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					     Economic
      Bubbles
Products, Profits & Information
‘Classical’ product

• Physical product
• Owner controlled firm (no
  shareholders)
• Speculation in future profits
  impossible
  ‘Shareholder’ firm
• Physical product
• Separation of ownership from
  control
• Speculation in future profits
  possible through share dealing
  (trading in information not physical
  product)
      Asymmetric
      information

• all players dealing in shares do
  not have the same information
• ‘Arbitrage’ possible.
     Information
     uncertainty
• Trading in shares becomes
 risky
• Investors may be fooled
• The herd instinct
Louisiana bubble 1720

• Company had exclusive right to trade
 with the French territory of Louisiana
• Directors exaggerated the wealth of
 the territory
• Share price rose by a factor of 300
 between 1717 & 1720
       Louisiana bubble


• No physical products
• asymmetric/faulty information
• Share price fell back to original
  price in 1721
• Had real consequences in France
Other notable bubbles
•   Tulip mania (1637)

•   The South Sea Company (1720)

• Railway Mania (1840s)
•   Florida speculative building bubble (1926)

• Japanese asset price bubble (1980s)
•   The Dot-com bubble (1995–2001)

•   1997 Asian Financial Crisis
Common characteristics

  • trade relates to the prospects
    of future profits
  • Good information is the key to
    reasonable predictions
  • ‘Irrational exuberance’ in the
    markets
Financial crisis 2008

• Based on sub-prime house
 loans in US
• Mortgages were very risky
• Crash caused world wide
 recession
‘Traditional’ mortgages
• Long term loan issued by Bank (or
 Building Society) from depositor
 assets
• Secured on physical asset
• Risk assessed on basis of
 homeowner’s ability to pay (job
 prospects etc.)
    Securitazation of
       mortgages
• ‘Bundles’ of dissimilar mortgages
  sold on wholesale money markets
  (SIV)
• Funds recycled into further
  mortgages
     Securitazation of
        mortgages
• Probability of default affecting an SIV
  decreased
• Risk decrease - prices increase
• More funds available for house loans
• Riskier mortgages (sub-prime) issued
     The Bubble?


• The irrational belief that
 house prices would continue
 to increase.....
 The communication
     difference
• Electronic transfer of funds
• World Wide trading of SIV’s and
 CDO’s
• ‘Market sentiment’ turned quickly
The role of information

 1.Price of shares or contracts
   partially dependent on
   information
 2.ICT created a world wide market
   which could react quickly.
Significant difference


• Most former bubbles had limited
 impact in the wider economy
• Speed of crash was different
  Possible Regulation


1.(Re)separate retail and investment
  banking
2.Restrict the use/development of
  electronic financial markets

				
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posted:6/13/2012
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