Raymond Ojserkis On The Causes And Consequences Of Speculative Bubbles & Whether Central Banks Should Try To Burst Them

What Are Speculative Bubbles?

Aiden Singh: What are asset bubbles?

Raymond Ojserkis: Asset bubbles are a rise in the price of a class of assets to a point that's not justifiable by the fundamentals. 

People may disagree during an asset bubble about whether they're in one; whether the price really is justifiable by the fundamentals. Bubbles are easier to spot after they collapse. 

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Causes of Asset Bubbles

Raymond Ojserkis: There are a lot of ideas about why asset bubbles happen. 

Availability of Credit

Some of the ideas focus more on finance and credit availability. We've talked in our conversations about Hyman Minsky and this notion that expansions inherently involve an expansion of credit. 

Not all asset bubbles are driven by expansions in credit, but many are. And whether or not an asset bubble is driven by an expansion of credit is an important determinant of what the bubble’s macroeconomic effects are going to be. 

For example, the dot-com bubble, for the most part, was not highly leveraged. And that’s one of the big reasons there wasn’t a big financial crisis when it collapsed.

So the greater the degree of leverage and whether there is a lender of last resort with the ability to solve any banking crisis that ensues after a bubble bursts is really going to determine to a large extent how awful the effects are going to be on the macroeconomy.

The ones that cause bank failures on a massive scale - the ones that are basically driven by leverage - are the most destructive to the macroeconomy.

Psychology

Ideas about why bubbles happen also focus a lot on psychology.

There's the idea of a recency effect: people tend to focus too much on recent information. When they're looking at the price of an asset, instead of looking over the course of thirty or fifty or seventy five years of data, they're looking only over the course of maybe six months or a year or some other relatively short period. They're too focused on momentum. They're too focused on what they perceive other investors are doing. 

It's like a lot of human nature: we get caught up in fads in social activity. It's part of human nature to feel that maybe there's something wrong with us if we're going against the grain.

It takes a certain type of individual who's really confident in one's own reason to break free of this phenomenon.

And although we'd like to think that we're very rational creatures, in fact, humans are often not. 

Another thing I'll point out that drives these bubbles is some combination of either greed or of fear of being left behind. Charles Kindleberger had this way of expressing it: ‘There is nothing so disturbing to one's well-being and judgment as to see a friend get rich’.

And this fear of being left behind, it's not just about being left behind relative to other people, but also one’s self and one’s family. For example, we live in a country where there’s this idea that every generation should do better than the last. So if people think they’re not doing as well as their parents did, then maybe there’s a fear of being left behind. 

Or what about even ourselves? People may think, am I slipping? Am I behind where I was ten years ago?

And once you get caught in that psychology, you start taking risks that you probably shouldn't be taking, and you may get caught up in bubbles. Or even worse, you can get caught up in straight up Ponzi schemes.

Aiden Singh: This psychological component of bubbles is sometimes,  I’d argue, quite evident and clear to see.

In 2021 when the GameStop/AMC meme stock mania was going on, if you read those the Reddit forums where people were discussing their trades, there was a lot of talk about posters feeling that they were falling behind economically. And there were clear elements of class involved - the idea that these Wall Street guys are really screwing us and this is our chance to stick it to the hedge funds who are short these stocks by squeezing them out.

And there was also a lot of posts about, ‘well I made a bunch of money off of this trade so you jump in too’ or ‘this guy made money on this trade, so I should jump in too.’

So you can see the social psychological element of bubbles play out in real time today on social media in a very self-evident way.

Raymond Ojserkis: I’d add to that point that we’ve had bubbles in so many different contexts, in different countries, across different time periods. So this points to the idea that there must be a psychological component - a human component - to bubbles which transcends particular contexts. 

There was a tulip bubble in the Netherlands back in the 1700s. 

In Britain, you had huge asset bubbles: the South Sea bubble and railroad bubbles. 

There have been bubbles in the Latin American, Russia, and Southeast Asia. 

The United States has had a number of bubbles, some of them equities, some of them in real estate, some of them in land. 

Asset bubbles have happened in places with vastly different kinds of financial systems, vastly different kind of monetary policies, and so forth.

So an explanation of the causes of asset bubbles has to be more than just about the way a particular asset class functions or the structure of finance in a given country at a given time.

The fact that they’ve happened in so many time periods in so many places suggests that there is a pretty big psychological element to it. 

How else can you explain railroad bubbles that occurred before the Federal Reserve even existed and also the bubbles we've had in our lifetime after the creation of the Fed?

You're going to struggle come up with an explanation that doesn’t say something about human nature.

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Why Do Bubbles End?

Aiden Singh: And what do we know about the reasons why bubbles come to an end or collapse? 

Raymond Ojserkis: Well, the only thing that really has to happen is that the flow of new money into the asset stops.

You're either run out of available ‘dumb money’, for lack of a better phrase, flowing in, or you run out of credit, or there's a realization that these assets are not going to be providing the returns investors had expected.

When a speculative bubble inflates and there's so many people who are just looking for short term gains - they want to get in and out of the market very quickly - they don't need much of a signal to get out. As soon as the prices change in an unfavorable way, they're gone - they’re headed for the hills.

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Exogenous Events May Or May Not Play A Role In Ending Bubbles

Raymond Ojserkis: There could also be some sort of exogenous event that causes a downturn - something like a a natural disaster or a war.

For example, in 1906 an earthquake in San Francisco played a role in weakening the financial system and setting the stage for the 1907 panic. 

Some historians also consider credit phenomena such as increases in interest rates as exogenous events.

But you don't necessarily need the start of a war, or a natural disaster, or an increase in interest rates, or some other exogenous event to trigger the end of a bubble.

For example, in October 1929, nothing along those lines took place when the stock bubble peaked. And in March of 2000 when the tech bubble peaked, there’s nothing along those lines that happened. 

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Do Banking Crises Precede Or Follow The End of A Bubble?

Raymond Ojserkis: It’s worth noting that the collapse of bubbles usually precede banking panics. It’s not vice-versa: it’s not that there's a banking panic that cuts off the credit and then the bubble collapses. It’s historically been that the bubble collapses and as the price of the asset class drops, the default rate skyrockets. And then you have a banking crisis. 

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U.S. Asset Bubbles

Aiden Singh: Can you share a few examples of asset bubbles that have occurred in U.S. history?

The Jackson Land Price Bubble

Raymond Ojserkis: The Jackson land price bubble is an example. 

There was a Native American removal policy which President Jackson was deeply associated with. And many Americans are aware of this historical event and the cruelty of what we call the ‘Trail of Tears’. 

What they may not be as aware of is that there was a massive influx of people looking for land opportunities in the wake of Indian removal.

In fact, some of the Native American removal policy was due to the fact that miners had found gold in parts of Georgia. 

And so there was a speculative land bubble.

That might be surprising on some level because you might think, ‘Well, all this land is becoming available so quickly, so the price of land on the frontier should be dropping’. 

And yet the exact opposite happened. 

Part of this was due to Jackson's decisions regarding credit. President Jackson vetoed the renewal of the charter of the Second Bank of the United States. He took federal funds that had been deposited there, withdrew them from the Second Bank of the United States, and put them into privately-owned state chartered banks. Most of these privately-owned state chartered banks were located out in areas that voted for him. And many of those areas were on the frontier, close to the where land was becoming available. 

And these banks were very reckless in their lending activity. There were no reserve requirements being set at the time. There was no central bank. 

So you end up with this vast land price bubble where land at auction is going for stupendous prices. 

One of the things that's especially unusual about this is that Jackson, although he's seen as one of the authors of the bubble, also punctures the bubble. 

So Jackson's actions with the Second Bank of the United States and with Native American removal helped create the bubble.

But then when Jackson saw that there was a problem he issued executive orders effectively trying to force people to hand in what was then being used as currency: notes issued by banks saying you have money on deposits. 

Jackson says, if you want buy any more land or you want to pay your taxes, you have to do it in gold. And so he brings about deflation. He basically brings about the panic of 1837. 

But if he hadn't had done that, maybe the bubble would have gone on and got bigger, and the panic would have been even worse. 

So that’s an example of a famous bubble in American history.

The Crash of 1929

I think the most famous example of a bubble that burst is the stock market crash in 1929. 

One of the things to note from that crash is that, all the way down after the peak, there were a lot of people who were, in today's language, ‘buying the dip’. 

But at the time, from October 1929 when the crash started, right on down until, basically the middle of 1932 when the market actually bottomed, no one knew where the floor was. Now in retrospect we know just how unbelievably big this wipeout was and the scale of economic contraction that followed it. 

Some Other Examples

There’s also the two railway bubbles, 1873 and 1893. There’s the dot-com bubble, and of course, the housing bubble.

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Asset Bubbles & Fluctuations In GDP Growth

Aiden Singh: How much of the variation in GDP growth do you think speculative bubbles and their bursting are responsible for? 

Raymond Ojserkis: There's so many things that affect GDP growth: new technologies and processes, managerial techniques, changing education levels of the workforce, immigration and internal migration, deregulation.

There’s both extensive and intensive growth. 

So there’s intensive growth in which you're producing greater output with the same assets by using them better. 

But, especially early American history, there’s tremendous extensive growth owing to an increase in assets: there's massive acquisition of land, there’s discovery of new mineral resources, there’s immigration adding to the population. So you’re literally adding land, labor, and capital into the economy.

And speaking of capital, there’s foreign investment flows which can play a big role in GDP growth. 

There's an almost endless variety of things that can affect GDP growth.

And speculative bubbles are just one of those things. 

They can definitely affect GDP, both on the expansion and the contraction side.

Yes, it’s true that speculative bubbles for a time can help with corporate investment. If corporations own land and land prices go up, they can more easily use that property as collateral for loans. If bond prices rise, they can now pay lower yields and can raise more money in the debt markets. Likewise, if share prices rise, they can issue more equity to raise more money. So it’s true that asset bubbles, while they're occurring, can be very helpful for corporate investment.

But then you also have to take into account the collapse. And sometimes that collapse involves credit being much less available and massive problems in the financial system.

So looking over the entire cycle, I think it would be hard to conclude that asset bubbles have a net positive effect on GDP growth. 

But it’s hard to say how much of the variation in GDP growth they’re responsible for.

They are likely responsible for causing increased variation from the trend line of GDP growth: so instead of having, say, 2% GDP growth year after year after year, you’re more likely to get extreme boom and bust patterns because of bubbles.

Aiden Singh: What types of asset bubbles tend to be most destructive to the macroeconomy?

Raymond Ojserkis: The ones that cause bank failures on a massive scale; the ones that are driven by leverage - which is most, but not all.

We mentioned the dot-com bubble, which was not driven by leverage.

But many others have been driven by leverage and can cause massive bank failures. In the winter of 1932, about a quarter of all the banks in the United States had to suspend operations. The banks couldn’t loan any money and couldn’t even give depositors back their money; they had to wait and hope that maybe investors would buy their shares and maybe some other more solvent banks would lend them money. But you’re in the middle of a liquidity crisis; all the other banks are also looking for cash. And they’re not getting bailed out by the government yet (that wouldn’t happen until FDR became president). So they’re not getting direct help from either the Treasury or the Federal Reserve, their not getting help from investors, and they’re not finding other banks that will lend them money. So the banks just sit there suspended.

So the degree of leverage and the competence of the lender of last resort to solve the banking crises really determines how awful the effect of a bubble is going to be on the macroeconomy. 

Aiden Singh: What role does fractional reserve banking play in contributing to these more damaging, leverage driven bubbles?

 Raymond Ojserkis: These leverage driven speculative bubbles are characterised by a run up in lending activity - loans are widely available. And this expansion of credit can be facilitated by fractional reserve banking, especially if reserve requirements are set low. So fractional reserve banking is definitely a factor in contributing to leverage fuelled bubbles.

Aiden Singh: What institutions in the US try to prevent asset bubbles and how do they try to do this?

Raymond Ojserkis: The Federal Reserve would be the main institution today. 

If you were to go back into American history, the Treasury would probably be considered the main institution, but since the creation of the Federal Reserve, it’s been the main institution responsible.

The Federal Reserve Act of 1913, which created the Fed, stated that there will be an elastic currency, a discount market for commercial paper, and that the Fed is going to regulate banks. And all three of these are useful tools for dealing with bubbles.

Charles Dice, who was an economist at Ohio State University in the 1920s - very early in the era of the Federal Reserve system - was already suggesting that maybe instead of just viewing the Fed as an institution that can come along and save the economy after a bubble has burst, you could use this idea of elastic currency constantly, in good times and in bad times, to try to limit the extent of booms and busts and have a smoother growth curve. 

This idea didn’t become popular immediately. But the idea that if you use monetary policy wisely, it could limit the formation of bubbles, has been around for some time. 

In addition to this, the Fed has a regulatory role for banks. It sets reserve requirements, telling its member banks how much money they have to deposit with the Fed. 

It can also change the rate it pays banks on their deposits with it.

And it buys and sells securities in the open markets.

So the Fed has all sorts of levers it can pull on and it’s usually the institution that is seen as responsible for dealing with bubbles.

Aiden Singh: There is a debate about whether the Fed should really be responsible for trying to prick bubbles in the early stages or not. 

Some argue that the Fed should try to stamp out bubbles in the early stages because allowing them to develop and then burst can be destructive to the economy.

Others argue that monetary policy is too blunt of an instrument - when you adjust monetary policy, you’re not just affecting the asset that is subject to a bubble, but also other parts of the economy.

Any thoughts on this?

Raymond Ojserkis: The first thing that comes to mind is that, after the 2008 financial crisis, Alan Greenspan published an op-ed in the Wall Street Journal called The Fed Didn’t Cause The Housing Bubble. 

Obviously he had a self-interest in writing it, but I think he brought up some good points.

The linkage between domestic mortgage rates and overnight lending rates can become decoupled. So there is the issue of to what extent can the Fed really target bubbles.

But to the concern that, well if the Fed becomes worried about bubbles it may tighten and make it harder for first time homebuyers to get a mortgage and for small businesses to borrow: well-taken. 

But think about how much damage a bubble can do if the Fed does nothing. Would you rather pay 100 basis points more now to borrow to prevent a credit crisis in the future? I think I’d say yes.

Aiden Singh: The thought that comes to mind is just how difficult the job of a central banker really is. 

You have these tools which can be very blunt instruments, the link between them and the thing you’re trying to target can be tenuous, and then on top of that, there’s not even a consensus on how to determine when you’re in a bubble so you may not even know you’re in one but are somehow supposed to respond to it. It’s really an incredibly difficult task.

Raymond Ojserkis: And it can be politically fraught. Certain presidents - perhaps the one in office now - may complain if the Fed takes away the punch bowl.

In the 19th century what they would do when bubbles burst is just shut down the exchange. It was like a cooling-off period - which, by the way, presumes that there’s a psychological element here: people should just take three weeks off and come back.

So, yes, it’s a very hard job. It’s more an art than a science. Some might liken it to alchemy.

But if it’s not going to be the Fed, who is it going to be? What other institution has this many levers? What other institution has this many means to have an effect on bubbles?

I don’t see another institution that can do it. And I think it’s better to try to puncture them than to let it be.

Aiden Singh: How relevant is the study of old asset bubbles to today’s economy?

Raymond Ojserkis: Unfortunately, I think it’s very relevant.

I wish we could say that humans have become far more rational and that we are collectively better capable of predicting and detecting bubbles. But the fact that they’ve occurred in so many different cultures in so many different time periods doesn’t give me a lot of hope about that.

When I was in college in the 1990s, I was told that bank runs are a thing of the past; that the FDIC, among other institutions, had eliminated bank runs. And yet, in 2008, there were bank runs: Washington Mutual was losing $1 billion a day in the last five days before it shut down. 

And I find the arguments against the existence of bubbles a little bit weak. 

Some economists have argued in favor of the efficient market theory - that prices really do reflect all available information. I don’t find that to be borne out by history.

Some people have argued that the structure of the economy is so different today than it was in the 19th century.

Others have argued that bubbles aren’t inherently that dangerous.

I’m not convinced by these arguments. 

So bubbles and busts are unfortunately going to happen again in our lifetime. And I think the bubbles of the past warrant continued study today.

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