Digitalics

Tiny Bubbles

December 31, 2008

My vote for 2008 word of the year is bubble.  (With Ponzi scheme being a close second only because it’s top of mind right now.)

We’ve seen so many bubbles come and go, many bursting in the last year.  Housing bubble, stock market bubble, CDO bubble, Wall Street salary bubble, debt bubble, and now a divorce bubble.  Kind of makes you nostalgic for the Internet bubble, doesn’t it?

We’ve even had a labor bubble.  In the auto industry, most of today’s at-risk workers should have been laid off years ago as Detroit rationalized its businesses.  Instead, GM et al hung on for dear life and the labor force remained too large while the air went out of the market.  Now we’re facing all of those job losses at the same time.

Like a tub full of soap suds, these bubbles have decayed into a single, giant, “mother-of-all” bubble.  Which, naturally, has popped in turn.  And as Paul Krugman wrote recently in a New York Times op-ed, there aren’t any more bubbles left.  No wonder we’re in such a mess.

It’s not for lack of trying, though.  We want things to go back to the way they were before.  Despite what they might be saying, the Treasury, the Fed, Congress, and others are all essentially trying to re-inflate the world.  Refinance mortgages!  Force banks to issue more debt!   Buy distressed assets!  Stop foreclosures!  Loosen credit and people will spend money!  Get house prices back up!

(Isn’t this what got us into trouble in the first place? Do we really believe that easing credit will get people to buy cars when they’re worried about whether they’ll have a job?)

But the rips in the fabric are too large, and our sources of air are far too small.  Using TARP and other Fed/Treasury funds to re-expand the “mother bubble” is like trying to fill a hot-air balloon with a bicycle pump.

Worse yet, every one is now lining up for their bowl of gruel–finance firms that want to be bank holding companies, auto executives trying to build cars no one will buy, mall owners who can’t pay their mortgages, etc.  Who’s next, I wonder?

Please sir, I want some more.

Despite the comic relief I got watching auto execs jump through hoops for doggie treats (or this gem of a parody here), that way lies madness.

Even if we could find a big enough pump, prices have to reach a bottom eventually, so markets will clear. There is no pain-free recession.  The alternative is wide speculative swings and an oscillating market.

Prices drop through the floor (too low), then rebound to new heights (too high).  Lather, rinse, repeat.  We’ve seen this before when the Internet bubble was followed by a bull market fueled by debt and mortgage speculation.

Already, many believe housing in some areas is severely underpriced, as is the stock market.  CDOs and other “toxic paper” brought us to this tipping point because prices sank to artificially low levels,  driven down by mark-to-illiquid-market accounting.

We’ll see this in the job market soon also.  Companies shed consultants and temp workers to minimize employee pain, then lay off full-timers as things worsen.  But soon they’re hiring back the same consultants because they can’t get the work done without them (yet still can’t afford full-time employees).  And so on.

Oscillation is dangerous.  Not only paralyzing, but confidence sapping.  And that keeps markets from working efficiently.  Even if we’re successful at finding another bubble (or reinflating this one), it’ll just lead to another downfall a few years from now.

We can shed light on this phenomenon by looking to the lessons of classical mechanics.  We need some damping in the system. [Yes, I'm  a recovering engineer.  "Hi, my name is Scott."   "Hello Scott!"   "It's been 237 days since my last Fourier Transform..."]

Oscillations are minimized by introducing  some mechanism to slow down the wild swings.  Ideally, you want things to be critically damped (the diagram on the right, above).  That means a smooth movement to an equilibrium state, with no oscillations.  Think of the way a door closer works in your office building–smooth and easy–vs. the way saloon doors swing back and forth.

Economists, of course, call this a soft landing.

If we don’t critically dampen the system, we’ll have punishingly wild oscillations.  True, we can’t banish economic cycles.  But we should put in place safeguards that minimize the swings with only a small amount of undershoot.  (Blue line to the right).

In order to do that, we’ll need to find a way to “resegment” our large, sagging balloon, and use our available tools to reinflate a few of these markets, but on a much smaller scale.  Call them tiny bubbles.

A few ideas:

• Admit that owning a house isn’t a good move for everyone.
• As Robert Shiller suggests, create jobs.
• Refinance at new rates but not new prices.  Let housing find its level.
• Reinstitute the uptick rule.
• Let some banks and businesses fail, but not whole industries.
• Make banks lend, but only to credit-worthy clients.
• Don’t bail out speculators.
• Create public markets for CDOs.
• Stop (temporarily?) marking illiquid assets to market.
• Force higher capital requirements on banks when times are flush, and loosen them when the inevitable downcycle hits.

What we don’t want at the bottom of this long fall is a trampoline. Rocketing us back up again simply creates oscillations, prolongs the fear and anguish, and delays finding a bottom in each market. Besides, there’s nothing to look forward to there but another long fall.

What we need instead of a trampoline is an air bag. Something to cushion the impact. Or better yet, that material they wrap packages in to keep the contents from getting crushed.

You know, the stuff with the tiny bubbles.

Disclosure: I hold no position in any stocks mentioned here.

Salutation: Happy New Year!

Entry Filed under: Market, Miscellaneous. .