The question I have been pondering for a while now is why did we witness 3 bubbles in the last decade. First the tech bubble of late 1990s, followed by the housing bubble and the current credit bubble. A common thread connecting the three apart from excessive leverage and greed, is the lack of value creation. Through out history society has evolved through science, innovation and technology. James Watt invented the steam engine that mobilized transportation and powered the industrial revolution. Global economy benefited as a result. All through the 20th century great inventions fueled the global economy. Inventions like telephone, airplanes, television and automobiles brought the world closer and gave rise to new sectors in economy; creating jobs, increasing productivity and bolstering society.
Unfortunately cutting edge inventions have not come through the last 30 years with the exception of internet. Education has not kept pace with growth in technology and science; and society tends to identify more with Britney Spears than with Thomas Alva Edison. But money needs to be invested somewhere and investors see mirages (illusionary value). Spotting of water leads to booms, when identified as mirage leads to busts. The amplitude get magnified by excessive leverage. To further fuel this problem lawmakers who neither understand the problem nor are prompt in addressing issues. Regulations tend to come orthogonal to booms are busts. They are loose when there is a bull market and become over-regulated when there is a bear market. A framework thats meant to fail efficiently.
Speaking of efficiency, the efficient market theory that we all learnt in school has two critical assumptions; rational expectation of human behavior and de-correlation of major events. Nash states equilibrium is achieved when people do what's best for themselves "in the interest of common good". Human mind fails to apply the latter clause. Had politicians and policy makers followed these principle, the world wouldn't have witnessed many catastrophic events. Failure of Lehman is an instance in point. Even if the holes to plug in the economy were identified, it will not get smoothly and quickly. My concern is that the $850 bln bailout package will not only be inadequate but also will not be wisely spent.
What we need is a globally coordinated set of monetary and fiscal policies to address the issue. This is a global problem not just an American or European one. In market, look for increased failures in retail and consumer discretionary sector, followed by entertainment and broadcasting companies. Look for even worse labour market numbers and unemployment rate to edge towards double digits by mid 2009. This necessarily does not imply a downward spiral in stock prices. To break the 850 support on S&P, market needs increased failures and contracting financial sector. But in the long term unless sustainable value is created, there will be more bubbles.
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