Incentives Align To Create Bubbles

from the blame-game-not-necessary dept

In the latest financial crisis, we’ve seen even more focus on casting blame than following most financial crises. It may be because of the sheer size of the mess this time, and it may be because the events that led up to this mess are a lot more difficult to understand than in the past — and may even feel more nefarious. However, the deeper you look into the crisis, the harder it is to directly assign blame for the majority of the mess. Yes, there were scammers and fraud on the margins, but for the most part, everyone was doing things in a way that makes sense. This, among other things, is a key point brought out by Henry Blodget’s article in The Atlantic about why these types of collapses happen so often. Basically, there is some amount of irrationality in the system, but over time, as more and more people seem to be making money against the irrationality, more and more explanations are made for why that irrationality is actually rational. And since the irrational activity goes on for so long, it becomes nearly impossible for most people to really believe that things are so irrational. So, it’s not that there’s anyone who did anything wrong that needs to be blamed, so much as we need to blame ourselves, for not taking enough time to recognize that what seems irrational in the beginning actually is irrational.

Of course, along those lines, it’s important to realize that, as painful as market corrections like this are going to be, the end result is often beneficial. During the bubble period, lots of money gets thrown at certain things (infrastructure or products) that post-bubble are available for quite a discount. Bubbles help build up new institutions, and even if the original investments get washed away, something good often comes out of them in the end. It may not be clear yet how this financial crisis will eventually work out, but now is a decent time to be looking for opportunity in the carnage rather than worrying about who to blame.

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Comments on “Incentives Align To Create Bubbles”

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Kiba (user link) says:

Broken Window Fallacy

Please don’t get on the bandwagon that bubbles are good because they provide such and such benefit. Bubbles are just that, malinvestment. It is better if the investment were aimed at something sustainable over the long run.

Also, I like to point out that the feds make funny money by the virtue of printing them like crazy. This have an effect of fooling investors no matter how smart they are as price signals get distorted. Bubbles will keep happening over and over again because of the fed’s control over the banking system. Whether or not that bubbles will cease to happen when we embraced free banking while also abandoning the fiat money system remained to be seen. What is certain is that the regulations of the banking system has not prevent these business cycles or perhaps is the cause of business cycles. See the Austrian Business Cycle Theory.

Keep in mind that loss are an important part of capitalism as much as profit. Failure of a whole of bunch of firms is the free market’s way of flushing out bad allocation of resources and begun the process of allocating resources to firms that actually generate wealth.

Anonymous Coward says:

frankly who to blam is a non issue as far as im concerned, the issue here are:
– how to clean up the mess and get the economy back on track (for every1)
– how to minimize the chance of this happens again.

I do understand that crashes will happen every so often and that is fine, but for the most part this crash was caused by playing the system (for a lack of a better term).

going slightly off topic but remaining on the main subject those bail outs are going to make things worse, they are rewarding the “bad behavior” that caused the crash and most ppl who got affected (loss of property, loss of Jobs etc…) are still out in the cold.

Anonymous Coward says:

Its the exposition of core problems

“In the latest financial crisis, we’ve seen even more focus on casting blame than following most financial crises. “

The reason is largely because this particular crises DISPROVES one of the fundamental tennants of capitalism. The idea that institutional self interest will force financial markets and large financial market players (like Banks) to self regulate. We have found (once again actually) that this is simply not true and that shakes basic market economics to its core.

Kiba (user link) says:

Re: Its the exposition of core problems

It has not disproved free market capitalism. All it does is point out that regulations couldn’t prevent market crashes.

Some would go so far as to claim that regulation is responsible for introducing moral hazards into the system.

In any case, bank failures actually show the free market is working. It is simply an immune response to overallocation of resources in a particular area.

Anonymous Coward says:

Re: Re: Its the exposition of core problems

“In any case, bank failures actually show the free market is working.”

It does not such thing : there s no free market in America, business does not take the same risks it would in a free market because they know it doesn’t exist and bale outs etc. are available and always will be so long as the rich and powerful stay that way …

observing the current mess tells you exactly nothing about free markets and how they would behave if they ever exist.

Anonymous Coward says:

Re: Re: Its the exposition of core problems

“Some would go so far as to claim that regulation is responsible for introducing moral hazards into the system.”

Yeah we will continue these cycles primarily because many people will always cling much stronger to thier beliefs (greed is good), when the ugly lessons of reality begin slapping them in the face (greed stimulates short term excess and creates the illusion of mitigating risk). Its far easier for most to rationalize away what doestn agree with thier personal philosophy of the universe (an unregulated market is a detriment to society and the creation of real wealth). However the point remains that many who have spent thier lives in economics have been rocked to the core by the realization that institutional self-interest doesnt work as it has been thought too for the last hundred years. These ripples may have not yet worked thier way out of the academic, “think-tank” economics world, but they will.

Josh says:


There is simply no way to make something that is fundamentally irrational into a rational proposition. Any explanations trying to do so are wrong. The only irrationality built into the system is the people in that system.

Whether they are willfully irrational (refuse to accept despite knowing better), unsophisticated irrational (normally rational person that just doesn’t understand the market, yet is in it anyway), or ignorantly irrational (can’t think rationally to save their life) – it doesn’t matter, and there’s no point arguing which they are – it is the people that are irrational, and thus we get this mess.

Beliefs like ‘housing values will continue to increase indefinitely’ and ‘a good idea is selling credit default swaps as insurance to someone who doesn’t own a stake in a company and may have motive and ability to force a company to the point of failing (otherwise known as buying insurance on your neighbors house and then setting it on fire)’ are irrational no matter how you try to explain it.

There were (rational) people giving warnings that this was going to happen as much as a year before everything collapsed and they were mostly ignored. The real question is why banks and financial institutions didn’t start deleveraging in an orderly way, or reducing their own exposure to the CDOs and mortgage-backed securities.

Chris H. (profile) says:

There are two ways to reduce bubbles. First, make rules when everything is calm and then stick to them when irrational euphoria sets in. For example, if the traditional mortgage 28-36 rules (28% house payment-income ratio, 36% debt-income ratio) were adhered to by banks, this bubble would *not* have happened. Second, when bubbles do happen, do not interfere with the market; let the companies that made bad choices fail. The idea that bubbles are unavoidable, that “no one is to blame but ourselves”, is nonsense.

gene_cavanaugh (user link) says:

Bubbles in the Economy

This article is well-thought-out and compelling, but I would like to add “another dimension”.
We all know that a child, if not corrected, becomes more and more irrational in his/her demands (spoiled brat).
What we choose to ignore is that there is a spoiled brat in all of us. We would like to think a wonderful economy is all good; but with no “correction” we become more and more irrational – it is the NATURE of the beast!
So, yes, the correction may be good; and the “more painful the more gooder”, to some extent.

Lawrence D'Oliveiro says:

Re: Bubbles in the Economy

gene_cavanaugh wrote:

We all know that a child, if not corrected, becomes more and more irrational in his/her demands (spoiled brat). What we choose to ignore is that there is a spoiled brat in all of us.

So who can take the role of the parent and ensure the child is “corrected”? If the correction can only come from another “spoiled brat”, then what good is it?

Jack Heald says:

I Beg to Differ...

I can put you into contact with two different people who were fired from their jobs as loan underwriters at major, national banks because they refused to underwrite clearly fraudulent loans. Fraud was not just committed but encouraged at the C-level of these two banks. What really happened is that the banks found a way o do something illegal and not get caught, so they got into fraud on a massive scale. The idea that “no one is to blame” is laughable. The executives in these banks walked away with millions for doing the same things that sent Bernie Ebbers and Ken Lay to prison.

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