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2021 | OriginalPaper | Chapter

2. The Story of the Original Boom and Bust in Western Finance: The Mississippi Bubble

Author : John E. Silvia

Published in: Financial Markets and Economic Performance

Publisher: Springer International Publishing

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Abstract

Excess in one market motivates change in other markets since prices in each of the four markets (goods, credit, equity, and foreign exchange) are mutually dependent. The illustration of these excesses provides light on real-world events and the movement of market prices. Prices reflect forward-looking expectations. When actual events differ from those expectations, prices move. Often one expectation is that when markets are shocked, prices will return to prior values—positive static stability. Yet, that is seldom the case as commodity prices as well as other prices, drift, or migrate to new set of prices, neutral static stability, or crash—negative static stability. Public and private sector actions and, imbalances between markets, generate shocks. Intellectual biases, such as the confirmation bias, the framing of risk, and illusory correlation, often limit responses to those shocks. These biases influence the boom and bust of financial cycles.

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previous chapter Why Finance Matters for Economics: The Story of Financing the Railroad

next chapter Price Determination in a Multi-Sector Global Economy

For a perspective on the housing situation early in the crisis see Robert J. Shiller, “Things That Go Boom,” Wall Street Journal, 2007, 8 (February).

One take on the links between finance and nominal GDP appears in Albert Wojnilower “Finance is the Original Sin,” April 12, 2016. Craig Drill Capital Newsletter.

Overshooting was initially put forth with the work on exchange rate by Dornbusch. Rudiger Dornbusch, “Expectation and Exchange Rate Dynamics”, Journal of Political Economy, 1976, 84 (December): 1161–1176.

See John E. Silvia, Dynamic Economic Decision Making, Wiley 2011, pp. 361–367 for prior applications for this approach. The original reference to the Hodrick-Prescott filter is found in R. J. Hodrick and E. C. Prescott, “Postwar U.S. Business Cycle: An Empirical Investigation,” Journal of Money, Credit and Banking, 1997, 29 (1): 1–16.

Trend-stationarity means that the difference between actual output and a deterministic trend is not explosive.

This unit root problem was identified, and a test developed, by D. Dickey and W. Fuller (1979), “Distribution of the Estimates for Autoregressive Time series with a Unit Root,” Journal of American Statistical Association, 74: 427–431; D. Dickey and W. Fuller (1981), “Likelihood Ratio Tests for Autoregressive Time Series with a Unit Root,” Econometrica 49: 1057–1072. These tests, and their applications, appear in Chapter 4 of Economic and Business Forecasting, John E. Silvia et.al., 2014 Wiley.

A state space approach is utilized here. See G. S. Maddala and In-Moo Kim, (1998), Unit Root, Cointegration and Structural Change. Cambridge, UK: Cambridge University Press.

Test employed here follows W. A. Brock, Dechert, and J. Schenkman. A Test for independence based on the correlation dimension. Working Paper. University of Wisconsin at Madison, University of Houston, and University of Chicago, 1996.

See for example, 2 Thomas Laubach and John C. Williams, “Measuring the Natural Rate of Interest,” Review of Economics and Statistics, 2003, 85 (4) (November): 1063–1070. Kathryn Holston, Thomas Laubach, and John C. Williams, “Measuring the Natural Rate of Interest: International Trends and Determinants,” Journal of International Economics, 2017, 108 (May): S59–S75.

The financial stresses of the 1990 period are reviewed in “The Capital Crunch: Neither a Borrower nor a Lender Be,” Journal of Money, Credit, and Banking, 1995, 27 (3) (August).

We shall discuss more on this later with reference to Governor Powell’s presentation at Jackson Hole in August 2020.

We shall see in Chapter 5 further evidence of the procyclical nature of credit availability.

The importance of illiquidity in financial cycles and crisis is discussed in Jean Tirole, “Illiquidity and All Its Friends,” Journal of Economic Literature, 2011, 49 (2): 287–325.

This particularly associated with the Challenger space shuttle disaster. See Diane Vaughan, The Challenger Launch Decision: Risky Technology, Culture and Deviance at NASA. Chicago: University of Chicago Press, 1996.

Even more recently, consider the case of Turkey and its policy shift. “In Turkey, Weak Lira Powers Fresh Gold Rush,” 09 14 2020 Financial Times.

A central bank reaction function refers to how a central bank will react to changes in its target variables such as inflation and unemployment. This is very evident in Governor Powell’s recent comment that the Fed will accept a period of higher inflation above its target of two percent.

This detrending procedure has its own limitations as cited by Timothy Cogley and James M. Nason, “The Effects of the Hodrick-Prescott Filter on Trend and Difference Stationary Time Series: Implications for Business Cycle Research,” Journal of Economic Dynamics and Control 19, 1955a (January/February): 253–278).

Licor Beirao is a very traditional after dinner Portuguese liquor.

In the case of the South Seas Bubble, The British King and Parliament passed the Bubble Act of 1720 which effectively limited other stock issuance in favor of the South Sea promoters and thereby funneled further money into that venture. See John Carswell, The South Sea Bubble. London: Cresset Press, 1960.

Charles P. Kindleberger, Manias, Panics and Crashes, Basic Books, 1978, New York, pp. 135–137.

Too much cash is chasing too few desirable assets, May 5, 2020, Financial Times.

Peter Bernstein, “Against the Gods,” Wiley, 1996. A classic read into the history of risky ventures and a reminder that all investments, and economic activity, involves risk. One of my most marked up books and one of the twelve must reads.

John Carswell, The South Sea Bubble, London: Cresset Press, 1960. In the case of the South Seas Bubble, The British King and Parliament passed the Bubble Act of 1720 which effectively limited other stock issuance in favor of the South Sea promoters and thereby funneled further money into that venture. This is an important lesson in the actions of government leading to unforeseen financial bubbles.

Rudiger Dornbusch, Open Economy Macro-Economics, Basic Books, 1980. A macro text that brings international economic behavior into the core macro curriculum. A book written by a dear friend and mentor who passed away too soon.

D. Dickey and W. Fuller, “Distribution of the Estimates for Autoregressive Time series with a Unit Root,” Journal of American Statistical Association, 1979 (74): 427–431; D. Dickey and W. Fuller, “Likelihood Ratio Tests for Autoregressive Time Series with a Unit Root,” Econometrica, 1981 (49): 1057–1072. These tests, and their applications, appear in Chapter 4 of Economic and Business Forecasting, John E. Silvia et.al., 2014 Wiley. Too many economic/financial graphs are used to illustrate patterns when, in fact, these graphs, simply illustrate a trend that needs to be adjusted to allow for causal relationships to be identified between economic series.

Niall Ferguson, “The Ascent of Money,” Penguin Press, 2008. A broader history than that of Kindleberger with a writer’s flair. Another of my most marked-up books and one of my twelve must reads.

R. J. Hodrick and E. C. Prescott, “Postwar U.S. Business Cycle: An Empirical Investigation,” Journal of Money, Credit and Banking, 1997, 29 (1): 1–16. A very useful technique to identify deviations from trend that economic and financial analysts will find useful in evaluating over and under valuation in markets.

Thomas Laubach and John C. Williams, “Measuring the Natural Rate of Interest,” Review of Economics and Statistics, 2003, 85 (4) (November), 1063–1070. Kathryn Holston, Thomas Laubach, and John C. Williams, “Measuring the Natural Rate of Interest: International Trends and Determinants,” Journal of International Economics, 2017, 108 (May): S59–S75. An essential read into the search for a “natural” rate of interest.

Charles P. Kindleberger, Manias, Panics and Crashes, Basic Books, New York, 1978. This is the essential first read on booms and busts—after Thomas Carlyle, of course.

G. S. Maddala and In-Moo Kim, Unit Root, Cointegration and Structural Change, Cambridge, UK: Cambridge University Press, 1998. A state space approach is utilized here to identify structural breaks. Much of the economic analysis in this book focuses on the post 1981 period since structural breaks in economic time series as pervasive between the inflationary 1970s and the disinflationary 1980s.

Title: The Story of the Original Boom and Bust in Western Finance: The Mississippi Bubble
Author: John E. Silvia
Publisher: Springer International Publishing
Book: Financial Markets and Economic Performance
Print ISBN: 978-3-030-76294-0

Electronic ISBN: 978-3-030-76295-7

Copyright Year: 2021
DOI: https://doi.org/10.1007/978-3-030-76295-7_2