Wednesday, December 26, 2012

Begun, the Bubble Wars have...

What's a "bubble"? Not in the soapy water sense, but in the financial or economic sense. Here is Investopedia on the matter:
1. An economic cycle characterized by rapid expansion followed by a contraction. 
2. A surge in equity prices, often more than warranted by the fundamentals and usually in a particular sector, followed by a drastic drop in prices as a massive selloff occurs. 
3. A theory that security prices rise above their true value and will continue to do so until prices go into freefall and the bubble bursts.
Nasdaq says something similar:
A market phenomenon characterized by surges in asset prices to levels significantly above the fundamental value of that asset. Bubbles are often hard to detect in real time because there is disagreement over the fundamental value of the asset.
Finally, we have the Financial Times Lexicon:
When the prices of securities or other assets rise so sharply and at such a sustained rate that they exceed valuations justified by fundamentals, making a sudden collapse likely (at which point the bubble "bursts")
The basic idea is that the costs for something go up at a drastic rate, costs that people/investors are willing accept, to the point that the current realistic value of those somethings is far surpassed. At that point, the bubble "bursts" as the market for the overpriced somethings collapses. The quintessential historical example is the Tulip Bulb Bubble in the 17th century Netherlands:
Bulb prices rose steadily throughout the 1630s, as ever more speculators wedged into the market. Weavers and farmers mortgaged whatever they could to raise cash to begin trading. In 1633, a farmhouse in Hoorn changed hands for three rare bulbs. By 1636 any tulip--even bulbs recently considered garbage--could be sold off, often for hundreds of guilders. A futures market for bulbs existed, and tulip traders could be found conducting their business in hundreds of Dutch taverns. Tulip mania reached its peak during the winter of 1636-37, when some bulbs were changing hands ten times in a day. The zenith came early that winter, at an auction to benefit seven orphans whose only asset was 70 fine tulips left by their father. One, a rare Violetten Admirael van Enkhuizen bulb that was about to split in two, sold for 5,200 guilders, the all-time record. All told, the flowers brought in nearly 53,000 guilders.
This may sound crazy to many people today, but note that part of what drove this bubble was variety: certain tulip bulbs were rarer than others, some exceedingly so. In some ways, the market was like the one for baseball cards. Rare bulbs commanded very high prices; because of that, investors were quick to speculate on other bulbs which had yet to become rare. And for another point of comparison, 1000 guilders in 1637 would be equal to just over $90,000 in today's dollars.

Then, quite suddenly, the tulip bulb market crashed:
It began in Haarlem, at a routine bulb auction when, for the first time, the greater fool refused to show up and pay. Within days, the panic had spread across the country. Despite the efforts of traders to prop up demand, the market for tulips evaporated. Flowers that had commanded 5,000 guilders a few weeks before now fetched one-hundredth that amount.
Following the collapse of the markets, tulip bulb growers were stuck with contracts for sales that no one wanted to honor. The Dutch government ultimately stepped in and rendered all of the contracts null and void by declaring them to be "bets," not legitimate contracts. Thus, the growers ate the losses in that regard, as did those who still held actual bulbs; many of those engaged in naked speculation were saved from making good on their promises to pay.

The Dot-Com Bubble at the end of the twentieth century (circa 1995 to 2001, or so) mirrored the Tulip Bubble in a number of ways. As was the case with tulip bulbs, growth in stock values for internet companies were fueled by naked speculation. And because of widespread success in the beginning--people accumulating small fortunes almost overnight--more and more people joined the fray, forcing prices higher and higher, as just about every start-up that had any sort of ptoential attracted flocks of investors.

Thus many of these internet stocks--in the form of IPOs--were for companies that had never turned a profit; they had potential maybe, they may have even had significant revenue streams, but their bottom lines were just not good. And like tulip bulbs, stocks in such companies were not purchased to hold, in the hopes that the company would grow and become strong. They were purchased in order to be sold for a profit, as quickly as possible. But the rolling effect of such strategies created a phony appearance of value in these companies, drawing in the gullible investor who believed the value was real and measurable, that the stock had an intrinsic value equal to or greater than it's market price (as was again the case for tulip bulbs).

To be sure, some of the companies that benefited from the Dot-Com Bubble really did have a strong future, and Google being two excellent examples of such.'s share price is instructive in this regard. From under $5 per share at the end of 1997, Amazon stock climbed to over $100 per share by the end of 1999, then plummeted back down to under $8 per share by September of 2001. From there, the stock began a long climb upwards; it now trades at over $250 per share. But again, this was the exception, not the rule, for internet-based companies in the Dot-Com Bubble era.

Late entrants into the Dot-Com game fared the worst, by far, when the end came, as did those still holding large amounts of Dot-Com paper (including institutional investors). Unlike the Tulip Bubble, there was no means of redressing losses, by and large. Many who made small fortunes and lived high on the hog for years came crashing back to earth, it is true. Companies went bankrupt, mutual funds and various brokers lost all kinds of customers, but all in all it was still just a collapse of a market sector.

The next bubble we might consider is the so-called Housing Bubble, which started at roughly around the same time as the Dot-Com Bubble (not un-coincidentally) and "burst" near the end of 2005 (depending on where one looks). What makes this bubble somewhat different than the other two is that the initial boom was in very distinct geographical areas. In fact, it began specifically in California--and somewhat in New York and South Florida--exactly where the Dot-Com Bubble was centered.

It might have remained somewhat limited, but due to a number of government policies and financial instruments (like MBSs and subprime mortgages), the nature of the housing market changed drastically. More and more people entered it, at one end or the other. Thus, there was naked speculation on home values (which led to "fipping") and naked speculation on the value of MBSs. The double-barreled nature of the speculation along with the breadth of impact the Bubble had (due to the sheer number of home owners, new and old) led to the more catastrophic bursting of the bubble, as it was the primary catalyst for the Financial Crisis of 2007-2008. And we're still dealing with the repercussions of all of this.

But now, there is a new Bubble du jour: the Education Bubble. Costs for higher education have been going up, up, up for years. It's a familiar theme among financial planners and a commone story in the media. Since 1983, the average total for tuition and fees at major universities has risen faster than almost any other economic metric, for instance five times faster than inflation:

And this rapid increase in costs over time coincides with a similar trend in the actual number of students. This indicates--on its face--costs increasing as demand increases in a traditional economics paradigm: more and more people want a college degree so degrees become more expensive. But those in the higher education field don't like to see it that way (despite their widespread inability to think outside such a limited economic box). They prefer to suppose that increased tuition costs simply reflect real needs. Why those needs have increased so dramatically--as opposed to everything else--they can never really say.

Regardless, the point is that everyone is told to get a college degree these days and such degrees cost more than ever before. Once upon a time, the net benefits of having a degree most definitely outweighed the costs. This is no longer a given. With potential student debt for just a four-year degree pushing into the mid five-figure range (or even higher), a failure to graduate can be catastrophic (graduation is not a given, after all). Even if one graduates, the accumulated debt can take years--even decades--to pay off, especially given rising costs in other areas. The last supposes one is able to find a job that pays significantly more than can be had without a degree, no longer a certainty in today's environment.

Yet, traditional colleges and universities have a virtual monopoly on degrees in the United States (which is why they can keep jacking up the cost). Given all of this, one could ask "how is this a bubble?" For it to be a bubble, it needs to be able to pop. What might bring that on? The answer (one we can thank Al Gore for): the internet.

Walter Mead at the American Interest--along with many others--points out that the times, they are a-changin' in the world of higher education, thanks to online coursework and online edeucation, in general:
But that’s all about to change. Online education, spearheaded by programs such as Coursera and EdX, is catching on faster than anyone anticipated even a half-decade ago, as millions of students take advantage of their new access to courses once offered only to a select few. Today, it is possible for anyone from Alabama to Indonesia to take a wide range of courses from MIT and Harvard, among others, and while these courses may not offer credentials, the most forward-looking schools are already looking for ways to address this issue as well.
Why pay outrageous tuition dollars for something that can be had online for a fraction of the cost. In fact, why pay for a degree at all, if the skills needed for an occupation can be had without the cost of a degree? The online Khan Academy offers all kinds of educational videos for, get this, free. It's mission statement:
The Khan Academy is an organization on a mission. We're a not-for-profit with the goal of changing education for the better by providing a free world-class education for anyone anywhere. 
All of the site's resources are available to anyone. It doesn't matter if you are a student, teacher, home-schooler, principal, adult returning to the classroom after 20 years, or a friendly alien just trying to get a leg up in earthly biology. The Khan Academy's materials and resources are available to you completely free of charge.
The founder is a former hedge-fund manager with degrees from MIT and Harvard, so it's safe to assume the content here is no joke. The only link missing for a massive bubble-pop is some level of acceptance in private industry of people so-educated, perhaps a means of testing proficiency in desired skills. Once that happens, once a few major companies decide skills are more critical than degrees, all bets are off.

Some people see the writing on the wall, though. In Texas, there is an initiative underway to create a degree program with a total cost of less than $10,000. It has garnered a lot of attention and a lot of praise. And justly so. But is it ultimately several decades too late? Survey says...probably.

Cheers, all.


  1. Great essay, except not one word on what makes such bubbles possible - nay, inevitable. Austrian Business Cycle Theory at least deserved a nod. ;)

  2. I almost quoted a Mises piece on the Tulip stuff, but decided it would create tangent that I wanted to avoid in this piece. :)

  3. Walter Mead had been harping on the higher ed issues ("the war on the young" he calls it sometimes) for a while now. Not long ago he made a post about people heading higher ed institutions, overwhelmingly liberal crowd who presume to lecture the rest on how things should be run, basically running their institutions into the ground.

    I also had an interesting discussion on possible new higher ed paradigms in an "entrepreneurship for engineers" class about half a year ago.

    It will be interesting what will happen in the next decade or so