Thursday, June 10, 2010

The Anatomy of a Bubble

In order to understand a bubble, one has to examine two conditions of our environment. One, there is a randomness with the way we interact with our economic community; everybody works, but we all have different types of jobs. Two, our resources are finite; they can be exhausted by consumption.

The first step of a bubble is the severe misallocation of resources. Production focuses on one particular item. The misallocation, means that we are about to allocate most of our resources towards that one goal. This starts out gradually and then progressively consumes more and more resources.

In the second step of a bubble, a large group of people are no longer interacting with the economy in a random fashion; they are all pursuing the same wealth creation formula. This too, starts out with a normal amount of people employed in the bubble sector of the economy. As the bubble gets more robust, more people with a desire for riches join in with lost abandon.

As we enter step three, there is the comfort that everyone participating in the bubble, feels sort of group camaraderie (the herd mentality). Notice as people acquire more riches from their venture, they come to accept the fact that they’re just MORE intelligent than ordinary people. At this point greed and stupidity mix well; double your investment and in turn, double your profit.

Then we come to the final stage (step four) loss of control; the resources are exhausted and the bubble collapses. The damage has been done and it is real.

Examine these two bubble examples from the past:

A river boat ferry, in India 20 years back, was packed with 600 people. Two teenagers in love were going to jump off the boat and commit suicide (their parents wouldn’t let them get married). Needless to say 600 people rushed to one side of the ferry to witness the event. The ferry capsized with a very large loss of life. What happened was sudden and very unexpected by all involved.

The second case was in Africa 50 years ago. Wealth was measured in cattle. The more cattle you owned, the more wives you could afford (this also produced a lot of kids that had to be fed). Cattle production shot through the roof over several years, everyone was getting rich. Even the people growing the hay to feed the cattle were making money. The price of cattle feed started to increase; there wasn't enough supply to meet demand. The cattle were starting to exhaust their food supply. Farmers found it difficult to feed all of their cattle, so more went to market for sale. Prices started to drop and the cattle market collapsed. The livestock died off in mass and the general population faced the aspect of starvation. There wasn’t any drought that brought this famine on, just the misallocation of resources.

Identifying a bubble is at best, very difficult in the early stages. The housing bubble over time has become obvious. Medicare is a bubble in progress. Resources are limited more so than is apparent; high costs in the past have kept medical demands in check.

The national debt is also a bubble but the concept of what constitutes resources (real money) is one of those magic acts, that go on forever. An increase in the interest rate to 9% could spell doom for the US Treasury and the national debt (of course that could never happen).

The ferry boat (our Ship of State) is full and pushing away from the dock; I wonder if Romeo and Juliet are on board?


Rob in NS said...


As always I love your analogies. You should write a book. Anyhow great post. It's ironic but the word verification I need to use to post this message is an actual word "spent". Pretty much sums up the state of economy. Cheers and have a glorious weekend.

Rob in NS

Jim in San Marcos said...

Hi Rob

Thanks for the ata-boy. Looks like Japan is hanging on by their fingernails, and California wishes they had some to hang on with.

Enjoy your weekend

Take care

frakrak said...

Interesting thing about bubbles, you can make a killing (financially) just by good timing by investing at the beginning and then exiting before you get the inevitable "PRIC" that deflates your hopes and dreams.

Now in this day of economic modelling and advanced economic theory, I would humbly suggest that what we have seen with these last couple of bubbles, is a degree of "engineering" to maximise someones profits and to sharpen the great unwashed herd mentality!!

Capitalism doesn't operate in a free market anymore, and to a large extent the tax payers are here for financial fodder of the too big to fail!!

I guess Jim I feel it maybe more a case of who is blowing bubbles .... and yes I have heard the joke:>)

Jim in San Marcos said...

Hi Frakrak

Be careful in your thinking here. Bubbles also affect the innocent bystanders. The captain and his crew on that ferry were committed to the same fate as all of the passengers.

The real bubble we are looking at is the trashing of all of the worlds savings. It is the retired people who will suffer, they are too old to work anymore. The irritating thing is, it doesn't matter how frugal they were, someone else has already spent it.

The good thing I see happening is that it will get rid of the obscenely rich. This is the last phase of the Kondratiff wave where all of the players totals are reset to zero.

So as you approach old age, you want to look for a walker that is convertible into a ladder, suitable for dumpster-diving;>)

frakrak said...

Good analogy re captain Jim, yes I feel that also, this has caught up everyone, the greedy, the financially prudent ....
I'm going straight to ebay and doing a search for that walker :)

Jim in San Marcos said...

Hi Frakrak

With all of this handicap stuff we have, why not have a dumpster with handicap access for seniors? They could cut us a side door to access the garbage.

Anonymous said...

Continuing the dumpster analogy, I've always thought that in the future, we would be mining our own landfills. Now I see that they will also need access ramps.
Great Bubble post by the way.

Jim in San Marcos said...

Hi Anon 12:12

You have a point there, when you think about it, there has to be a high metal content in that sort of land fills.

Somebody will figure out how to make it pay.

Thank you for your comments.