About Madness and the Deluded

Bubbles occur when prices of a particular item rise far above the item’s real value. A stock market bubble is a self-propagating rise or increase in share price of a stock – investors buy more stock at an inflated price believing the price will continue to rise. In the regular market, housing prices typically rise along with the rate of inflation or increase in average income. In the US the inflation adjusted house prices nationwide were on average essentially unchanged from 1953 to 1995.1 In 2008 housing prices were falling at more than a 30% annual rate in the most rapidly deflating markets.

One of the largest bubbles in the 18th century was the South Sea Bubble. Following the War of Spanish Succession the British government became concerned over the size of the government debt. Harley, Earl of Oxford was the lead on setting up a scheme to buy up government debt, and trade in the South Seas. Insiders spread rumors that Spain would grant Britain free trade access to four ports in Spanish America (the South Seas) – promising huge profits. The British Empire spread around the world; there was great confidence such a project would succeed.

There were no regulations against this activity at the time. To ensure that the company would be awarded the government debt option, key members of Parliament were bribed – receiving shares in the South Sea Company without cost. It triggered massive lending against shares. Easy credit was available – investors went for lottery-like payoffs (as a result of shares being sold with only a small down payment). It became an exercise in Ponzi finance – individuals paid inflated prices for shares on the belief huge profits would be made from trade with Spanish America. Wampole, the Prime Minister, at the time, opposed the project, but could not drive the debate in Parliament. The stocks peaked and then crashed in 1720. Two generations of wealth were lost when the bubble burst. Hurley and other directors of the company had friends in high places, so none went to jail. The Bubble Act was passed before the bubble burst, but it was too little too late.

The majority of politicians supported the ongoing expansion of housing as it became the main driver of the economy following the bursting of the Internet Bubble. There was confidence that the global economy didn’t require regulation, and could self-correct from any excess. The Wall Street-Washington corridor ensured politicians who needed funds for re-election were supportive of activities such as allowing banks to assign their own risk level. Brooksley Born, the head of the Commodity Futures Trading Commission (CFTC) – warned of the potential for economic meltdown in the late 1990s, but was unable to get key economic powerbrokers to take actions that could have helped avert the crisis.

The market was leveraged by bundling regular mortgages with high risk mortgages – creating new and alluring securities that could be bundled together and sold (to pension funds as low risk products) as alternatives to traditional bonds and traditional government bonds. To lure in more borrowers, the sub-prime mortgage with initially low interest rates was promoted – which worked perfectly as long as interest rates stayed low.  It became a Ponzi finance system based on the idea that housing prices would appreciate into the foreseeable future. Homes were used as piggy banks at the height of the real estate boom. People refinanced high-interest credit cards with a low interest second mortgage on their home – many subsequently lost their home.

The middle class saw their wealth decrease by over 30% as their major investments (homes and pension funds) shrunk. The economic debacle of 2008 created a lost generation with ongoing high unemployment and loss of opportunity for a younger generation. No one went to jail for manipulating and almost tanking the economy. The Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) was passed in July 2010 and is being slowly implemented.

The South Sea Bubble and the Housing Bubble both shared the problem of insiders exploiting asymmetries (such as risk information) fraudulently. In 1720, Isaac Newton, who lost money in the South Sea Bubble, claimed “I can calculate the motion of the heavenly bodies, but not the madness of people.” During either bubble there was no effective regulation. In 2009 Joseph Stiglitz, Nobel Prize winner in Economics, observed “Today only the deluded would argue that markets are self-correcting, or that they can rely on the self-interested behaviour of market participants to guarantee that everything works and honestly.”

1Baker, D. 2002. “The Run-Up in House Prices: Is It Real or Is it Another Bubble.” Washington, D.C.: Center for Economic and Policy Research [http://www.cepr.net/index.php/publications/reports/the-run- up-in-home-prices-is-it-real-or-is-it-another-bubble/].

2 Horsman, Greg. 2012. Objectivism Lost and an Age of Disillusionment (p 91)

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One Response to About Madness and the Deluded

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