Why financial bubbles are normal

The Sensex went up by 500 points in eight trading sessions. Real estate prices in the past two years have gone up by as much as 50 per cent and even doubled in some places. Gold prices are increasing quickly. So are the prices of most other commodities.

So what's going on? Are we thrashing around inside a financial bubble? A bubble, as everyone knows, "is a highly volatile domestic financial assets not backed by solid fundamentals, sound government policy, and institutions."

Often, we Indians tend to focus on the sources of funds driving the bubble. It is the puritanical streak in us -- the hai, tauba (Oh, God!) syndrome when it comes to money.

But we never ask why financial bubbles really happen. If we did, as this paper by Ricardo J. Caballero of MIT and Arvind Krishnamurthy of Kellogg* points out, we might avoid future bubbles.

Just for the moment, forget the source of funds. Assume the money is there, for whatever reason. The question then becomes, how do people find a safe store of value?

The problem, says the authors, is that "the corporate and government sectors do not generate the financial instruments to provide residents with adequate stores of value."

So when you have few controls on capital flows, the money will flow out. If that is not possible, feasible or profitable, you get bubbles. There is no place for the money to go, so it bloats the markets up.

But this is old hat. What's new about what the authors say is that "bubbles are beneficial because they provide domestic stores of value and thereby reduce capital outflows while increasing investment."

What is also new in this paper is that the authors say that capital outflows are not a feature of abnormal times; they happen during normal times. It is huge capital inflows that are a sign of abnormal times.

We are seeing that now. But then since nothing comes for free, these benefits come at a cost for the simple reason that bubbles can burst and capital inflows can be reversed, as happened in Thailand in 1997.

So what's the answer? The authors show that "domestic financial underdevelopment not only facilitates the emergence of bubbles, it also leads agents to undervalue the aggregate risk embodied in financial bubbles."

This is the crux of the matter, I think. This is why our small investors, driven in equal measure by greed and ignorance, get nicely done in during bubbles. "In this context, even rational bubbles can be welfare reducing," say the authors.

They also say "that liquidity requirements, sterilisation of capital inflows and structural policies aimed at developing public debt markets "collateralised" by future revenues, all have a high payoff in this environment."

At the bottom of it all lies financial underdevelopment, in the form of people not having a large number of alternatives for parking their savings or ill-gotten gains, mostly the latter. So bubbles get created.

But eventually these burst and what is important, going by the East Asian experience, is that "over time, the liquidity crunch disappeared, but the bubble-assets were not recreated. The latter phenomenon has played out in much of the Emerging Market world as well as in some newly industrialised economies… the disappearance of the bubble assets is an important factor behind the acceleration of the capital inflows to the US, and hence the worsening of the US current account deficit, since the Asian/Russian crises."

And then comes the main point to note, that it is not China's dollar reserves that are a problem. What is a problem is that "Chinese savers are forbidden from accessing US instruments directly. A normalisation of capital controls may lead to a crash in their buoyant real estate market and increased capital outflows toward the US."

You could say this of India as well, which places the policymakers in a difficult situation. He is damned either ways.