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The Classical Economists' Perspective

Discuss about the Credit Availability and Asset Price.

Great white whale of finance theory was one of the reasons behind creation of asset bubble. The reason should be known to all the individuals who involve in financial planning activities as well as overall economy (Sornette, 2017). In case, there is sudden crash in the asset price takes place that will leave behind growth in a dwindling state of years.

An Asset bubble can be referring to a phenomenon where there is rise in prices of assets as compared to real prices (Taffler, Agarwal and Wang 2017). The reason behind the increase is because of price instability of assets and lead to sudden fall in the prices (the fall may be either down to its real price or even below in some cases). There are two perspectives explained below that will help in understanding the causes of an asset bubble.

In this contemporary or modern world, role of central banks plays important role and carries equal attention in the financial environment. However, it is expected by the central banks that they should manage the economic growth as well as engage in preserving towards attainment of sustainable prosperity. This can be gained by either using or manipulating tools such as interest rates at its disposal (Selvakumar and Kirubakaran 2016). According to classical economists, their opinion is opposite regarding them as they treat them useless and reason behind it is abnormal market behavior. These classical economists believe that there is intervention by central banks of the country as well as interlinked monitory that becomes sole reason behind creation of asset bubble.

In one of the Book titled as “Early speculative bubbles and increases in the money supply”, it was written by Douglas E. French about printing of currencies by the central banks. It was mentioned as this activity lowers the interest rate than its normal rates as well as motivates investors to undertake investments that were not possible otherwise. Lowering of interest rate creates asset bubble and this will have volatile implications. However, the sudden outburst of the bubble can lead to liquidation of the mal investments. In his book, he explained that careful study of the history depicts that government meddling with the financial as well as monetary affairs lead to economic booms and inevitable bursts (Nemoto 2017). Therefore, other mainstream economists kept blaming the phenomenon on the animal spirits of the market participants.

As per Keynesian perspective, it is believed that there is nothing wrong or odd when there are recessions or depression taking place in the market. In this theory, it states that these activities bound to happen as well as there is nothing that anyone can perform to control the situation or even stop it in that case. It further explains the point where role of central banks is to reduce the aftermath of the depressions as far as possible. As compared to other classical theories, the Keynesian perspective focus on the importance of central banks and the theory does not claim central banks to be reason for creation of asset bubble.

The Keynesian Perspective

Before creating any of the asset bubble, asset needs to pass through different stages. On careful study about the stages, it help shareholder to evaluate in which cycle the asset is presently located as well as their future prospect of the assets. It is even needed to find out whether the asset will be able to fulfill the requirement of the investor.

Inception- Inception is the starting stage of creation of asset bubble at a certain point through the prices of the assets that may be treated unjustifiable at the end. The reason behind increased price is because of some of the valid points.

For instance- the dot com bubble was created because of optimism of the people or in that case larger mass for bringing development in the technology that took place at that point of time. It can be treated logical now because of the number of person using internet was increasing on rapid basis. It was believed by the investors that technology sector will helps them to get high yield in the future and this is the reason behind creation of an asset bubble that started with that mindset of investment. 

Gaining momentum- The increased rate in the asset prices may be slow at the starting. After that, it is the investors who come in the scenario and there is increase in the rate of prices on substantial basis. However, increased asset process can be further accelerated by media coverage as well as professional comments at the same time (Albrecht et al. 2017).

Euphoria- When the greed of the investors overcomes the caution, this is the time when asset bubble reaching this state (Euphoria). In this. The investors try to justify the cause behind increase price by knowing the fact that the assets fundamentals are strong as well as would be even stronger in the upcoming financial years. In the case study on Morocco Real Estate Bubble, it is properly mentioned about the situation at the time of booming period of the economy (Andonov, Eichholtz and Kok 2015). This is the time where real estate developers predict population growth as well as higher purchasing power of the citizen. Therefore, the investors have already believed in building up towns for population that can accommodate 3,00,000 residents. On the other hand, the population inhabiting the town comprises of 32,000 people.

Profit making- On reaching specific level, all the prudent investors start engaging in liquidating their investment. It will be difficult to predict the process as well as time of profit booking by the investors. In this stage, the investors have the tendency to sell their investments as well as engage in booking their profits. This can be done by selling their assets at higher price (Ashfaq 2016).  

Panic – In this stage, the sentiment of the investors gets reversed when there is substantial amount of profit booking taking place. The sentiment of the investors who were thinking of pushing the prices in the above situation now waits for taking U-turn. This is due to panic because of many failure cases of a bank (Bhala, Yeh and Bhala 2016).

The Different Stages of an Asset Bubble

Revulsion- In this stage, investors shows no interest in purchasing any further stocks or reinvesting in them because of previous bad experience with it and that lead to drastic fall in the stock prices. However, prices of the asset do not increase again because of reduction in the stock prices as well as simultaneous non-participation of the investors for that point of time (Bredin, Conlon and Potì 2015).

Black Monday is referred to a crash that took place in the stock market in and across the world on 19th of October 1987 and the day was Monday. Due to this crash, there was eradication of huge amount of shareholders value for very short span of time frame. The effect started in Hong Kong and slowly and gradually spread like a wild fire to all of Europe and then hit United States. The other markets were even affected by this crash that resulted in huge amount of value (Chen and Huang 2018).

The crash had affected the markets in and across the world and it was quite immense by nature. The value of the markets of countries such as Hong Kong, United Kingdom, Australia, Spain and Canada fell down by 45.5%, 26.45%, 41.8%, 31% and 22.5% respectively. The crash had affected New Zealand the most as compared to other countries. The market value fell down by 60% from its peak value as recorded by it by the end of 1987. Therefore, it took several years for these countries to get normal economy and recovering from the change (Clark 2016).

There are different economists who all states the reasons for the crash were due to overvaluation, program trading as well as illiquidity and market psychology. Most of the public were of the opinion that program trading as one of the sole reason behind this crash. The working of program trading executes large amount of stick that is traded based upon external inputs as and when received. However, the systems made usage of arbitrage as well as portfolio insurance strategies.

Black Thursday is referred as one of the worst market crashes that were faced by United States on 24th of October 1929. The reason behind this crash was the effect it had in economy of United Sates for that duration. The country suffered from this crash for 12-year long Great Depression and would even included most of the other industrialized western countries (Dimmock, Gerken and Marietta-Westberg 2015).

Both Black Thursday as well as The Great Depression together pulled off financial crisis that would be referred as the largest crash during 20th century. The crash even resulted in depression in Europe. The economists could not understand the intensity of the crash that took place in United States. Under the aftermath of the crash, the intense connectivity at that time was understood properly that took place within the countries.

The real cause behind this worst crash in United States was due to involvement of manufacturing business as well as steel production business that had recorded historic profits at that point of time. The people thought that the stocks will never come down that lead to over speculation. Due to that, loan amount taken by the people for funding their investments was more than $8.5 billon and this was quite higher to that of total currency present in United States at that point of time (Dymski and Shabani 2017).

Comparison between Black, Black Thursday and the Japanese Crash

In the year 1927, there took place financial panic under the reign of emperor Hirohito of Japan. Due to this crisis, the Prime Minister (Wakatsuki Reijiro) had been brought down the government and after that Zaibatsu had taken over the banking industry in Japan.

The real cause behind creation of an economic bubble resulted from an increased amount of investment on the part of public who look for benefits of increased production capability in the name of business. With this crisis, the country faced slow economic downturn and even Great Kanto Earthquakes in the year 1923 resulted in further worsening of the condition. By the year 1927, it is noted that the government involved in contemplating redeeming of bonds and there was rumor that the banks are engaging in holding these bonds (Fender et al. 2017).

After studying about worst crashes that took place in the stock market, the common thing noticed was the belief of the investors on matters relating to the performance of specific sector. As far as Black Monday was concerned, the investors were of the opinion that prices of technology sector companies will never come down. The case was same during Black Thursday as well as Japanese crash. During these crashes also, the investors had believed that prices of steel producing company will never come done and they will deemed to perform well in the future. The investor believed that the market will have constant trend for longer period of time and this had resulted in downfall in the economy (Fu et al. 2018). Therefore, this was the direct result after creation of any economic bubble because of the demand asked by the investors in this market.

Avoiding using misleading mortgage products- It is advisable to avoid any misleading mortgage products. Some of the economies in this world still aim at providing mortgage products that have teaser rate (Monk, Sharma and Sinclair 2017). This means the mortgage products have more appealing introductory rate for initial 2 to 3 years and after that, the interest will suddenly shot up. This sudden change creates immense economic burden by the borrower that results in defaulting position at some point of time.

  • Improving the capital ratios of the banks- It is advisable to make an attempt to improve the capital ratios of the banks. Before the crisis period, it was noted that because of the boom in the economy, the banks started providing ridiculous amount of loans and this lead to degrading capital ratios on regular basis. This activity by the banks had led to vulnerability at the time of credit crunch period (Kotsantonis, Pinney and Serafeim 2016). However, if banks are to keep capital with them, it would thereby assist them to face the situations such as abnormal exuberance on the part of people. However, the funds that are kept by the banks can be remitted back in case of difficult times.
  • Putting cap on dividend and pay- It is advisable to put cap on the dividend and star paying after that. After studying about Great Depression, certain facts can be gathered hat states that during that period, the bank faced loss of more than $60 million and they had to even pay dividend to the tune of $60 million. In addition to that, banks that had their listing in Stock Exchange faced huge pressure in paying dividend as well as keeping their reserves lower. As far as banks are concerned, they should prefer using German Model to overcome the issue (Jackson 2018).
  • Monetary policy- On analysis, it is found out that central bank plays major role and the role is immense. To that, it is seen that the interest rates are kept lower for given period of time and this was noted prior to any depression. The main emphasis put by the banks is to look after the inflation rates. However, the banks generally miss out aftermaths of the bursting of the economic bubble that is being created in the economy because of the steps undertaken for controlling inflation (Galbraith 2017).

Ponzi is one of the pyramid structure schemes that basically functions on the “rob Peter to pay Paul” principle based on the definition stated by the US Financial regulator Securities Exchange Commission (Zhu et al. 2017). Under such scheme, the fraudster promises one investor that they will be getting huge returns on his money and then uses the money for paying back the dues of other investors. After the money comes in from any new investors, it is noted that the system collapses at that time. In this entire scheme, the loser is the person who is making the last transaction in investment with the fraudster because all the other investors are cleared by the returns and there is no funds left behind to pay newest entrant. Charles Ponzi was one of the fraudster and the scheme was named under his name. He had promised the investors of New Zealand to give a return of 40% on their investments as compared to the 5% current return that they were earning from their saving accounts. However, the returns that were to be paid by this person was from the profits he would expect from the exchange rates difference in US dollars and any other currencies for the purpose of purchasing as well as selling international coupons at a profit (Wolinsky and Rubin 2014).

This success of the scheme was noticeable where Charles Ponzi earned whopping of more than $420000 till May 1920 that can be converted as $5.13 million in 2017 currency. During the month of June, people started investing more than $2.5 million in this Ponzi scheme and by the month end; he was able to rank in millions of dollars per week as it were rising. Charles Ponzi had purchased international coupon to the tune of only $20 and this was noted after the collapse of entire system that was based on such small amount or rather it can be treated as zero amount investment done by him (Nash, Bouchard and Malm 2018).

As far as rich families were concerned, they had huge funds to invest upon. However, they do not have enough knowledge about the same for investment related decision-making process. To be on the safer side, they believe in keeping huge funds under the custody of wealth managers as well as private banks and hedge funds. After that, these selected institutions approaches specialist funds managers who have been consistent in their performance. To that, the select consistent performer named is Madoff. This person was popular as he had guided people with funds for a fee. The problem started when he started paying the profits back to the clients first and then invest the money thereafter. After financial crisis hitting the economy, all the clients start coming to Madoff and ask him for money. The fraud was exposed because of the absence of money of such huge amount at that point of time.

Reference List

Albrecht, C., Morales, V., Baldwin, J.K. and Scott, S.D., 2017. Ezubao: a Chinese Ponzi scheme with a twist. Journal of Financial Crime, 24(2), pp.256-259.

Andonov, A., Eichholtz, P. and Kok, N., 2015. Intermediated investment management in private markets: Evidence from pension fund investments in real estate. Journal of Financial Markets, 22, pp.73-103.

Ashfaq, M., 2016. IMPACT OF GLOBAL FINANCIAL CRISES ON GLOBAL FINANCIAL STABILITY AND NEED FOR AN ALTERNATIVE FINANCIAL SYSTEM. Business Excellence, 10(2), p.109.

Bhala, K.T., Yeh, W. and Bhala, R., 2016. International investment management: theory, ethics and practice. Routledge.

Bredin, D., Conlon, T. and Potì, V., 2015. Does gold glitter in the long-run? Gold as a hedge and safe haven across time and investment horizon. International Review of Financial Analysis, 41, pp.320-328.

Chen, D.H. and Huang, H.L., 2018. Panic, slash, or crash—Do black swans flap in stock markets?. Physica A: Statistical Mechanics and its Applications, 492, pp.1642-1663.

Clark, G.L., 2016. The components of talent: Company size and financial centres in the European investment management industry. Regional Studies, 50(1), pp.168-181.

Dimmock, S.G., Gerken, W.C. and Marietta-Westberg, J., 2015. What determines the allocation of managerial ownership within firms? Evidence from investment management firms. Journal of Corporate Finance, 30, pp.44-64.

Dymski, G.A. and Shabani, M., 2017. On the geography of bubbles and financial crises. Handbook on the Geographies of Money and Finance, p.29.

Fender, R., Adams, R., Barber, B. and Odean, T., 2017. Gender Diversity in Investment Management: New Research for Practitioners on How to Close the Gender Gap. Research Foundation Publications, 2017(1), pp.37-38.

Fu, P., Zhu, A., Ni, H., Zhao, X. and Li, X., 2018. Threshold behaviors of social dynamics and financial outcomes of Ponzi scheme diffusion in complex networks. Physica A: Statistical Mechanics and its Applications, 490, pp.632-642.

Galbraith, J.K., 2017. Economics in perspective: A critical history. Princeton University Press.

Jackson, K., 2018. Asian contagion: The causes and consequences of a financial crisis. Routledge.

Kotsantonis, S., Pinney, C. and Serafeim, G., 2016. ESG integration in investment management: Myths and realities. Journal of Applied Corporate Finance, 28(2), pp.10-16.

Monk, A., Sharma, R. and Sinclair, D.L., 2017. Reframing finance: New models of long-term investment management. Stanford University Press.

Nash, R., Bouchard, M. and Malm, A., 2018. Twisting trust: social networks, due diligence, and loss of capital in a Ponzi scheme. Crime, Law and Social Change, 69(1), pp.67-89.

Nemoto, H., 2017. Credit availability and asset price: Empirical analysis of the Japanese bubbles in 1980s. Journal of the Japanese and International Economies, 44, pp.90-98.

Selvakumar, D.S. and Kirubakaran, P.S., 2016. Global Major Stock Market Crashesincluding Causes and Their Effects of 2016 Chinese Stock Market Crash. International Journal of Business Administration and Management Research, 2(1), pp.6-8.

Sornette, D., 2017. Why stock markets crash: critical events in complex financial systems. Princeton University Press.

Taffler, R.J., Agarwal, V. and Wang, C., 2017. Asset Pricing Bubbles and Investor Emotions: An Empirical Analysis of the 2014–2016 Chinese Stock Market Bubble. In Behavioural Finance Working Group Meeting, Queen Mary University London, June.

Wolinsky, H. and Rubin, R., 2014. ‘Kicking the can’: science, Congress and a Ponzi scheme: Even if US Congress finally approved a tentative budget, scientists worry that the ongoing budget fights will damage US research in the longer term. EMBO reports, 15(1), pp.21-24.

Zhu, A., Fu, P., Zhang, Q. and Chen, Z., 2017. Ponzi scheme diffusion in complex networks. Physica A: Statistical Mechanics and its Applications, 479, pp.128-136.

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