Eapen thomas's Public Library

Typically, bubbles have an asymmetric shape. The boom is long and drawn out: slow to start, it accelerates gradually until it flattens out during the twilight period. The bust is short and steep because it is reinforced by the forced liquidation of unsound positions. Disillusionment turns into panic, reaching its climax in a financial crisis.

Bubbles that conform to this pattern go through distinct stages: inception; a period of acceleration, interrupted and reinforced by successful tests; a twilight period; and the reversal point or climax, followed by acceleration on the downside culminating in a financial crisis. The length and strength of each stage is unpredictable, but there is an internal logic to the sequence of stages. So the sequence is predictable—but even that can be terminated by government intervention or some other form of negative feedback.

The simplest case is a real estate boom. The trend that precipitates it is that credit becomes cheaper and more easily available; the misconception that turns the trend into a bubble is that the value of the collateral is independent of the availability of credit. As a matter of fact, the relationship between the availability of credit and the value of the collateral is reflexive. When credit becomes cheaper and more easily available, activity picks up and real estate values rise. There are fewer defaults, credit performance improves, and lending standards are relaxed. So at the height of the boom, the amount of credit involved is at its maximum and a reversal precipitates forced liquidation, depressing real estate values.

Yet, the misconception continues to recur in various guises. The international banking crisis of 1982 revolved around sovereign debt where no collateral is involved. The creditworthiness of the sovereign borrowers was measured by various debt ratios, like debt to GDP or debt service to exports. These ratios were considered objective criteria, while in fact they were reflexive. When the recycling of petrodollars in the 1970s increased the flow of credit to countries like Brazil, their debt ratios improved, encouraging further inflows and starting a bubble.

So here it goes. I contend that the puncturing of the subprime bubble in 2007 set off the explosion of a super-bubble, much as an ordinary bomb sets off a nuclear explosion. The housing bubble in the United States was the most common kind, distinguished only by the widespread use of collateralized debt obligations and other synthetic instruments. Behind this ordinary bubble there was a much larger super-bubble growing over a longer period of time which was much more peculiar. The prevailing trend in this super-bubble was the ever increasing use of credit and leverage. The prevailing misconception was the belief that financial markets are self correcting and should be left to their own devices. President Reagan called it the magic of the marketplace, and I call it market fundamentalism. It became the dominant creed in the 1980s when Ronald Reagan was President of the United States and Margaret Thatcher was Prime Minister of the United Kingdom.

What made the super-bubble so peculiar was the role that financial crises played in making it grow. Since the belief that markets could be safely left to their own devices was false, the super-bubble gave rise to a series of financial crises. The first and most serious one was the international banking crisis of 1982. This was followed by many other crises, the most notable being the portfolio insurance debacle in October 1987, the savings and loan crisis that unfolded in various episodes between 1989 and 1994, the emerging market crisis of 1997/1998, and the bursting of the Internet bubble in 2000. Each time a financial crisis occurred, the authorities intervened, merged away or otherwise took care of the failing financial institutions, and applied monetary and fiscal stimuli to protect the economy. These measures reinforced the prevailing trend of ever increasing credit and leverage, but as long as they worked, they also reinforced the prevailing misconception that markets can be safely left to their own devices. It was a misconception, because it was the intervention of the authorities that saved the system; nevertheless these crises served as successful tests of a false belief, and as such, they inflated the super-bubble even further.

While the prevailing multilateral system will try to reconstitute itself, China will expand on a bilateral basis. China is, of course, part of the multilateral system but it does not occupy within that system a position that is commensurate with its current strength; therefore its participation in the international financial institutions is rather passive and its active expansion is likely to go through bilateral channels. For instance, China will complain about the role of the dollar and will promote the role of Special Drawing Rights but it is unlikely to allow the renminbi to become freely convertible because that would destroy the mechanism that has allowed the state to harvest the fruits of cheap Chinese labor through an undervalued currency. China will continue to maintain capital controls but will establish bilateral clearing accounts denominated in renminbi with countries like Brazil. This will diminish the status of the dollar as the international currency without replacing it.

Just as at the end of the Second World War, we are at the end of an era, but this time, we are not fully aware of it. Neither of the currently available alternatives is attractive. The Washington Consensus has failed. International capitalism in its present form has proven itself inherently unstable because it lacks adequate regulation. It is also highly unjust. It favors the haves over the have nots.