Sidharta Chatterjee, very good question.

Please identify "the real economy". In answering your question, I would apply the principles of bioeconomics. Please see the vast material available on the net and libraries.

The anthropogenic economy is an entire bubble. Money are inventions backed up by the acceptance of the people under the "guaranties issued by states and governments".

There will be no long until the entire financial concepts, views and strategies will have to follow the biophysical principles that dictate the economics, the real economics, the natural economics. Again, your answer can be found within bioeconomics.

I also invite you to please read a 2011 paper (written by me), try my RG profile/publications "APPLICATION OF THE “TRIANGULAR ECO-KINEMATICS THEORY” (TEKT) (PART I) - THE PARADIGM OF ECOLOGY, PUBLIC HEALTH AND ECONOMY AS A SYNERGISTIC EFFECT UPON HUMAN RIGHTS (there is a full PDF or a link to it) or Google search, please download the PDF file (free).

Any comments are of great benefit to all of us.

Regards,

Adrian TW.

Stochiastic bubbles are a natural result of dynamics. Organisms attempt to optimize their ecological positions at the expense of other organisms in the same eco-niche. When they are too successful, they create the ecological equivalent to a bubble, and the niche gets overstressed and collapses.

The Housing Bubble for instance was caused by Real-Estate Speculation, In this case more and more expensive houses were built, despite the fact that only a small portion of the population could afford them. Instead of letting the market correct for the overvalued houses, Speculators increased the cost of used housing to match the cost of new housing by buying cheap homes and flipping them. As this trend continued, the banks got involved making the purchase of the overpriced housing more affordable (seemingly) by promoting easy mortgages.

At this point the bait and switch operators got involved promoting discount mortgages for the first 5 years of the sale, then increasing the mortgage percentage to par. This sold more mortgages than there were valid purchasers keeping the market going.

It was when the bait and switch mortgages got switched that the issue became really obvious, in that most people who bought at the lower rates were overhoused, but the prices were artificially high, and unsustainable. In reaction to the sudden drop in the payments, the market began to eat it's own tail, and the number of foreclosures began to go up, putting downward pressure on the market, at which point the speculators tried to dump and run, crashing the market.

The destruction of the housing market as a result of the below-prime mortgages, resulted in a loss of employment for the house builders, which put more pressure on the economy, but the real issue didn't hit home until the banks tried to keep their accreditation by selling the oversold houses on a bad market, and when they couldn't, tried to offload the bad investments in the form of fancy investment vehicles to their customers. When it was realized that these fancy investments were more risky than they at first seemed, a secondary bubble was created, and the Banking System nearly collapsed.

Bubbles themselves are sharp discontinuities in the market that cause rapid adjustments. They are caused by over-utilization of the economic niche, just like in an ecological niche. When they are at their worst is when multiple sectors of the economy conspire to extend the bubble beyond it's natural life. The real problem is probably Keynesian economics which claim you can inflate the economy without danger as long as certain economic indicators are kept in line. What happens is that the economy begins to anticipate the indicators, in an attempt to keep the inflation going without economic benefit. Eventually you have a direct loop where inflation is absorbed by the banks and never gets to the economy proper.

Dear Sidharta,

The "real economy" expression has a implicit assumption that there is a opposite economy, the fictional, fake or unreal economy. So, as Adrian said "Please identify "the real economy"".

Bubbles are not only financial in nature. There have been agricultural and industrial bubbles also. There is a omnipresent danger of overvaluation. We may say we can have a research and education bubble, a health services bubble, a law services bubble, as any good and service subject of valuation is susceptible to value overgrowth. In a sense markets always create and burst different size bubbles.

I think bubbles are good, as they force us to admit there is no risk free behavior, despite all technology, science, and (debatable) evolution.

Accepting risk as a part of life, is a return to reality. The cause of the bubbles can be a a white butterfly on my neighbor's cabbage.

Best regards,

Bradut Bolos

Mr. Graeme Smith, I agree with "Organisms attempt to optimize their ecological positions at the expense of other organisms in the same eco-niche. When they are too successful, they create the ecological equivalent to a bubble, and the niche gets overstressed and collapses.".

How it is actually working and the fate of "bubbles" and the environment, as I said in the previous post, see TEKT (PART I).

It is all there, proved and demonstrated. More is to come, more experiments on the works, soon deeper explanations will be published.

Normal bubbles are heteropoetic subsystems of a closed autopoetic overall system, they crash creating a reorganization of all subsystems, as they realign to obtain balance. Beeing containable, those bubble may be just a way system achieves equilibrium within itself. Like heart beating, those systems expand and contract within an enclosed space. This is a healthy economic systems allowing prices to grow and diminish correctly.

Dangerous bubbles are heteropoetic subsystems that manage to expand and consume the whole containing system, as a consequence the system containing them is not autopoetic, or capable of self-preservation. A dangerous bubble is a cancer overruling self-defense means of the economic system. In order to achieve that, the bubble must be impervious to justice, administration, law-making, basically non-democratic, but "democratic like" in order to achieve systemic contagion in a democracy. Fast bubbles are comparable to an aneurism, as they grow in size and burst killing the patient.

Bradut Bolos, please see above how far the "reorganization of all subsystems" can go. "Dangerous bubbles" you'll find (said in other terms), in the recommended reading, please see above post.

Among other issues, the point I am making, we, the humanity at large, are creating such "bubbles" knowingly towards self-destruction. The classical economy as we are accustomed to is a prescription to suicidal, slow but sure process. See above post please and read TEKT.

Thanks to all of you for your feedback. Well, I will try to put some response to your explanations one at a time, since there are aspects of bioeconomics and probably behavioral finance which you have delineated, all that needs to be considered in some detail. As Adrian has mentioned about "Dangerous bubbles" where it can go wrong, Bradut contends that some bubbles "are" dangerous itself after all by comparing this uncontrolled growth to carcinomatous metastasis to distant markets(a relatively well-established concept where certain oncovirus induce cancer in biological organisms- referring to Graeme's contention.) That said, some cancers are said to be contagious.

I like the concept put forward by Graeme as "life of a bubble", from its conception, maturity and death (crash), but the question is, should bubbles be allowed to take shape at all? Are financial bubbles good for the economy (i am avoiding the term "real economy" for the time being)?

By real economy, I meant the productive economy determined by production, output and wages, well yes, as Bradut has pointed above, something opposite the "virtual economy" that we have as a highly leveraged derivative market finance attributed to $600 trillion leverage ($600,000,000,000,000). The number is shockingly big, since the total world market value of derivatives is $15 trillion, slightly more than the US economy, and 1/4 th of the world economy valued around $60 trillion. There is very little "real money" involved in such a huge "virtual economy" as also, very little money changes hand as either. The notional value speaks for itself; the world derivative market is doubling every two years (all due to CDS instruments) having notional value of $393 trillion (out of $600 trillion). Well, that's a lot of money (even-though notional) outside the realms of the "real economy" with little regulation so far, and expecting to touch a staggering quadrillion-dollar market.

There is a continuous potentiality for a blow up, as the increase in the market value is solely based on derived money from underlying instruments carrying huge risks which fuel more speculation and hence increase in notional value-based bubble.

Now, the core liquidity is provided by that "real" money, $15 trillion from the real economy (see the ratio between the notional value: market value ($7.2 trillion)which is roughly, 56 times leverage on derivatives which is itself leveraged several times from its underlying "real assets", be it housing, interest rate, stocks/shares or bonds. So, market-wide liquidity per se has increased several times (call it a liquidity bubble if you wish). Now, what is its implications on the economy as a whole?

Shall I call it a bubble (even a real one)?

Sources*

Barrett Sheridan; Much of it is not real money: $600,000,000,000,000

Thanks to all.

Regards,

Sidharta

Thanks Dr. Adrian for your paper, I will post some comments once i have a reading of your paper.

Also to Prof. Bolos, your "autopoietic " system is an interesting concept, i have somewhere read a closer term apoptosis (sudden bubble burst). Do you have any paper on this particular systems of contagion?

Now Graeme, on your statement which could be counter-productive as well,

"Stochastic bubbles are a natural result of dynamics.", considering the staggering amount of virtual liquidity being created from a much smaller amount of money, how would one accept that bubbles are a "natural result of dynamics"? I am not able to see any "natural" dynamics except "unnatural" instinct i would say , 'SPECULATION'. Has anybody studied the Neurobiology of "Speculation, Speculative behavior" in some great details?

Perhaps, that would provide some ground to understand the molecular basis of "speculative bubble" if the neurophysiology of Speculation is understood well. I am keeping this issue open as Adrian has stated above this issue could be attempted from bioeconomic perspective-neurobiology of greed, speculative behavior, and bias as well as fear of loss aversion.

So, where do you see the result of "dynamics" only?

Dear Dr. Bolos,

"I think bubbles are good, as they force us to admit there is no risk free behavior..."

Ok, agreeably I think too that bubbles are good, but how far such "speculative bubbles" are good?

Best Regards,

Sidharta

Sidharta:" considering the staggering amount of virtual liquidity being created from a much smaller amount of money, how would one accept that bubbles are a "natural result of dynamics"? I am not able to see any "natural" dynamics except "unnatural" instinct i would say , 'SPECULATION'. "

Leverage, is just that, leverage to make the system more dynamic. With CDS, larger blocks of poor investments can be bought and sold with the same amount of money.

This means that a bubble inflates faster, and can crash harder. It doesn't change the nature of the bubble, just the dynamics of its formation. It also means that fewer people with real money can control larger blocks of assets more economically, but with a greater exposure to the bank lending the backing for the vehicle. Think of it like the difference between a family sedan and a race-car, they both have wheels and respond mostly to the same physical laws, but when the race car crashes, the results are often much more spectacular because it is traveling faster.

Essentially the problem is that CDS are new, and no one knows the rules for traveling at those speeds safely. But also the problem is the "Nut Behind the Wheel" is using the leverage to try and turn sows ears into silk purses without first making swede. When this happens, they short certain parts of the economy stunting it's growth while promoting others that require less oversight with the result that bubbles form wherever there is a bottleneck in the system. Just as there are certain curves you should slow down for, even on a racecourse, there are certain parts of the economy where a CDS will create a bubble faster than in other areas. The chance of crashing the bubble is much higher there.

dear Sidharta,

Autopoetic, heteropoetic and alopoetic, are living systems attributes describing the way systems interact within their environment. This attributes are used to describe health of living systems. I used this in my articles:

http://www.ipe.ro/rjef/rjef1_11/rjef1_2011p257-276.pdf

and here:

http://oeconomica.upm.ro/O_V/1_BradutBolos.pdf

You may find the original idea of using those concepts here:

http://www.tandfonline.com/doi/abs/10.1080/03081077708960651

http://www.tandfonline.com/doi/abs/10.1080/03081079208945066

Healthy living systems should be autopoetic. As i strive to promote the idea of Economic Epidemiology, as a part of economic science that should research economic disease definition, taxonomy, transmission and treatment, i needed a definition of economic disease, some way to conceptualize disease in economics, and found those old approaches of Zeleny, that really work in my opinion.

Thanks for your articles Dr. Bolos. I am going through it. This artihcle "BANCRUPCY-RECOVERY DECISION IN A SYSTEMIC VIEW" is interesting.

It may help to refer to the logistic map to understand that bubbles are natural. In the theory of chaos they are called fractal expansions determined by F (Feigenbaum value) and its newly discovered derivatives. Bubbles occur in almost every scale and almost everyday on different segments of the financial markets. That the basic universal properties of the logistic map are evidenced in real financial charts is critical for the assessment of risks involved in the "natural environment" of the dynamics. Certainly, only bubbles transmitted to bigger scales are visible to the public and only such are discussed in mass media. Smaller scales cannot be grasped by the public at all, It does not mean that things go on without any control, unless fraudulent behavior takes place. Markets do not exhibit difficulties in dealing with most liquid assets. However, strongly illiquid assets pose a real threat, and a meltdown is possible as was the case of subprime mortgages. Markets could have absorbed such shocks and withstood them if freer and more transparent trading had been employed and accessed to a wider range of traders. But then, the US would not have been able to transfer the subprime risks to the rest of the world. The subprime bubble was being dealt by professional investors and traders only. They proved to be have been making far too illiquid market to cope with the bubble. Again, instead of opening the market to all, they searched for the public money.

Markets have the ability to return from chaos to order. Currency markets are best examples of that.

Leverage should be properly understood. Due to it the dynamics of the system can be more pronounced both in value and time. It is questionable how much leverage can influence the length of a trend. In Minkovsky's space, the length of a trend depends on the amount of speculative capital on the market. An outflow of capital shortens the cycle, an inflow of capital makes the trend longer. We are not taking into account an idle speculative capital which may become active any time.

Leverage enables small investors to trade big things as well. It is very good for

the health or the quality of markets. In "real" or better said in physical economies I am unable to participate in buying/selling of the Empire State Building. In leveraged transactions I can be a trading worm, yet a counted worm or a small fish. The more fishes the better for the market. The intrinsic risks involved get shared, spread, diffused to some an extent.

The risk sharing is a physical bumper. It can save life. It can protect the system from undergoing a crash.

Smaller scale bubbles are inevitable, we should not fear that they take place at all. These are universal properties of chaotic systems. They develop exactly in the same manner no matter what markets we observe and what scale we choose.

Catastrophic fractal expansions are rife. It does not mean that the world is insane.

It just means that it is lively and orderly.

Dear Paul,

I agree about the fractal pattern of bubbles.

I am really not so sure about the ability of markets to withstand some shocks on their own. So i imagine three levels of danger, a small risk situation, like the ones that markets deal with maybe once every one or two years, a high risk situation, when markets are unable to deal with the situation using existing liquidity, and a systemic risk situation when even the currency can crash along with the markets. It's all about size in this cases.

best regards,

Bradut

Dear Paul,

Regarding "bubbles are natural", it's true, and so is the plague, or the flue, or cancer. It's a disease outbreak.

Best regards,

Bradut

Bradut:"So I imagine three levels of danger, a small risk situation, like the ones that markets deal with maybe once every one or two years, a high risk situation, when markets are unable to deal with the situation using existing liquidity, and a systemic risk situation when even the currency can crash along with the markets. It's all about size in this cases."

This is a little like the speed limit situation, there are high risk areas like our bedroom communities where the speed must be kept low, lower risk areas like the main streets where speeds can be slightly higher, and Low Risk situations like highways where speeds can be higher yet.

The problem with the sub-prime mortgages was that they were routing high speed vehicles at the very heart of the Banks Bedroom Community. The Mortgage backed Security. All the speed walls around the community didn't help because the racecourse ran right through the middle of the bedroom community.

If we think of leverage levels as speed then we need the equivalent of speed limits enforced at at least the three levels of risk. Low risk (in the sense of systemic shock) investments should be allowed the higher leverage vehicles, while high risk investments such as Mortgage Backed Securities should be limited to lower leverage. The interesting thing I think is risk in the sense of marketable risk is the exact opposite of this, the Low Risk investments are marketed as high risk (to the customer) the high risk investments (Low Risk) So the lower the marketable risk, the lower the speed limit expressed in Leverage percentage allowed. Sorry if I am confusing the issue with different definitions of risk.

@Graeme:

"Just as there are certain curves you should slow down for, even on a racecourse, there are certain parts of the economy where a CDS will create a bubble faster than in other areas. The chance of crashing the bubble is much higher there."

Its not just the matter of speed or bends and curves.

Exotic financial instruments like credit default swaps, interest rate derivatives and others are often meant to hedge market risk, as well model returns from assuming risk. The payoff in certain instruments are extremely high owing to the amount of risk associated with these investment avenues. These are hence generally innovations which are not for the general retail investors. The complexities in modeling risk and income / payoff from underlying instruments demands quantitative assumption of uncertainty. Hence, these market instruments are bound to be risky, since the more you assume risk, the higher can be the payoff. This is a game of risk with some luck attached to it- so it makes them look more like gambling or betting on assets which determine the payoffs.

Most of the Financial Derivatives are high risk market instruments where the sole idea is to correctly assume risk as far as possible based on quant strategies. The amount of leverage attached to these so generally be high, since one cannot profit much without leverage. Leverage increases the probability of higher payoff, the more the leverage, higher the profit and hence chances for losses also maximize if such models go wrong.

Accounting for market risk is a difficult business, as well, understanding risk factors are equally cumbersome. Some of these models works better on excessive volatility, yet often, they are themselves the real cause of such volatility in returns. Liquidity provisioning for such leverage mechanisms only increases the payoff horizon. The capacity to assume risk is not uniform, so investors who generally deal with these kinds of instruments have a far higher capacity to assume risk.

Here, experience do count but not much as great as the theory underlying the models and quantitative assumptions. Intuition do certainly play a role here, but that doesn't mean that one who is more experienced will have better intuition. These models continuously work on optimization, but indeed there are limits of optimization, and when they fail, they fail badly since the degree of leverage increases the losses manifold. Its more about decision-making than pure play of emotion.

So yes, their speed limit is not limited to just bedrooms, on every bends or turns, they optimize their speeds, perhaps moves more faster than general investors who are more cautious, in every turns or bends. So, leverage increases market-wide liquidity, but increases the level of underlying risks associated with such extensions.

Regards,

Sidharta

These are so called "Artificial Risks" in the market, risk created from more benign underlying assets. We can aptly call them "Artificial Risk in Financial Markets".

Right, and since the two are inverted from each other, the Artificial to Risk ratio Tells us something about the systemic fragility. If Artificial Risk is much greater than marketed risk, the system will be much more fragile because the leverage will favor dynamism over status.

Note here that we are working with the raw risk numbers not the securitized risk which is what the Marketed risk would be. The fancy Mathematical playground that calculates the marketable risk, is not as important as the ratio between true risk, and perceived risk. When real risk, as in the raw risk numbers is high, liquidity should be relatively low despite the marketed risk.

Just as you don't run a racecourse through a bedroom community, we should not allow large leverage on highly securitized vehicles. That is basically what the problem is with tying up liquidity by raising the effective size of the market without increasing the money supply.

The problem of just how much of free market is allowed to be functioning at various periods of time has not been mentioned yet. Take for example central banks and their open market activity in defence of the existing interest rates. A free market would have modified such rates to a great extent very quickly by the simple law of supply and demand. But the central bank artificially disables the role of a free market causing systemic tensions and imbalances. I know of one central bank which is buying back local currency from commercial banks to the tune of 20 times the weekly long term average every week. To prevent (high) rates from falling. Isn't that a bubble?

I am sorry if I am too harsh (and I love 'autopoesis etc) but we need to get back on track and continue improving present models; is anyone interested in Cowles type of models?

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2055187

Usually investors require a higher liquidity premium for less liquid assets. Thus, the cost of capital is higher if investor perceive lower liquidity for the future, and consequently lower investment will occur.

in my 17 years at Bear Stearns, I lived through two bubbles--one an equity market bubble and the other a debt market bubble. The equity market bubble that took the Nasdaq to the dizzying heights of 5,000 in March 2000 was very different than the housing market/structured debt bubble. I contend that monetary policy was relatively tight in the run up of the market and that the Fed tried to lean against the rise in equity prices (Greenspan's 'irrational exuberance' coment). I would also argue there was very little leverage involved given Reg T's 50% margin rule for equities. However, the advent of new technologies, which had the real world effect of raising productivity, were overplayed in the market place. Business plans that had no hope of turning a profit were quickly monetized and an upstart company like AOL used its inflated equity currency to buy Time Warner. Valuations became extended as some argued that traditional metrics didn't matter. Other asset classes were not swept along with the bubble as 10-year yields rose above 6% in early 2000 and gold prices fell to $250/oz. The good news for the real economy was that the boom accelerated the introduction of productivity boosting capital equipment and the advent of an interconnected information economy. When the bubble burst, the damage was largely limited to tech stocks. Seven years after the crash, the stock market made new highs even though the Nasdaq was more than 40% below its peak.

The mortgage/housing bubble was very different. I believe that at its source was a massive easing in monetary policy combined with the deregulation of banking (especially the ending of the separation of investment and commercial banking). Through in China's recycling of its massive FX reserve growth holding down yields and a perfect storm of liquidity supply and investment demand factors were in play. If the Fed had begun to hike rates in 2003 as price-level indicators such as gold and commodity prices argued for (and I made that argument to Bernanke in September 2003 only to be rebuffed), the liquidity fuel for the expansion in debt would not have been created. China's foreign exchange reserves would not have expanded as rapidly and Treasury yields would have risen--heading off the demand for high-yielding high-rated (at least on paper!) bonds. The one thing in common with the internet boom was that the investment banking machine sought to capitalize on the boom and minted ever lower quality assets (such as sub-rime CDOs). The main diifference was the role that leverage played as financial institutions levered over 30x (and arguably even more leveraged off balance sheet positions) held onto many of these assets. More houses were built than was necessary, which was followed by a dearth in housing construction (thankfully now beginning to recover). This boom-boost cycle did not benefit those who bought homes as homeownership rates did a Grand Old Duke of York marching from 64% in 1994 to nearly 70% ten years later before being marched back down to 65% at present. The overemployment in 2005-07 was more than offset by the massive underemployment since 2008. The cost of this episode is still falling on retirees and savers as the Fed holds long-term rates at very low levels (negative in real terms).

Which brings us to the present. The Austrian side of me (in an economics sense) believes that these debt episodes fueled by very low long-term rates promotes malinvestment. Various bank regulations, such as Basle III and new capital requirements, has limited (so far) the spillover into U.S. markets. However, good bubble candidates at present include long-term Treasury bonds (yields going back to mid-2011 levels would create 25% losses in long bonds), gold, and emerging markets.

My feeling is that bubbles that are fueled by monetary policy do not deprive other markets of liquidity (the 2005-07 housing bubble) but more self-contained bubble like the dot-com boom does deprive others. Central bankers can do a lot about the first kind but can (and probably should) do little about the second kind.

I think John Ryding's views are consistent with the academic arguments embodied in a relatively popular work by Schularik and Taylor. http://www.nber.org/papers/w15512. If you give this paper a look, I would be interested in your response.

Shularik and Taylor seem to be saying that asset bubbles are more dangerous to large economies, but the most dangerous bubbles are those that have both asset, and credit factors, or just credit factors attached.

Hi,

You may be interested by this paper:

Relative asset price bubbles

 Annals of finance,  May 2016, Pages 135-160B

Roseline Bilina Falafala, Robert A. Jarrow, Philip Protter est regards