Bubble economies like Australia in the 1960s and Japan in the 1980s occur because of sustained and systematic downplaying of the inherent risks in commercial judgment.
Market players become convinced values can only go up, that there is no "downside" they need to worry about. Asset values become over-inflated and disconnected from the real risks involved.
Eventually, reality intrudes and there is a massive asset value crash, typically generating a wave of bankruptcies as people and institutions are overwhelmed by liabilities suddenly much higher than their assets.
In some cases, the speculative "mania" may simply be sustained by shared beliefs. The infamous Dutch "tulipomania" of the 1630s, when wild demand pushed prices so high that the Government introduced controls on trade in bulbs, may have been of this kind. In other cases, the actions of authorities are behind the systematic misjudgments about risk.
In the case of the Japanese bubble economy of the 1980s, the centrally managed financial system continued to pile up huge sums in excess of domestic demand for investment funds. Companies could raise essentially costless capital on the managed stock market, allowing them to switch from being borrowers to depositors.
Swamped with funds and desperate to on-lend, Japanese banks lent money without heed to the underlying risks. Land prices soared to ludicrous levels, Japanese companies paid massively over-inflated prices for foreign assets, shonky domestic firms were swamped with cash.
The ensuing crash and the failure of the Japanese political system to engage in serious economic reform has seen Japan economically stagnant for most of the 1990s. The loss of wealth Japan suffered was stunning adjusted for inflation, twice the value of the assets destroyed by US bombing in World War II. One estimate was that Japan's losses on its overseas investment were equal to one year's GDP for Britain. There was a massive wealth transfer from Japan to the US, as Americans bought back from Japanese firms assets that had originally been sold for far more.
The Asian crisis was also significantly a case of government action suppressing judgment about risk. As prominent economist Deepak Lal has pointed in my recent publication, Renewing the Miracle: Economic Development and Asia, the "Asian" model of development had a systematic flaw in its use of government action to directly, or indirectly, overcome difficulties created by underdeveloped capital markets unable to provide the "lumpy" funds needed for the transition from small family firms to large complex manufacturing.
Banks lent on the basis of implicit or explicit guarantees of government bailouts if things went bad. Investment decisions were therefore disconnected from risk management and commercial judgment, being made on the basis of political guarantees in the form of political networks and the corruption which was an inevitable part of the process.
The failure of managed exchange-rate regimes whose regulators were quite incapable of making the sort of quick decisions needed to sustain them saw it all come crashing down.
THE AUSTRALIAN bubble economy of the late 1960s and early '70s the time of Poseidon and other such stocks was at the height of a system where the Federal Government protected Australian manufacturers from risk via trade protection and farmers from risks via subsidies and marketing boards.
The "minerals boom" provided a surge of investment and expectations in a "don't worry about the risk" policy and commercial environment. It all came tumbling down in the 1973-74 asset crash.
More recently, the WA Inc and VEDC/ Tricontinental disasters again saw political guarantees encourage asset bubbles that came apart nastily.
Having seen off the Soviet military superpower and the Japanese economic superpower in the same decade, the US has grounds to be pretty full of itself. Yet voices are being raised, wondering if we are now seeing a bubble economy in the US particularly in high-tech stocks. As the Federal Reserve's Alan Greenspan said recently, "We have nothing to fear but the lack of fear itself".
Confident talk of "new paradigms" might be the basis of a speculative mania we can't know if such talk is true for at least 10 years but there is doubt that any bubble is being sustained by mere belief. Is there an institutional factor which might be encouraging systematic downplaying of risk?
Deepak Lal also explains how the problems of Asia were aggravated by the actions of the International Monetary Fund and the entrance of foreign bankers as lenders in the newly liberalised capital markets.
Foreign bank loans are usually in US dollars so, when faced by a shock which requires a devaluation, the domestic currency burden of the foreign bank debt rises with the exchange rate. In the case of private-sector debt, the rising debt burden need pose no problem for the country if the relevant foreign banks run, the borrowers can always default on their debt.
The foreign banks, faced by a default on their Third World debt have, ever since the 1980s debt crisis, argued that this poses a systemic risk to the world's financial system, and asked in effect for an international bailout to prevent this catastrophe. The IMF has been more than happy to oblige, lacking a role since the end of the Bretton Woods exchange rate regime it was set up to manage. The IMF has increasingly become the international debt collector for foreign banks.
The crisis in Indonesia provides the clearest example of this metamorphosis. Before the Thai crisis hit the region, Indonesia had been fairly well managed, despite the "cronyism" of its capitalism. It had provided exceptional growth rates, with a sensible deployment of its oil revenues, so that Indonesia had made an impressive dent in mass poverty. At the time of the Thai crisis, its economic fundamentals were sound: it did not have a massive trade or budget deficit, it had a flexible exchange rate, its debt burden was not onerous and its foreign bank debt was all private.
WHEN THE contagion from Thailand spread, the foreign banks (mainly US and Japanese) ran, leading to a depreciation of the rupiah and a massive increase in the domestic currency costs of servicing these loans. Many of the borrowers would then have defaulted and that would have been that. But in comes the IMF. Under pressure from the governments of the foreign banks, it deemed such private-sector defaults would pose a risk to the world's financial system, and under the cover of an IMF program, the Indonesian Government was, in effect, forced to take on these private debts.
The money from the IMF paid off the foreign lenders, and the general taxation of the Indonesian populace will have to repay the IMF. The Indonesian people have, through the IMF, bailed out the foreign banks.
Foreign banks, increasingly confident of IMF bailout, have a much-reduced incentive to act prudently in their foreign lending. Even though money flows in the US boom dwarf those involved in Asia, the IMF has been systematically leaching prudent risk judgment out of the international financial system.
And where are the "hot" funds which got bailed out of Mexico and of Asia thanks to the IMF though a bit singed in Hong Kong?
Hi-tech stocks in the US?
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