The Seven Stages of a Financial Bubble

Since David McWilliams mentioned it tonight, I thought I’d reprise Open Window’s original posting on the OWL

Stage One – Displacement

Every financial crisis starts with a disturbance. It might be the invention of a new technology, such as the internet. It could be a shift in economic policy. For example, interest rates might be reduced unexpectedly. Whatever it is, the world changes for one sector of the economy. People see the sector differently.

Stage Two – Prices start to increase

Following the displacement, prices in the displaced sector start to rise. Initially, the price increase is barely noticed. Usually, these higher prices reflect some underlying improvement in fundamentals. As the price increases gain momentum, people start to notice.

Stage three – Easy Credit

Increasing prices are not enough for a bubble. Every financial crisis needs rocket fuel and there is only one thing that this rocket burns - cheap credit. Without it, there can be no speculation. Without it, the consequences of the displacement peter out and the sector returns to normal.When a bubble starts, the market is invaded by outsiders. Without cheap credit, the outsiders can’t join in.

Cheap credit is the entrance ticket for outsiders. For example, gas prices have risen sharply in recent years. However, banks aren’t giving out loans so that people can store gas in their garages in the hope that the price will double in three months. The banks, however, are prepared to give loans to people with poor credit to hold condos in the hope that they can be quickly flipped.

The rise in easy credit is also often associated with financial innovation. Often, a new type of financial instrument is developed that miss-prices risk. Indeed, easy credit and financial innovation is a dangerous cocktail. The South-Sea Bubble started life as new-fangled legal innovation called the limited liability joint stock company. In 1929, stock prices were propelled into the stratosphere with the help of margin calls. Housing prices today accelerated as interest-only mortgages emerged as a viable means for financing overpriced real estate purchases.

Stage Four – Over-trading

As the effects of easy credit kicks in, the market starts to overtrade. Overtrading stimulates volumes and shortages emerge. Prices start to accelerate, and easy profits are made. More outsiders are attracted, and prices run out of control. Accelerating prices attract the foolish, greedy and the desperate to enter the market. As a fire needs more fuel, a bubble needs more outsiders.

Stage five – Euphoria

The bubble now enters its most tragic stage. Some wise voices will stand up and say that the bubble can no longer continue. They put together convincing arguments based upon long run fundamentals and sound economic logic. However, these arguments evaporate in the heat of the one over-riding fact – the price is still rising. The wise are shouted down by charlatans, who justify insane prices by the euphoric claim that the world is different and this new world means higher prices.

Of course, the “new worldâ€

This was from a radio interview with Austin Hughes in September 2006 which I transcribed, even though he does not realise it, he’s describing perfectly the transition from stage 5 through stage 6 and towards stage 7 in Hyman Minsky’s universal framework for understanding bubbles.

Ah the OWL, man I am starting to think you eat google for breakfast. Vast, what have you got lexus nexus, the NSAs latest goodies under your bed?

I found that lisitng on a blog somtime back, I wish I had the link.

I think we must have a “seven stages of a bubble” page on the site itself.

https://www.idorfman.com/Charts/sentiment_cycles.jpg

A chart that can be used to track market psychology through the various stages of a bubble.

Somwhere between Anxiety and Denial at the moment, yes?

I’d go for Euphoria>>>Anxiety myself!

Excellent posts GB/Duplex.

I am of the opinion that peoples feelings towards the market vary depending on what information they have available to them. For instance the solictor who is currently trying to sell all 21 of her properties at once is probably at the anxiety stage, while the builders son who just bought property in his Dad’s development is at the thrill stage. Those people in Bulgaria on last nights “In Search of the Pope’s Children” were clearly in euphoric mood waxing on about the quality of the concrete and the paper gains they made.
On the whole people outside this thread have a fairly positive sentiment towards property as a speculative asset, however that is changing with the inventory buildup on DAFT. Dan McLaughlins reportin the summer probably summed up the high point of the euphoria and peak of the market.

One of the comments in reply to the UWG article on indymedia,

*Fundamentals
by JFH Wed Nov 15, 2006 10:16

My wife and I, after rearing our children, sold our Dublin house in July and moved to the West. The twigger that made us do that was the sight of the major Banks selling off their branches. This to us was a fundamental sign as we guessed that they did their homework!*

indymedia.ie/article/79668

ALso a sterling rebutle from the torjan GREEN BEAR

Make up your own mind, here is the data
by Green Bear Wed Nov 15, 2006 22:33

Unlike previous warning’s that the Irish property market was going to crash, this time it is backed by solid data which clearly indicates the Irish economy has become unbalanced and will experience an economic recession, mainly as a result of a downturn in the construction sector and excess debt, but also econmic problems of external trading partners such as the USA. The property market in Ireland manifests every, and I mean EVERY trait of a classic asset bubble. Don’t take the doomsayers word for it, they have not been able to time any downturn to date, go look at the data and make up your own mind as regards the short to medium term trends of this particular sector of the economy (23% of 2005 GNP) and its underpinnings.

Construction and Housing in Ireland July 2006
cso.ie/releasespublications/ … tr…g.pdf

Central Bank & Financial Services Authority of Ireland Financial Stabilty Report 2006
centralbank.ie/data/FinStaRepFiles/Part%201%…6.pdf

Irish Property Boom - It’s easy to underestimate how much economic prosperity depends on it
By Michael Hennigan, Editor and Founder of Finfacts, Nov 6, 2006
finfacts.com/irelandbusiness … rt…shtml

The Irish Property Review A Quarterly Analysis – November 2006
Dr. Dan McLaughlin, Chief Economist Bank of Ireland
bankofireland.ie/html/gws/in … l/…6.pdf

Irish property: government finances exposed to a correction - October 2006
By Rossa White
davydirect.ie/other/pubartic … rt…6.pdf

IBF/PwC Mortgage Market Profile New Lending - Quarterly Report (Q2-2005 to Q2-2006)
ibf.ie/pdfs/ibf_pwc_mortgage.pdf

Construction and Housing in Ireland Report: CSO says Construction Output up 80% in 5 years - Mortgage debt increased from €33bn in 2000 to €100bn in 2005
finfacts.com/irelandbusiness … rt…shtml

Key workers can’t afford houses in main cities - September 2006
rte.ie/business/2006/0920/housing.html

Department of the Environment, Heritage & Local Government Construction Industry and housing Statistics
environ.ie/DOEI/DOEIPub.nsf/ … la…en#I2

Buy-to-let yields at a historic low
timesonline.co.uk/newspaper/ … 3,…html

Daft.ie Q3 2006 report
daft.ie/report/pat-mcardle.daft

The Time of Our Lives? Ireland '86-'06
rte.ie/thetimeofourlives/boom.html [realplayer required]

Primetime - Fears of slow-down in housing market
dynamic.rte.ie/av/230-2183980.smil [realplayer required]

Irish Forum GlobalHousepricescrash.com
Related Link: forum.globalhousepricecrash.com/ … fo…um=16

That John guy on indymedia seems certain that Irelands economy and property market is in fine fettle despite the mounting evidence to contrary and pure common sense. Cretin.

Yes indeed, I was looking to see how to post but I couldn’t find it, I think someone like John would have a good run on this very site don’t you!