The Easiest Bubble Spotting Around

Despite their bubble-like growth, we’ve recently discussed the investment potential of emerging markets. Similarly, we’ve looked at whether certain bubbles, like housing in China, are real or not so real.

Today, in that same vein, we consider economics professor Kenneth Rogoff’s nuanced view of bubbles and how we can learn to spot them as an ongoing and pernicious phenomena.

From the Financial Times:

“In the classic bubble, an asset (say, a house) can have a price far above its ‘fundamentals’ (say, the present value of imputed rents) as long as it is expected to rise even higher in the future. But as prices soar ever higher above fundamentals, investors have to expect they will rise at ever faster rates to make sense of ever crazier prices. In theory, ‘rational’ investors should realise that no matter how many suckers are born every minute, it will be game over when house prices exceed world income. Working backwards from the inevitable collapse, investors should realise that the chain of expectations driving the bubble is illogical and therefore it can never happen. Are you reassured? Back in my days as a graduate student, I know I was…

“The answer, as Carmen Reinhart and I demonstrate drawing on centuries of financial crises, is to look particularly for situations with large rapid surges in leverage and asset prices, surges that can suddenly implode if confidence fades. When equity bubbles burst, investors who made money in the boom typically swallow their losses and the world trudges on, for example after the bursting of the technology bubble in 2001. But when debt markets collapse, there inevitably follows a long, drawn-out conversation about who should bear the losses. Unfortunately, all too often the size of debts, especially government debts, is hidden from investors until it comes jumping out of the woodwork after a crisis. In China today, the real problem is that no one seems to have very good data on how debt is distributed, much less an understanding of the web of implicit and explicit guarantees underlying it. But this is hardly a problem unique to China.”

Rogoff sees the coming bubble in sovereign debt, and the unique complexities associated with it… both as opposed to equity bubbles, and with the special additional concerns found in emerging markets like China.

He also cites how “huge off-balance-sheet guarantees and borrowings remain hidden for political expedience around the world.” Clearly, this has been a major problem in Greece… but, hopefully it’s not a problem we’ll have crop up at home in the US anytime soon.

You can read the full details in Financial Times coverage of how bubbles lurk in government debt.


Rocky Vega,
The Daily Reckoning