Asset
bubbles are not the exclusive domain of stock exchanges and shares.
"Real" assets include land and the property built on it, machinery, and
other tangibles. "Financial" assets include anything that stores value
and can serve as means of exchange - from cash to securities. Even
tulip bulbs will do.
The recent implosion of the global equity markets - from Hong Kong to
New York - engendered yet another round of the semipternal debate:
should central banks contemplate abrupt adjustments in the prices of
assets - such as stocks or real estate - as they do changes in the
consumer price indices? Are asset bubbles indeed inflationary and their
bursting deflationary?
Central bankers counter that it is hard to tell a bubble until it
bursts and that market intervention bring about that which it is
intended to prevent. There is insufficient historical data, they
reprimand errant scholars who insist otherwise. This is disingenuous.
Ponzi and pyramid schemes have been a fixture of Western civilization
at least since the middle Renaissance.
Assets tend to accumulate in "asset stocks". Residences built in the
19th century still serve their purpose today. The quantity of new
assets created at any given period is, inevitably, negligible compared
to the stock of the same class of assets accumulated over decades and,
sometimes, centuries. This is why the prices of assets are not anchored
- they are only loosely connected to their production costs or even to
their replacement value.
Asset bubbles are not the exclusive domain of stock exchanges and
shares. "Real" assets include land and the property built on it,
machinery, and other tangibles. "Financial" assets include anything
that stores value and can serve as means of exchange - from cash to
securities. Even tulip bulbs will do.
In 1634, in what later came o be known as "tulipmania", tulip bulbs
were traded in a special marketplace in Amsterdam, the scene of a rabid
speculative frenzy. Some rare black tulip bulbs changed hands for the
price of a big mansion house. For four feverish years it seemed like
the craze would last forever. But the bubble burst in 1637. In a matter
of a few days, the price of tulip bulbs was slashed by 96%!
Uniquely, tulipmania was not an organized scam with an identifiable
group of movers and shakers, which controlled and directed it. Nor has
anyone made explicit promises to investors regarding guaranteed future
profits. The hysteria was evenly distributed and fed on itself.
Subsequent investment fiddles were different, though.
Modern dodges entangle a large number of victims. Their size and
all-pervasiveness sometimes threaten the national economy and the very
fabric of society and incur grave political and social costs.
There are two types of bubbles.
Asset bubbles of the first type are run or fanned by financial
intermediaries such as banks or brokerage houses. They consist of
"pumping" the price of an asset or an asset class. The assets concerned
can be shares, currencies, other securities and financial instruments -
or even savings accounts. To promise unearthly yields on one's savings
is to artificially inflate the "price", or the "value" of one's savings
account.
More than one fifth of the population of 1983 Israel were involved in a
banking scandal of Albanian proportions. It was a classic pyramid
scheme. All the banks, bar one, promised to gullible investors ever
increasing returns on the banks' own publicly-traded shares.
These explicit and incredible promises were included in prospectuses of
the banks' public offerings and won the implicit acquiescence and
collaboration of successive Israeli governments. The banks used
deposits, their capital, retained earnings and funds illegally borrowed
through shady offshore subsidiaries to try to keep their impossible and
unhealthy promises. Everyone knew what was going on and everyone was
involved. It lasted 7 years. The prices of some shares increased by 1-2
percent daily.
On October 6, 1983, the entire banking sector of Israel crumbled. Faced
with ominously mounting civil unrest, the government was forced to
compensate shareholders. It offered them an elaborate share buyback
plan over 9 years. The cost of this plan was pegged at $6 billion -
almost 15 percent of Israel's annual GDP. The indirect damage remains
unknown.
Avaricious and susceptible investors are lured into investment swindles
by the promise of impossibly high profits or interest payments. The
organizers use the money entrusted to them by new investors to pay off
the old ones and thus establish a credible reputation. Charles Ponzi
perpetrated many such schemes in 1919-1925 in Boston and later the
Florida real estate market in the USA. Hence a "Ponzi scheme".
In Macedonia, a savings bank named TAT collapsed in 1997, erasing the
economy of an entire major city, Bitola. After much wrangling and
recriminations - many politicians seem to have benefited from the scam
- the government, faced with elections in September, has recently
decided, in defiance of IMF diktats, to offer meager compensation to
the afflicted savers. TAT was only one of a few similar cases. Similar
scandals took place in Russia and Bulgaria in the 1990's.
One third of the impoverished population of Albania was cast into
destitution by the collapse of a series of nation-wide leveraged
investment plans in 1997. Inept political and financial crisis
management led Albania to the verge of disintegration and a civil war.
Rioters invaded police stations and army barracks and expropriated
hundreds of thousands of weapons.
Islam forbids its adherents to charge interest on money lent - as does
Judaism. To circumvent this onerous decree, entrepreneurs and religious
figures in Egypt and in Pakistan established "Islamic banks". These
institutions pay no interest on deposits, nor do they demand interest
from borrowers. Instead, depositors are made partners in the banks' -
largely fictitious - profits. Clients are charged for - no less
fictitious - losses. A few Islamic banks were in the habit of offering
vertiginously high "profits". They went the way of other, less pious,
pyramid schemes. They melted down and dragged economies and political
establishments with them.
By definition, pyramid schemes are doomed to failure. The number of new
"investors" - and the new money they make available to the pyramid's
organizers - is limited. When the funds run out and the old investors
can no longer be paid, panic ensues. In a classic "run on the bank",
everyone attempts to draw his money simultaneously. Even healthy banks
- a distant relative of pyramid schemes - cannot cope with such
stampedes. Some of the money is invested long-term, or lent. Few
financial institutions keep more than 10 percent of their deposits in
liquid on-call reserves.
Studies repeatedly demonstrated that investors in pyramid schemes
realize their dubious nature and stand forewarned by the collapse of
other contemporaneous scams. But they are swayed by recurrent promises
that they could draw their money at will ("liquidity") and, in the
meantime, receive alluring returns on it ("capital gains", "interest
payments", "profits").
People know that they are likelier to lose all or part of their money
as time passes. But they convince themselves that they can outwit the
organizers of the pyramid, that their withdrawals of profits or
interest payments prior to the inevitable collapse will more than amply
compensate them for the loss of their money. Many believe that they
will succeed to accurately time the extraction of their original
investment based on - mostly useless and superstitious - "warning
signs".
While the speculative rash lasts, a host of pundits, analysts, and
scholars aim to justify it. The "new economy" is exempt from "old rules
and archaic modes of thinking". Productivity has surged and established
a steeper, but sustainable, trend line. Information technology is as
revolutionary as electricity. No, more than electricity. Stock
valuations are reasonable. The Dow is on its way to 33,000. People want
to believe these "objective, disinterested analyses" from "experts".
Investments by households are only one of the engines of this first
kind of asset bubbles. A lot of the money that pours into pyramid
schemes and stock exchange booms is laundered, the fruits of illicit
pursuits. The laundering of tax-evaded money or the proceeds of
criminal activities, mainly drugs, is effected through regular banking
channels. The money changes ownership a few times to obscure its trail
and the identities of the true owners.
Many offshore banks manage shady investment ploys. They maintain two
sets of books. The "public" or "cooked" set is made available to the
authorities - the tax administration, bank supervision, deposit
insurance, law enforcement agencies, and securities and exchange
commission. The true record is kept in the second, inaccessible, set of
files.
This second set of accounts reflects reality: who deposited how much,
when and subject to which conditions - and who borrowed what, when and
subject to what terms. These arrangements are so stealthy and
convoluted that sometimes even the shareholders of the bank lose track
of its activities and misapprehend its real situation. Unscrupulous
management and staff sometimes take advantage of the situation.
Embezzlement, abuse of authority, mysterious trades, misuse of funds
are more widespread than acknowledged.
The thunderous disintegration of the Bank for Credit and Commerce
International (BCCI) in London in 1991 revealed that, for the better
part of a decade, the executives and employees of this penumbral
institution were busy stealing and misappropriating $10 billion. The
Bank of England's supervision department failed to spot the rot on
time. Depositors were - partially - compensated by the main shareholder
of the bank, an Arab sheikh. The story repeated itself with Nick Leeson
and his unauthorized disastrous trades which brought down the venerable
and veteran Barings Bank in 1995.
The combination of black money, shoddy financial controls, shady bank
accounts and shredded documents renders a true account of the cash
flows and damages in such cases all but impossible. There is no telling
what were the contributions of drug barons, American off-shore
corporations, or European and Japanese tax-evaders - channeled
precisely through such institutions - to the stratospheric rise in
Wall-Street in the last few years.
But there is another - potentially the most pernicious - type of asset
bubble. When financial institutions lend to the unworthy but the
politically well-connected, to cronies, and family members of
influential politicians - they often end up fostering a bubble. South
Korean chaebols, Japanese keiretsu, as well as American conglomerates
frequently used these cheap funds to prop up their stock or to invest
in real estate, driving prices up in both markets artificially.
Moreover, despite decades of bitter experiences - from Mexico in 1982
to Asia in 1997 and Russia in 1998 - financial institutions still bow
to fads and fashions. They act herd-like in conformity with "lending
trends". They shift assets to garner the highest yields in the shortest
possible period of time. In this respect, they are not very different
from investors in pyramid investment schemes.
