Understanding Finance from scratch

Chapter 37: The Financial Crisis No One Can Escape—Know a little about the truth about the financial crisis every day (4)
What is an economic bubble?The definition of a bubble most commonly used in economic research is the unexplained portion of asset price movement that is based on what we call fundamentals.Fundamentals are the collection of variables that we believe should drive changes in asset prices.In a particular model defined by asset prices, if our forecasts of asset prices are seriously biased, then we may say that there is some kind of bubble.

Bubbles lie at the juncture of finance, economics, and psychology.Recent explanations of massive asset price movements tend to place psychology first, influenced not only by stories from the bleak past but also by the crisis years of 1997, 1998 and 1999 most of the events.Most of the early bubbles were driven by fundamental factors. They originated from the combination of more fundamental factors such as finance and economics, and psychological factors were just the background.Examples include the Dutch Tulip Mania, the Mississippi Bubble, and the South Sea Bubble, all of which are seen as examples of private capital market madness.

Financial behaviorists have found that there are several psychological problems that are most likely to occur during the bubble period: First, the "anchor effect".Typical of most bubbles is that price and value-added effects usually persist for a long time before the final stage, which causes investors to change their expectations and justify high prices.Second, "herd effect".Even many savvy professional investors always try to "inflate with the bubble" instead of trying to avoid it. In the process of price rise, they usually think that it is safer to follow the trend than to take a different approach. Going it alone is less likely to make mistakes.Third, cognitive dissonance.People always tend to choose those views that "can confirm our choice". For example, one of the characteristics of the market during crazy periods is that people are always not interested in the early warning of overpricing, and even very angry.Fourth, disaster neglect and disaster amplification.For negative events with a low probability of occurrence, investors always think that "it is difficult to happen to me", and once a disaster occurs, he always worries that "misfortunes never come singly, and a bigger disaster will follow".

In economic overheating and market panic, monetary factors are very important.The Chicago School believes that the authorities are always stupid and the market is always smart. Only when the money supply is stable at a fixed level or increases at a fixed growth rate, can economic overheating and market panic be avoided.However, the paradox of reality is that bankers only lend money to people who do not want to.When an economic collapse occurs, the banking system will inevitably be impacted. In addition to changes in the amount of money, banks will control credit quotas, which will inevitably lead to sudden credit stops and liquidity failures in certain capital operation links.

Nevertheless, the famous monetarist theorist Owen Stone firmly opposed to expanding the money supply in times of crisis, and Herbert Spencer expressed it more sharply: "Protecting mankind from the bitter fruit of stupid actions will only make the whole world suffer." The world has become stupid."

In this regard, Kindelberger believes that in the long run, the money supply should be fixed, but it should be elastic during a crisis, because a good monetary policy can alleviate economic overheating and market panic, and should also eliminate certain risks. some crises.It is based primarily on studies of the French crises of 1720, 1873, and 1882, as well as those of 1890, 1921, and 1929.In each of these crises there was no lender of last resort, and the post-crisis depression was long.

The complete process of the financial crisis: First, in the process of economic development, people have finally seized new profit opportunities after various efforts and began to pursue this new profit. In the process of pursuing profits, the excess nature of the prosperity stage It will really be reflected. At this time, the financial system will go through a "painful" stage.At this stage, there is a rush to reverse the course of the economic expansion in a way that resembles a market panic.During the overheating phase, all the money people have is used to buy real estate or illiquid financial assets, and those without money borrow money to do so.But the ensuing panic phase of the economy is just the opposite, wealth is transferred from real estate or financial assets to money, or to pay down debts, and this behavior finally leads to the collapse of commodity, house, land stock and bond prices, that is, Anything that becomes an investment in an overheated economy will collapse in price.

We have observed financial crises in history, and there have been more than 30 financial crises similar to the above process, which basically occur once every ten years.In the early years, its objects of profit ranged from coins to flowers to real estate or land. In recent years, it has ranged from bonds to funds to stocks and even derivative products. Anything that can bring profits is an object of investment (speculation).But this kind of investment needs to go through a rational and irrational process in order to turn it into a crisis.

Overheated economy: Who's the lender of last resort
Children like to play a game of throwing firecrackers, but if child A throws a squib at the foot of child B, child B picks up the squib and throws it to child C, who then throws it to child D, and so on, until Child Y threw it at Z, and the squib finally exploded in Z's face and blinded Z's eyes.Here, A is the distant cause, Y is the proximate cause, and there are a series of connecting points from B to W in the middle.So, who is responsible for this matter?

This small metaphor can be seen as a process of the development of the financial crisis, which erupts through the accumulation of various factors.So who is to blame for the financial crisis?
The cause of a financial crisis is speculation and credit expansion, and the proximate cause is some insignificant accident, such as a bank failure, someone's suicide, an innocuous quarrel, an unexpected revelation, or a refusal to support someone. Some people take out loans and just a change of perception.These events have discouraged market participants into thinking a crisis is imminent, throwing out everything that can be converted into cash such as stocks, bonds, real estate, foreign exchange and commercial paper.When everyone who needs money can't find money, the collapse in the financial field will be transmitted to all aspects of the economy, leading to a decline in the overall economy and the advent of a financial crisis.

For speculation to become a "hot", it generally needs to be fueled by the expansion of money and credit to accelerate its development. Sometimes, it is the initial expansion of money and credit that promotes the frenzy of speculation.As far as the well-known tulip speculation, it was formed by the banks at that time by issuing private credit; as recently as the stock market boom caused by the expansion of the New York short-term lending market before the Great Depression in the 20s.In fact, in all the processes from prosperity to crisis, there is a shadow of money or bank credit, and the expansion of money is not a random accident, but a systematic and internal expansion.

Then, the question arises: Once the credit expansion has started, is it realistic to specify a point in time to stop the expansion?And, can this be done by automatic laws?
After clustering research on historical events, it can be seen that as long as the authorities stabilize or control a certain amount of money M, whether it is controlling the absolute amount of money or controlling the supply of money according to established trends, it will lead to more overheating of the economy.This is because: if the definition of money is fixed in a particular form of liquid assets, and the economy overheats and "monetizes" credit in new ways outside of that definition, then money, though defined in the old way, will not growth, but its velocity of circulation will increase; in a modern economy, it is difficult for people to determine the money supply at all levels.Therefore, monetary expansion is unlikely to be stabilized through monetary stabilization policies. By extension, the currency will still push the "heat" even hotter, and crises are still inevitable.

Since human beings entered the market economy, human beings have been repeating the same mistakes, and the beginning of these mistakes are irreproachable and rational behaviors.

With regard to market finance, each school of economics holds different views, and Professor Kindelberger has conducted a detailed investigation and comment on the views of each school in his book.

Monetarists are optimistic, and they believe that there cannot be speculation that leads to instability.The reason is that speculators tend to buy when prices rise and sell when prices fall. Because they buy high and sell low, they will inevitably lead to losses, so it is difficult for them to survive.Kindelberger believes that speculation and greed are the human basis for fraud. From a psychiatric point of view, the relationship between fraudsters and victims is a symbiotic relationship that is bound together to satisfy and depend on each other.Fraud is determined by demand, which follows Keynes' law that demand determines supply, rather than Say's theory that supply automatically creates demand.In times of economic prosperity, wealth is created, people's greed increases, and fraudsters emerge.This situation is like many sheep waiting to be sheared. Once the fraudster appears, they offer themselves as sacrifices.After all, nothing troubles the mind and judgment more than watching a friend become rich.

As we all know, currency factors are very important in economic overheating and market panic.The Chicago School believes that the authorities are always stupid and the market is always smart. Only when the money supply is stable at a fixed level or increases at a fixed growth rate, can economic overheating and market panic be avoided.However, the paradox of reality is that bankers only lend money to people who do not want to.When an economic collapse occurs, the banking system will inevitably be impacted. In addition to changes in the amount of money, banks will exercise quota control on credit, which will inevitably lead to a sudden stop of credit and liquidity failure in certain capital operation links.

Nevertheless, the famous monetarist theorist Owen Stone firmly opposed to expanding the money supply in times of crisis, and Herbert Spencer expressed it more sharply: "Protecting mankind from the bitter fruit of stupid actions will only make the whole world suffer." The world has become stupid."

In the long run, the money supply should be fixed, but it should be elastic during a crisis, because good monetary policy can alleviate overheating and market panic, and should also eliminate some crises.It is based primarily on findings from the French crises of 1720, 1873, and 1882, as well as those of 1890, 1921, and 1929.In each of these crises there was no lender of last resort, and the post-crisis depression was long.

However, it is also superficial to interpret this view simply as the establishment of a lender of last resort.The market will be less or even unwilling to assume responsibility for ensuring the efficient functioning of money and capital markets during the next economic upsurge if it knows that it will have the support of a lender of last resort whose public goods nature would cause the market to delay adopting fundamental Corrective measures, weakening of incentives, loss of self-dependence.A "central bank" should therefore provide a resilient currency, but it is uncertain whose shoulders the responsibility falls.This uncertainty is good if it doesn't disorientate the market, because it sends an uncertain message to the market, making the market have to rely more on self-help on this issue.There is moderate uncertainty, but not too much, which is conducive to the establishment of self-independence in the market.

This creates problems for two types of speculators, the insider and the outsider.Generally speaking, insiders often use speculation to drive prices up and sell speculative items to outsiders at the highest point of price, which leads to market instability.Outsiders, on the other hand, buy goods at the highest point of price and sell goods at the bottom when insiders take steps to bring the market price down.The outsider's loss equals the insider's gain, and the market as a whole remains unchanged.

In general, for every unstable speculator, there must be another stable speculator corresponding to it, and vice versa.But the professional insider initially disturbed the market by accelerating the rise and fall of prices, while the amateur outsider who bought high and sold low was less able to manipulate prices than the victims of speculative fever, who were only speculative. The latter is affected only later.After the loss, they go back to their normal jobs and keep saving for another gamble.

Another example of an erratic outside speculator who buys high and sells low is the instructive historical story of Isaac Newton.As a great scientist, he should be rational. In the spring of 1720, he wrote: "I can calculate the motion of celestial bodies, but I cannot calculate the madness of human beings." Therefore, he sold his shares of the South Sea Company on April 4 and obtained a high profit of 20%, about for £100.Unfortunately, further impulses seized him shortly thereafter, and contagious by the speculative fever that swept the world that spring and summer, he bought more shares at the top of the market and ended up losing £7000.Many people who have experienced such disasters have this irrational habit, and eventually he put the experience behind him, and for the rest of his life, he could not even hear the name of the South Sea.

But even when every participant appears to be behaving rationally, speculation at various stages or by insiders and outsiders can still lead to wild economic expansion and panic.This is known as the fallacy of composition, where the whole is not equal to the sum of its parts.The fact that everyone acts rationally—or should be—doesn't mean that everyone else acts in the same way.If someone moves very quickly and buys and sells before others, he may do well, as the insiders do, even when the overall situation looks bad.Any increase in excess of the actual value of the capital is a mere imaginary matter; no matter how ordinary arithmetic is stretched, 1 plus 1 will never equal 3 and a half, and as a result, any imaginary value will be a loss to some or others .The only way to stop this is to sell early and let the devil catch the last man.

(End of this chapter)