In their seminal work Manias, Panics, and Crashes, Charles P. Kindleberger and Robert Aliber argue that the rise and fall of asset bubbles can be related. Along the lines of that thesis, they suggest that the Japanese and Nordic asset bubbles that arose in the 1980s, the Asian financial crisis of 1997-98, and the U.S. technology stocks bubble that imploded in 2000 were all related. They explained:

The first of the four distinct asset price bubbles in the last fifteen years of the twentieth century was in real estate and stocks in Tokyo in the second half of the 1980s, and the second, at about the same time, was in real estate and stocks of three of the Nordic countries—Finland, Norway, and Sweden. The third was in Bangkok, Kuala Lumpur, Jakarta, and Hong Kong and nearby national financial centers in the mid-1990s, and the fourth was in U.S. stocks and especially those traded in the over-the-counter markets in the second half of the 1990s.

These asset price bubbles were systematically related. The bubble in the Nordic countries resulted from a surge in the loans of the offshore branches of banks headquartered in Tokyo and Osaka; the coincidence was that the Japanese banking regulators relaxed the restrictions on the foreign activities of Japanese banks at the same time that the regulatory authorities in the Nordic countries were relaxing restrictions on borrowing abroad by their domestic banks. The surge in the flow of loans from the offices of the Japanese banks based in London and Zurich and offshore centers to the borrowers in the three Nordic countries led to rapid increases in the prices of real estate and stocks. The bubble in Thailand and the other Asian countries was triggered by the inflow of funds from Tokyo in the several years following the implosion of the asset price bubble in Japan. The bubble in U.S. stocks began in the mid-1990s and accelerated rapidly following the implosion of the bubbles in Thailand, Malaysia, and Indonesia and their neighbors in the second half of 1997, which led to a surge in the flow of funds from the Asian countries to the United States…

The link between these asset price bubbles is that ‘monies sloshed’ from Tokyo to Bangkok and the other Asian countries after the implosion of the bubble in Japan, which led to an appreciation of the yen and a decline in Japanese competitiveness. Japanese firms began to outsource production to China and the countries in Southeast Asia in the effort to reduce their production costs. The implosion of the bubbles in Thailand and other Asian countries led to a sharp reversal in their external financial positions; the currencies of most of these countries (with the exceptions of the Chinese yuan and the Hong Kong dollar) depreciated sharply and there was a rapid turnabout in their trade positions that had a mirror-image counterpart in the surge in the U.S. trade deficit. There was a dramatic increase in the flow of funds from these countries to the United States that contributed significantly to the increases in the 0prices of U.S. securities; U.S. residents who sold securities to foreign residents then used a very large part of their sales receipts to buy other securities from other U.S. residents. The prices of these U.S. securities increased further; in turn the sellers of these securities used most of their sales receipts to buy other securities from other U.S. residents. The money became like the proverbial ‘hot potato,’ passed from investor to investor at ever-increasing prices.

Their book was published in 2005 and predated the implosion and ongoing contraction of the U.S. real estate bubble. Nevertheless, the question as to whether the U.S. housing bubble is, in some way, related to the earlier technology stocks bubble, not to mention those that preceded it, bears some consideration.

If one indexes the S&P 500 and Case-Shiller (CSXR) housing prices indices to nominal GDP beginning with 1994 Q1 (when the previous housing bust bottomed out), one finds some support for the provocative Kindleberger-Aliber argument on the relatedness of recent asset price bubbles. The following chart tracks these indexed prices from 1994 Q1 through 2006 Q4 when the U.S. real estate bubble was in the early stages of deflating.



Several developments stand out:

• Following the end of the 1989-94 housing bust, home prices generally rose more slowly than nominal economic growth, even as stocks rocketed relative to nominal economic growth beginning in 1995.
• The CSXR as indexed to the nominal GDP began its ascent around the time stocks were peaking relative to the nominal GDP.
• The CSXR as indexed to nominal GDP grew increasingly excessive relative to nominal growth following the implosion of the equities bubble.
• The rise in home prices relative to nominal GDP was not disrupted during the March-November 2001 recession.

As early as September 2002, Stephen Roach, chief economist and director of global economics at Morgan Stanley was arguing that the U.S. equities bubble was America’s post-2000 economic development and that its rise and fall had a profound impact, including the creation of new bubbles. In the September 22, 2002 edition of The New York Times, Roach wrote:

But while Sept. 11 was a defining event for America, it was not a defining event for the economy or the financial markets. That role belongs to the stock market bubble of the late 1990’s that finally popped in March 2000… The bubble expanded high enough, and for long enough, to have infected the behavior of consumers and businesses alike.

The equity bubble helped to create other bubbles—most notably in the housing market and in consumer spending.

He went on to warn that these bubbles posed “a serious threat to lasting expansion” but that “puncturing them” would present serious economic risks of its own. He also suggested that “the consumer-spending bubble will undoubtedly be the last to pop.”

What might pop that last bubble? Roach speculated that “a spike in oil prices, a surge of white-collar layoffs or a collapse of the property bubble” could bring about that outcome. If so, the U.S. will likely continue to face a challenging economic environment for some time to come.

If there is a relationship between the bubbles that have imploded, the currently contracting U.S. real estate bubble, and a possible U.S. credit or consumer bubble that is unwinding or about to do so under the strains of the fallout from the combination of high energy prices, dissipating housing bubble, and a post-housing bubble credit squeeze, the issue as to whether fresh bubbles could erupt elsewhere in the world takes on added importance, even as such bubbles might not rise for several years or longer.

If historic experience with the emergence of asset bubbles is representative, nations that could be especially susceptible to the development of such bubbles would be among those experiencing the most robust economic growth and/or strong capital inflows combined with a persistently expansionary monetary and/or fiscal policy (including nations that peg their currencies to the U.S. dollar and that have adopted an aggressively accommodative monetary policy in response to the Fed’s interest rate cuts). A financial regulatory structure that is weak or rapidly moving toward deregulation could offer an additional catalyst. Candidates for asset bubbles through the medium-term might include, but not be limited to, oil-producing Middle Eastern states, China, and India.

Whether or not such bubbles would be regional, national or international in scope would remain to be seen, as such asset prices bubbles have ranged from localized to international in the past. The fallout from such bubbles would pose the risk of stifling international growth, if high-growth areas experience the rise of such bubbles.

During the euphoria in which robust growth evolves into a mania or frenzy that builds a bubble, one typically witnesses an erosion in prudence and an increasing appetite for taking on risks as overconfidence and overoptimism take hold. During such periods, lending, borrowing, and investing standards break down. Corruption also seems to increase. That the Enron and WorldCom scandals, among others, and Arthur Andersen's abetting Enron's swindle, took place during the rise of the tech stocks bubble is probably no coincidence.

Kindleberger and Aliber wrote the following on the issue of fraud in the book that I quoted in my initial post:

Fraudulent behavior increases in economic booms. Fortunes are made in a boom, individuals become greedy for a share of the increase in wealth and swindlers come forward to exploit that greed. The number of sheep waiting to be shorn increases in booms and an increasing number offer themselves as sacrifices to the swindlers...

Swindling increases in economic booms because greed appears to grow more rapidly than wealth; it’s as if the increase in wealth triggers an increase in greed...

Similarly, it is not too surprising that one witnessed Countrywide Mortgage, a firm that was once critical of the lending standards of its rivals that it felt were overly lax, sacrifice its own standards in a bid to grab an ever larger piece of the home mortgage market as U.S. home prices rode the crest of an increasingly frothy market. Many in the real estate industry, even as late as 2006, argued that home prices reliably increase in value and would continue to do so. Forgotten was that (1) homes are no different from any other asset in that they can see rising or falling values; (2) real estate has been an especially bubble-prone industry often at a regional and sometimes national level; and (3) a national real estate bust was not that far into the past (1989-94).

Very well said, Iriemon.

In my opinion, the periodic rise and fall of bubbles (or whatever term one wants to substitute to describe the unreasonable valuations that emerge after excessive and irrational speculation) reflects the fundamental tendency for human nature to go to excess. Not surpisingly, rather than migrating closely along the path of valuations that would be derived from market fundamentals e.g., expected earnings, one witnesses prices of assets overshooting and undershooting those valuations.

Given that tendency in human nature, excessive leverage can create extremely volatile situations. Research has confirmed the important role easy credit has played in fueling the speculation behind asset bubbles.

Given that tendency in human nature, the seeming inability of people to learn from past experience with asset bubbles that has also shown up in the research is also to be expected.

Originally Posted by donsutherland1 Very well said, Iriemon. In my opinion, the periodic rise and fall of bubbles (or whatever term one wants to substitute to describe the unreasonable valuations that emerge after excessive and irrational speculation) reflects the fundamental tendency for human nature to go to excess. Not surpisingly, rather than migrating closely along the path of valuations that would be derived from market fundamentals e.g., expected earnings, one witnesses prices of assets overshooting and undershooting those valuations. Given that tendency in human nature, excessive leverage can create extremely volatile situations. Research has confirmed the important role easy credit has played in fueling the speculation behind asset bubbles. Given that tendency in human nature, the seeming inability of people to learn from past experience with asset bubbles that has also shown up in the research is also to be expected.

Originally Posted by rathi The tech bubble was no the same as many other types of bubbles. The rise of the internet led to a completely new paradigm on business and growth. What exactly would happen to money invested was largely unknown. Granted, people still invested money with far too little caution. Still, that bubble was mostly a somewhat inevitable result of learning what the boundaries were for the internet market. It followed a classical logistic equation, with the sharp correction once it went beyond carrying capacity. With no history to base on, people couldn't see what the limits were until they had already broken them. The housing bubble is a more classic example of speculation. A market does well, so everyone starts putting their money into it, then it becomes wildly overinflated and everyone pulls out. This bubble was quite annoying considering that there was countless economic analysis pointing out that real estate was highly overvalued. Yet the American public didn't seem to notice. Of special note should be the subprime mortgages with the differed interest rates and the disaster they created. Although both bubbles proved to be hard failures, the tech bubble came from a lack of caution when entering new markets, while the housing bubble came from blatant stupidity and greed.

Although the emergence of the Internet was something new, the tech stocks bubble was not unlike other earlier bubbles in that it was triggered by a major economic displacement. In the past, the rise of railroads triggered witnessed the development of asset bubbles.

As bubbles begin to develop, one has historically witnessed the proliferation of what can be labeled "new era" thinking or, as you described it, a "new paradigm." Under such thinking, the old rules are thought no longer to be relevant. Once that happens, excessive optimism overwhelms reasonable perceptions of risk. Buying commences, asset prices soar. The soaring asset prices seem to confirm the existence of "new era" and that unlike in the past when asset prices soared beyond conventional valuations, "this time is different." Driven by those assumptions, the situation feeds back to even more aggressive and unrestrained buying. Later, like all other bubbles, the party does come to an end.

The tech stocks bubble was no different. There were documented instances where venture capital firms provided funding to individuals (albeit reasonably well-known prospective entrepreneurs) based largely on their reputation in the absence of a business plan. There were stock market analysts who set price targets for comapanies' stocks based not on the usual analytical tools, but on how those stocks performed in the previous quarter. There were arguments made that in the dot.com age, revenue growth, not profitability, mattered most.

Near its end, the symptoms of the psychosis that was feeding the internet stocks bubble were pervasive. In her regular column in The New York Times, Gretchen Morgenson wrote, "Investing in the stock market for the long term, the strategy that has made the most sense and the most money for people over the years, is all but dead... New numbers show the betting has become faster and more furious there than at any time since the 1920s." Another article published in that newspaper on the length of the economic expansion that had reached 107 months observed, "However the expansion is finally explained, an old set of rules, deeply ingrained in economic forecasting and college extbooks is losing its punch." Finally, highlighting the psychology that had gripped investors, the January 3, 2000 edition of The New York Times noted:

There is something about being around so many winners that makes people want to make ever biger bets. So after a year when the only thing flying higher than Internet stocks was the price of the televsision ads that the start-up companies bought with their stock money, people and companies in the media and technology industries are feeling lucky. And many are now prepared to bet their fortunes--or at least test their skills as visionaries-that they can find success in something the rest of us may not yet be able to see.

Prior to the collapse of the tech stocks bubble, some economists were warning that tech stock prices were far out of line with reasonable valuation yardsticks, an entirely logical development given the breakdowns I noted earlier. For example, Yale University economics professor Robert Shiller (co-architect of the Case-Shiller Index that measures housing prices) wrote that "the stock market displays the classic features of a speculative bubble: a situation in which temporarily high prices are sustained largely by investors' enthusiasm rather than by consistent estimation of real value." Princeton University economics professor Burton Malkiel echoed him, warning, "Few of the Internet darlings will ever justify their current valuations, and many investors will find their expectations unfulfilled."

In the end, only the technology behind the tech stocks bubble was new. Everything else from the breakdown of rational valuation methodologies/perspectives to the euphoria that fueled the rise of the bubble, was a replay from past bubbles. The difficult lesson those who entered the investment feeding frenzy near its peak rediscovered was that "this time" was not different. Relearning that the "new paradigm" was little more than euphoric illusion can, of course, be quite painful for those late entrants and the fallout can adversely impact the broader economy.