How To Blow A Bubble

Matt Taibbi has rightly directed our attention towards the talent, organization, and power that together produce damaging (for us) yet profitable (for a few) bubbles.  Most of Taibbi’s best points are about market microstructure – not the technological variety usually studied in mainstream finance, but more the politics of how you construct a multi-billion dollar opportunity so that you can get in, pull others after you, and then get out before it all collapses.  (This is also, by the way, how things work in Pakistan.)

In addition, of course, all good bubble-blowing needs ideology.  Someone needs to persuade policymakers and the investing public that we are looking at a change in fundamentals, rather than an unsustainable and dangerous surge in the price of some assets.

It used to be that the Federal Reserve was the bubble-maker-in-chief. In the Big Housing Boom/Bust, Alan Greenspan was ably assisted by Ben Bernanke – culminating in the latter’s argument to cut interest rates to zero in August 2003 and to state that interest rates would be held low for “a considerable period”.  (David Wessel’s new book is very good on this period and the Bernanke-Greenspan relationship.)

Now it seems the ideological initiative may be shifting towards Goldman Sachs.

As Bloomberg reported on August 5th, “Goldman economists, led by Jan Hatzius in New York, now see a 3 percent increase in gross domestic product at an annual rate in the last six months of this year, versus a previous estimate of 1 percent. The new projections were included in a research note e-mailed to clients.”

Goldman’s public thinking, of course, has been that we face such slow growth that interest rates should be kept low indefinitely.  There is, in their view, no risk of inflation – and no such thing as potentially new bubbles (e.g., in emerging markets).  The adjustment process will go well, as long as monetary policy stays very loose – it’s back to Bernanke’s 2003 line of thinking.

This line of reasoning has been very influential – reinforcing Bernanke’s commitment not to tighten monetary policy in the foreseeable future and fitting in very much with the Summers model of crisis recovery.  Just a couple of weeks ago, in his July 14 report, Jan Hatzius argued, “further stimulus remains appropriate” and “the appropriate debate is not whether fiscal and monetary expansion is appropriate in principle but whether it has been sufficiently aggressive.”  I don’t know if he has revised this line in the light of the big upward revision in his growth forecast or whether he is still saying, “Ultimately, we do expect further stimulus, but it may take significant disappointments in the economic data and the financial markets before policymakers move further in this direction.”

Much faster growth than expected is, of course, in today’s context a good thing.  But it also brings complications.  If you keep monetary policy this loose for much longer, you will feed bubbles.  And if you encourage even looser monetary and fiscal policy, there will be a costly reckoning not too far down the road.

Monetary policy orthodoxy under Greenspan did not care about bubbles in the least.  Now we (led by Greenspan) have massively damaged our financial system, our real economy, and our job prospects, this view is under revision.

Of course, in principle you should tighten regulation around lending but, just like 2003-2007, who is really going to do that: the US, China, the G20?  On this point, all our economic leadership is letting us down – although they are getting a powerful assist from people like Goldman (and Citi and JP Morgan and almost everyone else on Wall Street.)

Next time, our big banks will take another massive hit – quite possibly bigger than what we saw in 2008.  Goldman and its insiders are ready for this.  Are you?

By Simon Johnson

34 thoughts on “How To Blow A Bubble

  1. Simon this is what you do best. A suggestion – You might nuance your understanding of how emerging economies function, because those who have not had this experience are probably unable to imagine and understand consequences and costs. One has a tendency to not pay much attention to the lack of a level playing field until one suffers the consequences of not having one.

  2. Actually, if you read the economic history of the United States, there is a long history of bubble making and conning the marks, with exception being the years from 1929-1969 when the New Deal consensus and a strong labor movement acted as a counter-balance to the Financial market. Whether Jay Gould or Tony Mozillo, the U.S. seems to produce these pied pipers that lead us over the cliff.

  3. Once again, GS is demonstrating its propensity – by now more of an entitlement – to be on all sides of any proposition with a scintilla of trading potential. Low interest rates at the discount, FDIC and other funding windows feed trading profits

  4. I sincerely hope that, to quote Douglas Adams, GS is “the first against the wall when the revolution comes.”

  5. Goldman’s public thinking, of course, has been that we face such slow growth that interest rates should be kept low indefinitely. There is, in their view, no risk of inflation – and no such thing as potentially new bubbles (e.g., in emerging markets).

    It sure looks like the whole system – administration, banks, and media – have already been trying to blow a new bubble with their zombie-bull stock market rally, goosed by fraudulent bank earnings reports and the green shoots propaganda campaign.

    (An example of Goldman’s role was its accounting trick of making December disappear.)

    The 100% artificial cash-for-clunker prop is another example, a violation of the DNR order history already signed for the “car” element of the car/debt civilizational model.

    Anything to get the sheep to start spending again, anything to make it look halfway plausible to start extending debt again.

    Yep, they’re searching for the next bubble which will:

    1. fleece the same consumer they’ve already fleeced twice in the last ten years,

    2. benefit from another massive wealth redistribution upward in the next round of bailouts after the next crash.

    (I don’t think they will be able to blow another such bubble, but that’s what they’re trying to do, since they have no other option. Given the debt/growth model, there is no longer any alternative to the bubble-crash, boom-bust cycle.)

  6. Supposedly, our economy relies heavily on consumer spending to grow (70 percent.)

    What I see now – an economy that shovels money to the financiers – and that’s it.

    At some point, (and right now, it’s looking sooner, rather than later) there will be no more middle class to pay for and prop up the profits sustained by Goldman, et al.

  7. The unique thing about the desire to re-inflate the bubble is that it represents a rare alignment of interests by three parties – Main Street, Wall Street, and Washington.
    For that reason I sincerely believe it WILL happen. The trick is that you can’t have mass delusion when everyone is looking for it. It will take some time, and will have to happen somewhere that people can convince themselves is legitimate.

  8. I’m not gonna play in their bubble factory. In fact, I’ve liquidated my mut fund and will be soon liquidating my other fund. No more stock (bubble) market for me. They want money? Print it for themselves because they aren’t getting mine (except my tax dollars, of course, and at this point I can’t do much about that).

    And no, I wont be joining in with any resurgence in borrow-and-spend either.

  9. Very insightful, Simon, as always.

    What you and Matt Taibbi are documenting is the boundary condition of the proverbial agency problem in economics and politics, a point to which the banks have taken this generation with such breath-taking alacrity. How did we go from massive profitability in 2007, when money was flowing like wine at a drunken orgy up and down Broad and Wall, to 2008, when we all donned sackcloth and poked among the ashes of what once was presumed to be well-functioning economies and markets? Could it be the “agency problem” writ large? Could be.

    The “research” function at GS and other banks is so entwined in the money-making part of the banks’ business — the part where they bid 100 for something that’s worth 150 and sell it at 200. How long would GS’s economics group remain employed if they put out research that caused the house’s position to take a huge loss? Would any of the bank trading desks not be loaded up on the “right” side of a research call before that research call is made public? At GS, JPM, C, MS, …, ? I highly doubt it.

    The “research” function is integral to the pump-and-dump they all work to assiduously to perfect, none moreso than GS, as MT and J.K. Galbraith so ably document. (See JKG’s book, The Great Crash 1929, and the CHAPTER he devotes to GS’s performance in 1929. It’s been a while since I read MT’s piece, but I think he missed one of the great pump-and-dumps of all time, as recorded by wikipedia on its GS page: “Goldman Sachs was one of the top 10 sellers of Collateralized Mortgage Obligations (CMO’s) and may have sold about $100 billion in CMO’s over the last two and a half years. But, by the start of the third quarter this year, those securities were being downgraded by the credit ratings agencies faster than any other subprime lender. According to a Reuters report, Citigroup’s research (June 22, 2007), stated “portions of Goldman’s GSAMP-issued bonds, which include subprime loans from a variety of lenders, have been downgraded a combined 69 times by Standard & Poor’s and Moody’s Investors Service in the year through June 15. Sixty of the GSAMP downgrades refer to classes from 2006 bonds,” Citigroup added, and Allan Sloane in The Washington Post stated that one of Goldman’s 2006 crop – the GSAMP Trust 2006- S3 – may actually be “the worst deal…floated by a top-tier firm.” One in every six of the 8,274 mortgages bundled together in GSAMP Trust 2006-S3 was already in default 18 months later. Whoever bought the S3 bonds will have either taken a 100% loss, or are waiting to sell it off at a heavy discount.” If someone could update those stats, it would be appreciated.)

    What we now see is the “research” function at these banks trying to affect policy and expectations to an inordinate extent. What could the goal possibly be? Well, among other things, they’re all still loaded up with Tier 3 assets — GS, for example, has, by its own suspect reckoning, has some $50-70b there, vs a market cap of what, $80-90b. Could it be they and their ilk need to reflate the bubble desperately? Could it be they’re not getting the assist they need any more from the media, as they did when every pronouncement of Abby Joseph Cohen’s was treated as if she was the Pythia herself? Could be. Could it be they’ve loaded up on even more toxic assets at “bargain prices” during the rout we’ve just been through, and would dearly love to see the gulls — those folks, er, customers, who believe GS’s “research” really is a disinterested assessment of reality — come in showing a bid for this stuff? Could it be the whole house is so full up on bullish macro bets that if we don’t see reflation they’ll tank? Again? Could it be every “bank” — and I use that term loosely — has the same position on? Could be. Could it be they all need to shake loose some dumb money to take all this drek off their hands?

    Could be.

    Could it be that nothing they say can be believed? Could be.

  10. I think we need to very, very careful of guys like Greenspan, Bernanke, Geithner & Summers. The talk like they’re smart, the look like they’re smart, they act like thet’re smart, but none of them are overly bright.

  11. This talk from Goldman fools no one, yet it is accepted anyway, and we proceed based on it.

  12. I suspect their schemes to blow more bubbles will not come into fruition this time around. A crucial component that allowed the formation of bubbles these past decades has been the US consumer, who increasingly abandoned savings and embrace debt and retail investing. This was all made possible by continually rising asset prices with which people could borrow against and also disinflation, which made debt cheaper to borrow.

    Now, it seems many of these factors are dissipating. Unemployment is at the highest it has been for a long time and it seems a portion of our labor and productive capacity will have to be permanently laid off to deal with the deleveraging that comes from decades of an overinflated world and lifestyle. Unemployment will make sure that people begin to save more, a crucial link in the schemes to blow bubbles.

  13. How can we defend ourselves from the wealthy and the powerful? How do we recapture our government?

  14. I’m more ready than I would have been without having insight from The Baseline Scenario…thanks!

  15. “What we now see is the “research” function at these banks trying to affect policy and expectations to an inordinate extent. What could the goal possibly be? Well, among other things, they’re all still loaded up with Tier 3 assets — GS, for example, has, by its own suspect reckoning, has some $50-70b there, vs a market cap of what, $80-90b.”

    The hedge funds are pulling their money from GS again.
    Last time GS was crying in the street, only Warren Buffet answered the phone.

  16. “The hedge funds are pulling their money from GS again.”

    No they’re not. Goldman is KILLING it in prime brokerage. You have no clue what you’re talking about.

    “Last time GS was crying in the street, only Warren Buffet answered the phone.”

    Wait, “only” Warren Buffet? The most respected and most financially secure private investor in the world was confident enough to inject $5bn of capital into Goldman while every other major bank was failing. That’s a sign of STRENGTH, genius, not weakness.

    The commentary on this blog is so awful that it’s just sad.

  17. Dude, having a personal data point re dealing with ole Warren, I can tell you Buffett makes Mack the Knife look like a Choir Boy. You’re better of going to the most ruthless loan shark you know than going to the Oracle of Omaha.


  18. Very sad. Such a flagrantly self serving analysis and forcast by Goldman. Obviously ridiculous, but designed to stimulate short covering in the stock market. If you can’t run with the bulls you can ride the turned coatails of the bears as they panic to escape from the hunters.

    Disgusting…. BTW – All credit in the WORLD to Matt Taibbi. Can you comprehend the courage it took to do what he did. An unbelievable act of patriotism!!!

  19. That’s why they guaranteed him 10 percent per annum for five years.They couldn’t get a dime from anyone, and confiscated 25 billion from the AIG second bailout. Warren Buffet lost 35 percent of his Berkshire Fund money in 2008, and hedge fund clients have pulled 25 percent of their money to date.

  20. Markets.aurelius: Well said. You realize, of course, that there is nothing new in this waterfall of insights, accurate as it is. It’s the nature of the sell side of the street. No experienced investor respects sell-side research (macro, sector, industry or company) for exactly the reasons you provide. Only the financial press and politicians use it. Oh, yes, the registered reps use it to flog their “clients” and prospects into transactions.

    The press uses it because they don’t have the time, tools, aptitude, education, experience or budget to do research of their own, and their mission is to “report”, not to evaluate, anyway. So, they lean on “sources” for cognitive activity more complex than choosing the stories most likely to sell whatever medium they’re publishing in, which function they reserve for their editors, who are directed by the media owners to publish the stories that increase readership (to sell more ads for higher prices).

    Politicians use it when it supports their presuppositions about how the world works, regardless of how actual events evolve, and when it will help them get or retain votes by quoting “authorities” who agree with them. It’s analogous to using the bible to appeal to evangelical christians or catholics. The priesthood and the temples are just different. The politicians, as are the journalists, are just preserving their jobs. (My apologies to those journalists who genuinely investigate and research their subject. In the financial press, there are maybe two of them left. Fortunately, there are many in other areas, Judy Miller and her co-reporter excluded from this apology)

    Simon, James, other bloggers (Krugman, deLong, etc.), several commenters on this blog and other blogs have noted the extreme danger of populating a federal agency or agencies with so many (actually, one is too many) still-practicing alumni(ae) of this particular priestly order. Of course they’re experts in the practice of their religion. But, they have a common agenda that excludes everyone who is not a card-carrying member of their club. They may say that they realize that the economic game is not zero sum and that acting for the common good lifts their quality of life, too, but, they don’t believe it. This agenda makes their expertise more dangerous, not more desirable.

    Their agenda is to ensure that the lifestyle they’ve achieved (“earned” in their parlance) remains constant or improves. Of course, that’s everybody’s agenda. One of aspects of living that makes it worthwhile is diversity (variety is, after all, the spice of life). We all have different ideas about what makes a good life, about how to use our time best and what constitutes fun or gratifying activities and outcomes. These people are willing, when certain choices must be made, to choose that course that benefits themselves the most in the shortest, narrowest concept of benefit achievable.

    This conflict isn’t just about GS or MS or JPM. It’s about Merck, Pfizer, Toyota, Mercedes Benz, Societe Generale, Ford, Microsoft, Intel, etc. And it’s about Harry Reid, John Boehner, et al. But, in this particular discussion, it’s about the power of a single belief system as enacted by the priests (high and mid-level) belonging to a particular religious order to influence or control the lives of this population (sheep?) unduly.

  21. Unbelievably, the President, the Congress, and the Supreme Court swear an oath to the US Constitution…

    …so do the armed forces.

  22. The Goldman Sachs prophecy is no mistake. Remember, for a while, propping up public confidence can hide the essential problems, kind of like getting a terminally ill patient convinced he is going to live. If you can convince him, by scientific fact, he will actually live longer than otherwise.

    Well, we will live, for a while, and then the second of the inevitable double dips will happen. The high rate of unemployment will drive down almost everything, but causing more defaults (mortages, car loans, credit cards), restricting the ability of the average citizen to spend, and causing more drains on public programs, such as Medicaid, unemployment, etc., and by causing a sharp drop in state and federal tax revenues. By sometime next year, the GDP will lose all momentum, and GS and the others will experience the drain of toxic asset failure. And, guess what, there will be NO

  23. A Bubble is a Ponzi Scheme, pure and simple. A Ponzi Scheme would be exposed by an honest book-keeping system well before the collapse. Honest book-keeping is what is missing in today’s culture. If we don’t bring it back we will not be a culture.

  24. Charles,

    Ah yes, ‘research’ is indeed propaganda. Nice comment, gets to what are the drivers of the market and our current predicament. Could have gone a bit deeper to the inherent problems of other peoples money and a fractional reserve regime in the instance of a fiat currency.

  25. While expanding the money supply right now is obviously not inflationary as we are in the contraction-deflation phase of our economic cycle, it does nothing about the cause of the problem in the first place.
    Which, if you take one step back from the macro-view, that is, even further removed, you will see that the cause of the problem is the failure of the fractional-reserve, debt-money system.
    It is a broken, insolvent system.
    It is a system that REQUIRES ever-expanding levels of debts so as to repay the debts that create ALL the money in the system.
    Simon, like Joseph, Paul, Jamie and Dean all suffer from the bizschool myopia of neoclassic liberal economics – they have not yet met the enemy.
    It is their private central bank dominated fractional-reserve debt-money system.
    Take a look, gang.

  26. I agree with you but would add that the alignment of interests is a desperate hope in restarting growth, which expansion holds the American psyche together. If growth has physical limits what is the meaning of “life, the universe, everything?”

    It looks like we’ve reached peak oil -as Greenspan hinted to the WSJ in Dec 07- and totally changes the future. Ultimately, money is not what keeps us alive -natural resources do.

  27. What people don’t seem to understand is that we are already in a new bubble – the tax payer bubble. The stimulus (tax payer money) programs have inflated equity prices again to such a degree that they will likely pop.

    Firstly, China is a huge example, with stimulus and loans going to businesses who decided that they didn’t want (or need) to better their companies but instead invest it in the stockmarket. Note 100% increases.

    The US is the second, banks that reinflated equities instead of tackling their massive, domestic Real Estate and Commercial Real Estate losses.

    No other time in history have we seen in so many countries close to 100% GDP debt, apart from World Wars. That is what we are in, a world financial War.

  28. Only in the movies and storybooks do the bad guys actually pay. In the real modern world, selfish psychopath “leaders of industry” win, run off with the money, and leave the honest folks stuck with the bill. The honest folks work off all the damage, and the psychopaths show up again to reap the benefits when times are good.

    It’ll happen again this time too.

  29. “Unemployment will make sure that people begin to save more, a crucial link in the schemes to blow bubbles.”

    Probably, you mean: to bust bubbles (as in the 2nd sentence you write about abandoned savings allowing the bubbles).

    Geithner/Bernanke/Summers/Blankfein want to reflate and *not* to bust bubbles: Bernanke ‘prints’ money, gives/loans it for free to GS et al., who rally the equity markets.

    And while the banks get a huge spreads, they do not give any of it to customers: borrowers still pay a high interest rate, but savers only get a low interest rate. Banks profit from both types of customers.

    Borrowers and savers would both be much better of connecting directly with each other, instead of via banks as middleman!!!!

    With interest on savings accounts at banks almost ZIRP, Bernanke et al. stimulate people to move their money from savings accounts into the equities markets, thereby continuing the rally.

  30. Greedscam — assuming his line of ‘thinking’ is still prevalent within the FEDs — laid it all bare in his article published in last month’s FT:

    “The rise in global stock prices from early March to mid-June is arguably the PRIMARY CAUSE of the surprising positive turn in the economic environment. The $12,000bn of newly created corporate equity value has added significantly to the capital buffer that supports the debt issued by financial and non-financial companies. Corporate debt, as a consequence, has been upgraded and yields have fallen. Previously capital-strapped companies have been able to raise considerable debt and equity in recent months. Market fears of bank insolvency, particularly, have been assuaged.

    … huge unrecognised losses of US banks still need to be funded. Either a stabilisation of home prices or a FURTHER RISE in newly created equity value available to US financial intermediaries would address this impediment to recovery.

    Global stock markets have rallied so far and so fast this year that it is difficult to imagine they can proceed further at anywhere near their recent pace. But what if, after a correction, THEY PROCEEDED INEXORABLY HIGHER? That would bolster global balance sheets with large amounts of new equity value and supply banks with the new capital that would allow them to step up lending. Higher share prices would also lead to increased household wealth and SPENDING, and the rising market value of existing corporate assets (proxied by stock prices) relative to their replacement cost would spur new capital investment. Leverage would be materially reduced. A PROLONGED RECOVERY IN GLOBAL EQUITY PRICES would thus assist in the lifting of the deflationary forces that still hover over the global economy.

    I recognise that I accord a much larger economic role to equity prices than is the conventional wisdom. From my perspective, they are not merely an important leading indicator of global business activity, but A MAJOR CONTRIBUTOR to that activity, operating primarily through balance sheets.”….

    For all clarity: Greedscam is on everybody’s top 10 list of most disastreous people, but when he writes that a prolonged recovery of global equity prices will end this crisis and enable economic activity again, one better takes note: His former colleagues are printing money, giving it for free to investment banks, who rally the US stock markets (EU follows slavishly, Asia also typically follows), and now fund managers are buying (having missed a huge part of the rally; don’t want to miss out even more), so their printing has now started a self-fulfilling prophecy.

    The $ 50 trillion (yearly world econ.) question is: will/can consumers start borrowing again, to get to the status quo ante? or do we get a new, living within our means lifestyle?

  31. ________

    Read “Bernanke’s Dark Kingdom.


    I am going to show here that central banks have excessive powers which are coherent neither with democratic principles nor with morality. Their existence can not be justified from a mathematical point of view.

    Worse, in light of the exercise of their extraordinary power by Bernanke, I argue that they can pose a real threat to democracy, peace, privacy and individual freedom.

    Because of the immediate dangers that are evoked in these lines I strongly suggest that you reproduce my deeds.

    My Yield Curve.


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