Law, Bubbles, and Financial Regulation

Erik F. Gerding

• Publisher: Taylor & Francis
• Year: 2013
• eBook ISBN: 9781134642762
• Edition: 1
• Topic: Business
• Subtopic: Business generale
• Index: Business

Financial regulation can fail when it is needed the most. The dynamics of asset price bubbles weaken financial regulation just as financial markets begin to overheat and the risk of crisis spikes. At the same time, the failure of financial regulations adds further fuel to a bubble.

This book examines the interaction of bubbles and financial regulation. It explores the ways in which bubbles lead to the failure of financial regulation by outlining five dynamics, which it collectively labels the "Regulatory Instability Hypothesis.".

The book concludes by outlining approaches to make financial regulation more resilient to these dynamics that undermine law.

Part I

The economics and legal history of bubbles

1 The economics of bubbles

Everyone and their uncle has an intuitive sense of what a bubble is. In folk wisdom, a bubble is a meteoric rise in prices of an asset followed by a calamitous crash. Everyone and their uncle blame the bubble on speculators who look to flip assets – selling to a “greater fool,” and pocketing a profit before prices crash to earth. After a crash, everyone and their uncle claim to have known all along that the boom times were a bubble bound to burst. (That is not to say that everyone and their uncle did not try to ride the boom themselves.) Once a boom and bust cycle has ended, everyone and their uncle see fresh bubbles forming everywhere. Indeed, the wake of the Panic of 2008 has been no different; as the Introduction to this book noted, journalists now spot bubbles everywhere.

Too bad that too few voiced concerns (let alone acted on them) during the boom times just ended. Wisdom in hindsight is cold comfort to those who lost mightily in the last crash. Although the folk wisdom of bubbles is not necessarily wrong, its lack of rigor offers little aid in identifying with any precision when a bubble has formed, how it formed, and whether past financial crises involved a bubble. Without a more rigorous definition and theory of bubbles, policymakers have little to guide them in seeking to guard against the economic and social damage caused by recurrent financial boom and busts.

The Potter Stewart approach to bubbles – “we know it when we see it” – only works in hindsight. A meteoric rise in prices in a financial market just might be justified by some transformational shift in the economy (a new technology, a new market, a new political order). Moreover, the financial lightning of an investment mania seldom strikes twice in the same asset class with the same group of investors. The burghers of Holland were unlikely to have participated in another Tulipomania, but severe losses in flower bulbs (or technology stocks) may do little to chasten investors from investing in booming real estate markets. And a new generation of greater fools is born every minute. The “new era” or “this time is different” logic takes hold because no two financial manias are quite the same.

How then can policymakers or scholars identify what constitutes a bubble and which financial crises involve bubbles? This chapter will examine the economic theories of bubbles and how they form. The chapter begins by looking at the thorny definitional issues of what is a bubble and what is “fundamental value.” It then turns to the principal sets of theories on how bubbles form. Behavioral finance offers a compelling account of bubble formation that informs much of the rest of this book. It argues that bubbles have their genesis in the behavioral biases and cognitive limitations of investors. These same limitations can afflict lawmakers and market participants in their decisions to make, enforce, or obey financial regulation.

The chapter also considers other theories of bubbles that offer crucial insights that will reappear throughout the book. In contrast with the cognitive limitations of behavioral finance, the “rational-bubble” literature contends that asset price bubbles can form when investors have rational expectations. Although this research has its limitations, which are outlined below, it offers two powerful lessons. First, once bubbles form and prices begin to skyrocket, it can be completely rational for investors to buy into a booming market. Indeed, it may be irrational for them to attempt to swim against the tide, as the marketplace may punish them for doing so. The complex interplay between “irrational” and rational decision-making reverberates as a theme in later chapters. Second, a subset of the rational-bubble literature explains how credit can fuel the growth of bubbles. This nexus between credit and bubbles is another thread that runs through the book. This chapter also considers other theories of bubbles that have, until recently, lain outside mainstream economic scholarship. For example, Hyman Minsky’s “Financial Instability Hypothesis” offers a powerful account of how cycles can destabilize financial markets. His work provides a template, not only for how bubbles form, but for cycles in financial regulation as well.

After considering economic theories of bubbles, the chapter returns to the difficulties of identifying bubbles, and discusses research in experimental economics that demonstrates the prevalence and robustness of bubbles in experimental asset markets. The chapter concludes with a discussion that introduces the tradeoff between achieving absolute certainty that a bubble exists with learning and applying pragmatic lessons about the risks and dynamics of bubbles. It bears repeating that the dynamics of the Regulatory Instability Hypothesis described in the ensuing chapters – the regulatory stimulus cycle, compliance rot, regulatory frenzies, and procyclical and herd-promoting regulations – do not strictly depend on asset prices diverging from fundamental value. Rather, the same dynamics that mark and inflate bubbles, as described in this chapter, also cause the deterioration in financial laws. Among these dynamics are rising prices, behavioral biases, rational and irrational herd behavior, short horizon investment, an influx of first time investors, and cheap credit and rising leverage. This chapter thus plays a key role in this book not because it suggests a foolproof answer to the riddle of when a bubble has formed, but rather because it unpacks the economic forces at work during bubbles that also affect and afflict financial laws during bubble periods.

Definitional problems: bubbles and fundamental value

The basic definition: price deviation from fundamental value

Earlier, economic research into bubbles had a less quantitative and more narrative methodology. This early literature (particularly the work of Charles Kindleberger) defined bubbles in terms of an extended rise in the price of a particular asset and a subsequent price crash.¹ This straightforward definition has numerous drawbacks. Although it captures the intuitive shape of a bubble, the definition fails to single out any causal explanation for the rise and crash of prices. It thus cannot generate any testable hypotheses or predictions.

So economists have searched for definitions with more explanatory power. The consensus definition on which many economists have settled defines an asset price bubble as a deviation in the price of a certain financial asset (or class of assets) from its fundamental value.² Fundamental value, according to most definitions in the economic literature, represents the present value of all future cash flows from that asset.³ As an example, the fundamental value of a bond equals the present value of future payments of interest and principal on the bond with some discount for credit risk.⁴ A bubble forms when the price rises above this present value. (Implicit in most bubble definitions is an assumption that only pronounced and prolonged deviations from fundamental value are of interest.)

This tidy example masks practical difficulties and several logical shortcuts. Three problems stand out. First, economists have calculated fundamental value for stocks and real estate by estimating future dividends and rental payments.⁵ But many companies have adopted policies of retaining earnings rather than paying dividends,⁶ and many real estate owners cannot rent their property due to legal or practical restrictions.⁷ For these assets, the only future cash flow is whatever price a buyer will pay on sale. This makes defining fundamental value not only a speculative endeavor (double entendre intended) but potentially a circular one as well.⁸

Second, defining bubbles by reference to fundamental value requires not only a calculation of future cash flows, but also a determination of the correct discount rate. The presence of two variables in this equation raises the “joint hypothesis problem” that has also plagued efforts to prove (or disprove) the Efficient Markets Hypothesis.⁹

Third, even measuring fundamental value solely on the basis of expected dividends or rental payments requires forecasting. It would be inappropriate to judge the decisions of investors with the benefit of hindsight. Just because prices later crashed, does not mean that investors were making decisions based on something other than forecasts of fundamental value. It is difficult to know in the middle of a price boom when the flavor of reasonable risk-taking becomes the poison of wild optimism. Whether a forecast is reasonable is inescapably subjective. To evaluate the reasonableness of future-cash-flow estimations, economists resort to a host of different metrics that usually involve looking at historical patterns of the relationship between an asset’s price and measures of an asset’s income (e.g., company earnings).¹⁰

However, reliance on historical patterns leads to the standard objection of securities disclosure boilerplate: past performance does not guarantee future results.¹¹ Transformational economic changes – the introduction of a new technology or the opening of a new market – may create historically aberrant growth.¹² These transformational changes generate fantastic early market returns and lead investors to believe that historical ratios between an asset’s price and measures of its income might be obsolete. The question is, how much of a price rise is justified?

Conflation of risk and uncertainty

The difference between the economic concepts of risk and uncertainty helps frame the dilemma faced by economists in determining whether prices have exceeded fundamental value. These two concepts were first distinguished by economist Frank Knight towards the beginning of the twentieth century.¹³ Risk describes potential losses or gains when the probabilities are known beforehand. Playing a game of dice involves risk. Uncertainty describes potential future gains or losses in which the probabilities are not known. Since historical prices of assets do not necessarily predict future prices (it is possible that economies can undergo transformati...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Dedication
• Table of Contents
• List of figures
• List of tables
• Acknowledgments
• Introduction: the Regulatory Instability Hypothesis
• PART I: The economics and legal history of bubbles
• PART II: The Regulatory Instability Hypothesis
• PART III: Fighting bubbles, feeding bubbles
• PART IV: The panic of 2007–2008 as master class in regulatory instability: the shadow banking bubble
• PART V: Lessons and solutions
• Index