Introduction to Bubbles: August 13, 2017 Snippets
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Today’s theme: What are bubbles? Unpacking what we think we’re buying, and what we’re willing to pay for it.
In the last few weeks we’ve talked a lot about cryptocurrency — we hope it’s been useful as we begin to explore those fundamental concepts like decentralization, consensus, and skin in the game. Starting this week we’re going to take a break from crypto for a few weeks to talk about a different but topically related subject: bubbles.
Today we’re going to talk about bubbles in financial economies: an introduction to what they are, why they form, and why they’ll keep forming. Next week we’re going to talk about why bubbles can be very useful, and how they drive the innovation economy we know today. Then we’ll take a detour and talk about how the bubble-fueled innovation economy looks a lot like another complex system that we see in nature — the immune system — and why they both evolved that way. And finally, we’ll return to the present and look at how software accelerates and intensifies bubble dynamics — and what it means for the current crypto bubble, among other things.
So what exactly are bubbles? Generally speaking, bubbles are phenomena that form when the price of something becomes convincingly detached from its real value. As Warren Buffett reminds us: “Price is what you pay; value is what you get”; bubbles are what happens when the two get radically disconnected from one another. There are two sides to the coin:
The first element of a bubble is our pursuit of future profits and comfort with risk taking. After all, if we weren’t greedy, there wouldn’t be any bubbles. The great economist Hyman Minsky articulates this well in his classical paper on bubbles from 1992:
Minsky’s hypothesis states that one of the primary drivers of bubble economics is the fact that investors and bankers, not just the businesses they fund, are interested in maximizing economic profit and will therefore naturally gravitate towards more and more “innovative” and risky financing so long as good times persist. Minsky describes three phases of financing dynamics: “Hedge”, “Speculative” and finally, “Ponzi”. The initial, most conservative “Hedge” mode of financing is when financiers give out a loan to finance a business whose cash flows are fully capable of paying back both the interest and the principal. The second phase, “Speculative” mode, is when entrepreneurs come back for a riskier loan, where the cash flows can pay back the interest but not the principal — the loan will have to be extended or rolled over to keep the lights on when the time comes. The final phase, “Ponzi”, is when we agree to make the third loan: into a project where neither the interest nor the principal can be paid back with real cash flows, and the entrepreneur must either sell assets or borrow more money simply to make their interest payments. When we reach phase three, that’s when we know we’re really in a bubble and things are inevitably going to fall apart. This logic can be extended beyond debt and into equity bubbles as well: from value investing to growth investing to purely bubble-driven companies with no real business plan and no path to profitability.
The second element of a bubble is the prices that we are willing to pay for those expected future profits. In Economics 101, we sit in class and learn that when prices go up, demand is supposed to go down. Then we enter the real world, and we discover that this isn’t always true — especially in financial markets. Prices in markets turn out to have two roles: they tell us something about the past, and they influence our actions — and therefore, their own price — in the future. Sometimes, in a big way, this dual role makes a particular asset class — tulip bulbs, railway stock, Canadian real estate, a digital token — become attractive solely because its price is going up. George Soros characterized and mastered this phenomenon, known as Reflexivity: when our views and our actions reinforce each other. If an expensive price means that something is high quality or otherwise attractive, we will tend to buy more of it and drive the price higher, independently of whether or not the thing is any good. It’s true for sunglasses, it’s true for ICOs, and a whole lot more.
Furthermore, rising prices can impact not only our desire to buy more of something but also enable our ability to purchase it. Consider a bank who’s allowed to use a set amount of leverage. As the market rises, their assets get more valuable, so they’re allowed to borrow more. In other words, the reward for assets rising is getting to buy more of those assets; like a pie-eating contest where the prize is more pie. This is the other side of the bubble-nomics coin.
These two elements — our pursuit of increasingly ambitious economic returns and the rising prices we’re willing (and able) to pay for them — combine to form a positive feedback system: prices go up, and up, and up, until they can’t anymore. Like any positive feedback system that drives perception and reality further and further apart, the phenomenon cannot continue forever. Eventually participants will recognize reality and sell, run out of money to pay their interest, or both — and the bubble pops. The whole cycle goes into reverse: our psychological perception of price plummets on the one hand, and our tolerance for risk taking plummets on the other.
But in the meantime, sometimes, something decisively important has happened: we’ve built something. We’re left in the aftermath of the bubble with something actually useful: canals; railways; electrification; fibre optic cables. Next week we’ll talk about that special category of bubbles — the productive ones — and how they fuel the innovation economy we know today.
Update: you can find the following week’s post here.
More on what cryptocurrency is, and isn’t:
Conversations with entrepreneurs:
Shifting values and their consequences:
Other reading from around the Internet:
In this week’s news and notes from the Social Capital family:
The state of Kansas is now officially powered by Airmap. Announced this past Tuesday, Kansas is now using Airmap for aerospace management across the entire state, establishing the next phase in development for drone operators and any number of unmanned flight applications: agriculture, search and rescue, construction, package delivery, and more.
The announcement comes in advance of Airmap’s planned rollout to fifty airports across the United States to perform automated, autonomous airspace control in collaboration with the FAA — including major airports like Miami International Airport and Phoenix Sky Harbor. Stitching together all of this airspace and its different requirements — from low altitude to high altitude, near cities, near airports — takes a lot of time and patience to get relevant stakeholders all in agreement, but the resulting opportunity it unlocks is tremendous. You can keep up with Airmap’s progress at their blog here, which is fun to keep tabs on for both drone enthusiasts and the rest of us.
We also have a fun problem to share with you from Brilliant, via contributor Laszlo Mihaly:
Four boats are on a large lake arranged so that they form the corners of a square of edge length l = 1 km. At time zero, each boat starts moving at a velocity of 10 km / h such that its bow is always pointed directly towards its counterclockwise neighbor:
How long will the boats take to collide (in minutes)?
If you can solve the answer, we suggest submitting your solution to see if it’s right — and maybe try a few more, or even sign up for Brilliant’s 100 day summer challenge. Their weekly problem sets are more than just fun brain teasers though — they’re one of many ingredients for Brilliant’s global community for STEM learning, all around the world. People of all ages, who may not have access to traditional textbooks, courses or support systems, are discovering that they’re passionate for science, engineering and math through Brilliant’s great work. Genuine talent and dedication to learning aren’t confined to any particular place, or age, or background — nor is it ever capped at a certain number of people or a certain limit of enthusiasm. It’s a special community of people who will one day make their impact on the world felt. If you’re interested in becoming a Brilliant team member, they’re currently hiring for a number of open positions — you can email email@example.com to find out more. You can also find out more about Brilliant’s mission by watching founder and CEO Sue Khim’s TEDx talk, reading their principles, and hearing from their members.
Have a great week,
Alex & the team from Social Capital