70. Excess of cash and the origin of bubbles
ASTRO — By Dmitry Podolsky on November 1, 2008 at 10:00 am
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Let us continue our dummy studies of the global financial crisis (2008-….). As we have concluded the last time, the intrinsic worth of US economy should be presently strongly overestimated while nominated in US dollars. The surplus – amount of US dollars printed by FED which are not backed up by anything except the price of paper they are printed on 
– should clearly have some use.
I would like to postulate at this point that the use of this excessive cash is related to investments. To say it poetically, the penny-worth pieces of paper with Franklin’s face on them
are invested into the Future of America (by the way, I’ve learned that eurodollars are mostly held by European institutions in the 100$ denomination).
This policy as it is sounds pretty reasonable, since the global (and local US, in particular) economics gets constantly warmed up by this cash flow. The problems start when this cash flow becomes excessively strong.
To understand what happens with world’s economy in this case, go to the bathroom. I am serious Open the tap just a little bit. What you will see is the laminar flow of water. Open the tap more now. At some point the flow starts to get fragmented into jets, numerous little drops will come off it, etc., etc. What you have just observed is the phenomenon of turbulence.
How does it have anything to do with the world financial crisis, you ask? When the flow of excessive cash pumped into economy starts to grow, institutional investors become more and more active, they invest more and more (we shall not care where to at this point). Since the price of a stock is ultimately determined by the demand-supply equilibrium (not the internal worth of a stock), a bubble will necessarily start to grow on the market.
While it is true that patterns of human psychology are very important for the development of bubbles on markets, I would like to argue that the ultimate reason why bubbles even start to take off is the excessive activity on markets, when institutional and public investors have too much cash to invest.
So, now the question I would like to find an answer to is the following. Fine, we saw lots of bubbles on different markets. Why the bubble on the housing market was so important for the development of the current crisis? About this – in the next time (if I shall be able to find a convincing explanation )
4 Comments
Nice writing. You are on my RSS reader now so I can read more from you down the road.
Allen Taylor
Hi Allen
Glad you are among my readers now.
Cheers,
Dmitry.
There are many classical economic theories on the origin of bubbles. In truth, there are probably many different effects that contribute, and all ‘pure’ theories fail in some way (hence model building and relaxing assumptions).
One of the usual complaints layed down by say the Austrian school, and various monetarist factions is that the federal reserve kept interest rates too low for too long. This increases the money supply and can cause a bubble if the money supply grow faster than GDP (they are tracked by indicators like M2 and M3).
Unfortunately its not entirely robust either, b/c bubbles have been created in the past even when the money supply is relatively low growth.
So I’d be wary about one size fits all explanations, but yea certainly effects like this can increase the probabilities or add pressure for euphoria phases.
(Interestingly in this case, the problem is not locused just in the US, but is global in nature, which complicates things to the nth degree as you have to account for all the different regulatory laws, different interest rates, different inflation rates and so on and so forth.. In short an analytical nightmare)
Hi Haelfix
Thanks a lot for the specialist explanation. I did not know about Austrian school although expected that my view cannot be very original. The goal was to figure out whether it is possible for a non-professional to understand at least in some approximation what happens with markets now.
As for M2 and M3 data, this was my key point that FED decided to stop publishing M3 data recently and therefore one cannot know anymore how many dollars are in circulation in the world.
Certainly, the problem is of the global nature, but my impression is that US is to blame for the crisis since US FED essentially controls the amount of reserve currency in the world.
With best regards,
Dmitry.
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