Bubble Trouble

Last Friday, the Wall Street Journal ran a front-page story about the study of bubbles throughout history. (Bernanke’s Bubble Laboratory, by Justin Lahart, WSJ May 16, 2008). The article highlighted a group of intellectuals assembled at Princeton University to figure out how and why bubbles form and what should or should not be done to prevent or mitigate the bubbles from forming/popping.

Considering that we have seen two bubbles form (dot com and housing) and burst within ten years, the topic is quite timely. The Princeton group notes that bubbles often emerge when a significant innovation occurs—in the 1920’s, it was automobiles and electricity and in the nineties, it was the advent of the Internet. The interesting thing to consider is that most bubbles start with a great idea. Both automobiles/electricity and the widespread use of the Internet were truly transformative moments in time that would impact the economy in significant and lasting ways.

But what can occur is that the great idea morphs into a mania and then all bets are off. All of a sudden, everyone knows that what is going on is crazy, but nobody wants to be left out of the money-making. I remember talking to clients late in the Internet cycle and hearing “I know that it’s insane, but can’t we own more technology? My cousin has all of his money in the ABC Internet fund and has made a fortune!” Those animal instincts are so hard to fight, so maybe it’s up to a higher power to help us. The higher power in this case is the Federal Reserve.

Last week, Fed Governor Frederic Mishkin “suggested that while it was inappropriate to use the blunt instrument of interest-rate increases to prick bubbles, if too-easy credit appeared to be fueling a mania, policy makers might craft a regulatory response that could ‘help reduce the magnitude of the bubble.’” I am not sure what response Mishkin is thinking about, but there is a very easy solution that exists: change margin requirements.

One of the accelerants to a bubble is the use of borrowed money. As a result of leverage, bubbles become larger, faster, but once the tide turns, “the speed of their fall is intensified as investors sell urgently to pay down debt.” By requiring that investors use cash, not borrowed money, or in the case of housing, by ensuring that 20% down payments are used to secure mortgages, the Federal Reserve may not be able to prevent a bubble from forming, but it sure would make the eventual bursting of the bubble easier for the economy, markets and people to absorb.