unregulated debt financing.

These kinds of speculative bubbles keep occuring approximately with a seventy to eighty years cycle and their recovery requires long periods of as much as a full decade.

Naturally such man made calamities have engendered a lot of punditry and political rethoric. Unfortunately the financial pundits have only an incomplete understanding of these phenomena. The political classes of any of the advanced countries have even less of a clear understanding.

In particular the party of the "optimates" (the right) believes that markets are self correcting and therefore there is no need for governmental intervention to correct such excesses. As we shall see below they are DEAD WRONG.

On the other hand, the party of the "populares" (the left) believes that government regulation and adjudication is a superior (more equitable) mechanism to insure financial stability and fair distribution of economic benefits. They are also DEAD WRONG

A true deep understanding of these phenomena would allow the formulation of correct policy wich:

A true deep understanding of these phenomena can be formulated if linear system theory is applied to the financial system.

The first step is to recognize that there is a profound difference between consumption (goods & services) markets and speculative/investment (assets) markets. In fact, the former are self regulating in so far that an increase in demand leads to an increase in price, which in turn tends to limit further price increases. Conversely a decrease in demand leads to a decrease in price which fuels an increase in demand which slows down the price decrease. That is consumption markets exhibit negative feedback.

This is NOT the case for asset markets which exhibt positive feedback insofar that price increases engender more demand (buying panic) and price decreases fuel panicky collapse of demand (crash).

Therefore it is clear that the right is correct in fighting against regulation of consumption markets but WRONG in opposing regulation of asset markets especially speculative asset markets.

It is equally clear that the left is correct in demanding regulation of asset markets but WRONG in favoring consumption market regulation.

The nefarious properties of unregulated asset markets become even more dramatically apparent when one considers the role of leverage. Leverage in financing refers to the multiplicative effect of using debt financing when participating in such markets. In fact, financial leverage is what system engineers call loop gain. It is well known in system theory that a system with positive feedbak loop with a gain greater than one is unstable and can develop a runaway catastrophic explosion. In 2009 many major financial institutions were using financial leverages as high as 40 to one!! No wonder we experienced a major world wide collapse.

The need to regulate lending institutions has been recognized for a long time. In fact, the act of lending creates money. It is actually quite easy to mathematically prove (see geometric series) that if institutions lends r fraction of their available capital they create, out of each dollar of capital, 1/(1-r) dollars in the economy. r is called the relend ratio and 1/(1-r) is the institution's financial leverage. r is a number between zero and one. If r=0 no money is lent and no new money is created in the economy. If r=1 all the money in all the participating institutions is lent and infinite money is added to the economy creating a runaway inflation even though the government is not printing any money! The relend ratio for banks is typically controlled by a central bank, in the US this is the FEDs. A typical mode of operation has r=.80 which implies that each dollar of capital creates five dollars in the economy.

The dangers presented by financial amplification when applied to positive feedback assets markets are far worse than those associated with debt financing of consumption markets. The latter, have been known for a long time to require strong regulatory control of the relend ratio which acts as the gas pedal of the consumption economy.

The extreme need for strong regulation of debt financing of asset markets is best understood if one highlights its basically criminal underpinnings.

Everybody understands that a Ponzi scheme is a criminal enterprise. In a Ponzi scheme the money of the most recent investors is disbursed to pay the "alledged" profits of older investors. This allows the promoters to advertise exceptional returns which, in turn, cause more people to join the fray. The scheme keeps on avalanching until either the pool of available investors dries up or a significant collapse of the broad market occurs (see Madoff), then it suddenly collapses. The criminality of a Ponzi scheme arises from not disclosing to potential new investors that they may lose all or most of their money to older investors and not disclosing to old investors the risk associated with a collapse that the authorities may require them to disgorge the illicit gains.

Debt financing of, especially speculative, asset markets has similarities to Ponzi schemes. In fact, in such cases banks and other financial institutions risk moneys entrusted to them on very risky loans without disclosing to their depositors the huge risks they are taking, while not sharing the huge profits they accrue in the case all works out. So as in the Ponzi scheme case the promoters of these activities violate their fiduciary duties. The Law should definitely prohibit or at least regulate such activities.

It turns out that, at least in the USA, indeed such activities were largely prohibited. In 1933 the Congress passed the Glass-Steagal Act that prohibited the commingling of consumer banking with investment banking which effectively prevented ordinary (consumer) banks from engaging in risky asset banking activities.

It is very interessting to note (Glass-Steagal) that in 1999 the act was repealed tanks to the effort of Sen. Gramm (R-tex) and the Democratic president Bill Clinton! Ten years later the largest financial bubble since the Great Depression burst dragging the whole world into a huge economic storm which is still (2013) causing a lot of suffering.

The key issue is then, what regulatory framework will be necessary and sufficient to prevent such bubbles from happening? XXX

Copyright Ugo O. Gagliardi 2013