Blowing Bubbles

The significance of this moment is akin to the Global Financial Crisis.

Charles Kindleberger was an economic historian who wrote seminal pieces about bubbles in financial markets. The United States was especially prone to these as it grew in the post-Civil War era. The bursting of the 1920s exuberance was just one of several booms and busts. For those who lived through the Great Depression, understanding what caused them in the hope of avoiding them in the future was paramount among the policy questions of the day. The economic distortions speculative froth and its unwinding imposed had real costs.

Here's a summary of the different phases of a bubble.

‘Phase One: Displacement. An event or innovation occurs that sharply changes expectations. This phase is typically grounded in reality and good intentions.

‘Phase Two: Expansion. This is the stage where the narrative takes hold and people begin bidding up asset prices.

‘Phase Three: Euphoria. By this point, all bets are off. Everyone assumes they can get rich easily and very quickly. Risk is taken with abandon and nobody worries about the hangover in the morning. During the dot-com bubble, this is the point where people decided they could make more money day trading IPOs than going to their day job. Euphoria makes people think the good times will last forever, or at the very least, they won’t be the ones holding the bag when it turns.

‘Phase Four: Crisis. The inevitable other side of any boom is a bust. This is the phase where the insiders begin selling, and panic buying quickly shifts to panic selling.

‘Phase Five: Contagion. Just as prices overshoot to the upside from euphoria, they often overshoot to the downside once the contagion of bad news spreads and people think things will never get better again’

Bubbles are a consequence of human nature. We haven’t been able to eliminate them. They pop up throughout history, though thankfully without the devastation of the Great Depression. There were the Nifty Fifty stocks, the commodities bubble of the 1970s, the Savings and Loan Crisis, the derivatives crisis of the late 1990s, the Dot Com crash, and, of course, the Global Financial Crisis.

A key driver for this cyclicality is the human blindness to history. This time is always different. The stability that ensues from the policy response to the prior event creates an atmosphere of calm that we extrapolate into the future. When it’s calm, we feel more comfortable taking risk. Bubbles inflate again. And then they crash.

This is what is known as a Minsky Moment.

‘When markets are good for an extended period of time, investors tend to keep borrowing and adding on risk in their portfolio. Investors continue taking on risk, speculating that the price of the asset will continue to increase.

‘However, when prices cease to rise, the investors have borrowed so much to obtain the assets that they do not have enough cash to pay off their debts. Lenders then call in the loan repayment, and therefore, investors start selling their assets. It can trigger a sudden collapse in the price of the assets, and the market witnesses a Minsky Moment.’

We saw this with Bitcoin and all the cryptocurrencies.

· Displacement: The Global Financial Crisis destroyed confidence in the financial system and government authorities. People sought out alternatives. Blockchain technology also held out the promise of a new form of computation.

· Expansion: Prices began to rise for Bitcoin and for Ethereum, feeding into a virtuous cycle encapsulated by the “HODL” mentality. These new instruments were a license to print money.

· Euphoria: Things start to get out of hand. The Bored Ape Yacht Club is an association of people who bid up the value of PDF drawings to stratospheric heights just because they are so-called non-fungible tokens. Initial coin offerings for so-called “shitcoins” proliferate. These cryptocurrencies have no pretense to being anything other than a way to speculate. Organized crime and terrorist organizations use these cryptocurrencies to launder money and move it globally. Teenagers engaged openly in pump and dump schemes. All of this is fed by unprecedented levels of combined fiscal and monetary stimulus for a population imprisoned in their homes by Covid restrictions. NFL legends and others peddle channels for speculation in Super Bowl commercials. Celebrities preach messages like “the only risk is not taking one.”

· Crisis: A series of hacks exploiting the technological immaturity of linkages between cryptocurrencies (part of a broader decentralized finance movement) combined with wholesale (and obvious) fraud lead to bankruptcies of some of the most high profile players such as FTX. Sam Bankman-Fried, front-man for the band, goes to prison.

· Contagion: Prices overshoot on the downside (relative to the underlying demand for a speculative alternative to financial markets), cascading across cryptocurrencies and market players. This only ends with the beginning of institutional engagement, in part as derivatives traders (the villains of the Global Financial Crisis) jump in and convince their erstwhile clients to see crypto as an asset class. Larry Fink is a bull because fees.

Blockchain is still nowhere close to changing the way we compute. It’s too expensive, at least the way it is structured currently. That will change one day. Then, and only then, will cryptocurrency become sustainable and real.

Bubbles aren’t just for financial markets, though.

Human beings are status-driven. Rob Henderson is a Cambridge University PhD in psychology who writes extensively on Substack. He has developed the concept of “luxury beliefs”, a concept that has the appeal of being familiar and intuitive.

“Luxury beliefs are ideas and opinions that confer status on the upper class, while often inflicting costs on the lower classes.’

This is an extension of Thorsten Veblen’s work on the leisure class.

“Veblen, Bourdieu and Zahavi all claimed that humans—or animals—flaunt certain symbols, communicate in specific ways, and adopt costly means of expressing themselves, in order to obtain distinction from the masses.

“Animals do this physically.

“And affluent humans often do it economically and culturally, with their status symbols.

“A difference, though, is that human signals often trickle to the rest of society, which weakens the power of the signal. Once a signal is adopted by the masses, the affluent abandon it.“

In an age of material plenty, with aspirational luxury goods all around us, beliefs become another vehicle for expressing distinction and signaling membership in the superior social class.

“But today, because material goods have become a noisier signal of one’s social position and economic resources, the affluent have decoupled social status from goods, and re-attached it to beliefs.

“The upper class craves distinction.”

A great example of luxury beliefs is what is known as “Diversity, Equity, and Inclusion” or “DEI.” For example, there is the Defund the Police movement. (Or as Joel Klein labels it, “Empower the Thieves.”) Another is the notion of effort.

“There are other examples of luxury beliefs as well, such as the downplaying of individual agency in shaping life outcomes.

“A 2019 study led by Joseph Daniels at Marquette University was published in the journal of Applied Economics Letters.

“They found that individuals with higher income or a higher social status were the most likely to say that success results from luck and connections rather than hard work, while low-income individuals were more likely to say success comes from hard work and individual effort.”

DEI is based on the notion that one’s circumstances determine outcomes to a far greater extent than the traditional view would have you believe. The traditional view avers that effort, talent, and attitude can take you far in life. DEI says, in its apocryphal extreme, that much of your life path is fixed before you come out of the womb by things like the color of your skin or your sexuality. For some, this mantra manifests as punitive; we must punish those who won the genetic lottery to lift others. For others, it is an opportunity to proclaim their differences.

There was a bubble in DEI, too.

· Displacement: George Floyd’s death and other events highlighted the difficulties faced by people of color and the poor in the United States, inspiring genuine frustration with the system’s slow progress towards ostensible ideals of justice and fairness.

· Expansion: Black Lives Matters and other groups led large-scale protests, during the Pandemic, seeming to galvanize public opinion in favor of dramatic action. For years, conservatives had accused schools, universities, and other institutions of bias stemming from an infiltration of anti-Western, anti-capitalist cohorts. This foundation now mobilized.

· Euphoria: Seizing on the moment, activists pressured governments at all levels to put into place active programs to address these concerns. This initiative spread quickly to the private sector. It seems as if everyone was exposed to reformist programming and guilt-based struggle sessions delivered by highly-paid consultants, even as these nascent DEI bureaucracies grew rapidly to influence hiring, programming, and operations.

· Crisis: With little progress to demonstrate, the backlash from the affected mainstream came with the election of reformers like the Trump administration who wasted no time in eliminating DEI bureaucracies and programming, even as these organizations tried to hide with new titles and new job descriptions.

· Contagion: This is now in the process of spreading to the private sector, with some of the largest companies eliminating their DEI initiatives ostentatiously after having been in the vanguard of this movement. Google’s reversal was a big blow for DEI, for example. Diversity advocates are busy disguising themselves to avoid retribution, even as they regroup for the next wave.

The bursting of the DEI bubble coincided with the dilution of the differentiating value of these luxury beliefs. When everyone can have a Coach or a Michael Kors bag, then they lose all meaning. When every housewife in middle America can claim to be woke, well, what’s the point? People move on.

Maybe people will fix again on ostentatious consumption. Anything is possible.