Anatomy Of A Market Bubble


  • Malinvestment best explains the US economic policy over the last 35 years - a policy that has produced three major market bubbles.
  • Misallocation of debt created new money – first into housing, and then into stocks – has produced two market bubbles since the turn of the century.
  • $10 trillion in new money has been created since the onset of the recession in 2008 with roughly 65% of it driving stocks and 35% driving the economy.
Market bubbles are the result of supply and demand just like any other dynamic that occurs in the world of economics. Bubbles are best described by what the Austrian School of Economics refers to as "malinvestment." Malinvestment is best explained in the following excerpt borrowed from Wikipedia:
In Austrian business cycle theory, malinvestments are badly allocated business investments. due to artificially low cost of credit and an unsustainable increase in money supply. Central banks are often blamed for causing malinvestments. Austrian economists such as Nobel laureate F. A. Hayek advocate the idea that malinvestment occurs due to the combination of fractional reserve banking and artificially low interest rates misleading relative price signals which eventually necessitate a corrective contraction - a boom followed by a bust.
The concept dates back to at least 1867. In 1940, Ludwig von Mises wrote, "The popularity of inflation and credit expansion, the ultimate source of the repeated attempts to render people prosperous by credit expansion, and thus the cause of the cyclical fluctuations of business, manifests itself clearly in the customary terminology. The boom is called good business, prosperity, and upswing. Its unavoidable aftermath, the readjustment of conditions to the real data of the market, is called crisis, slump, bad business, depression. People rebel against the insight that the disturbing element is to be seen in the malinvestment and the overconsumption of the boom period and that such an artificially induced boom is doomed. They are looking for the philosophers' stone to make it last."
On the subject of malinvestment, Mises and Hayek got it right. But that isn't really the end of the story. We can't summarily dismiss the Keynesian School and adopt the Austrian School as the "be all, end all" on the matter. It is indeed true that when Keynesian stimulus is taken too far or misallocated we create market bubbles that are followed by market crashes. On the other hand, the Austrian School's thinking on money supply is far from being a magic elixir that solves all problems.
An example of the flaw in the Austrian School's thinking is that money should be gold backed. That necessarily avoids the depreciation in the purchasing power of a nation's currency in that it makes money scarce by definition. In fact, under a gold backed currency system the opposite is true in that the value of money would be driven sharply higher as a result of its relative scarcity in relationship to population increases that increase production capacity.

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