Market Bubbles

For the purpose of explaining a market bubble, I’m going to use the example of comic books. I do this because bubbles can form around any economic activity. It’s not just the stock market which can form a bubble — as the housing crisis demonstrated.

Let’s say that we have a world with 10,000 people in it. 1,000 of those people like to read comics and each would like to collect the complete set of each of their favorite comics. Unfortunately, early issues of comics are scarce because they were unknown titles with no audience following. Printing off a lot of them, at the time, would have been silly. But with a growing audience and ever growing number of issues being published, the total number of people who want the full series from the start is more than is physically possible (assuming that new copies of old issues can’t or won’t be made, which we will assume).

Within our smaller market of 1,000 people, it will be fairly well understood that if you want the first issue of Superman you’ll probably not be able to get it unless you’re quite wealthy. If you happen to be someone fairly poor who collected Superman when you were young and still have it today, it’s very likely that one of the wealthy comic collectors will offer you a value that you simply can’t refuse, and subsequently he most likely won’t let it go for any price. But, as soon as our poor comic fan gets this money, he will almost certainly instantly turn around and buy old issues of some of his personal favorite series that aren’t so popular as Superman. In end result, the market for comic books isn’t profitable for anyone. The use of money allows the series to be distributed around according to wealth and fandom. All money gained is immediately spent. The amount of money that is in the comic market is limited to how much the actual fans of the comics have and are willing to spend on their hobby.

Now, let’s say that a non-comic book fan inherits his fathers old comic books. He discovers that there’s a market for these books, so he goes and sells them. While doing so, he discovers that some of them are worth fairly significant amounts of money and that due to the growth of audiences, one can buy comics, sit on them for 10-30 years, and sell them for up to thousands of times the cover price. If he was to embark on this bit of financial speculation, he wouldn’t be doing so to get his favorite comics, but rather for the purpose of making money based on his observation of how the market works.

A person can, essentially, make money like this. He’ll profit off of the comic book fans, leaching money from their contained economy, which money he’ll spend in the general market, and which eventually makes it back to the comic book fans so that things are more or less even.

The problem comes when a significant number of people come in to try and profit from the comic book market. Instead of buying and selling from fans, they’re liable to purchase from each other and that is a problem.

Let’s say that 80% of our comic book fans have $1 per day that they are willing to spend on their hobby. A further 20% have $10 per day that they are willing to spend. The total market is $2800 per day and that doesn’t change with time. Now a speculator comes in and buys up a significant number of comics that he thinks will be big sellers. He is willing to pay however much he thinks he can pay and still make a profit, not based on his personal budget compared to his level of fan-love for those titles. Now he waits 10 years and goes to sell them. If there he finds someone else who thinks he can make a profit if he takes those and waits another 10 years, he might sell to that person. Ultimately, the total amount of money in the comic book market might be double or triple the natural value of $2800 per day. Eventually, the prices become so high that the fans can’t afford to buy the comics anymore and all of the market action is between people who have no interest in the product. And at that point, it becomes only a matter of time before everyone realizes that there isn’t a guaranteed end-purchaser. Their only hope for selling the comic books that they have stored up is by finding someone else who isn’t aware that there’s no guaranteed market for the item and selling it to him, and of course as the panic hits and news spreads, that becomes impossible.

In the end, there was only $2800 per day to be made and the only way to guarantee that there would be someone who would want to buy the comic books you had was by maintaining the market at something near its natural equilibrium.

Overall, this seems to imply that speculation is inherently a broken process. Many markets can be grown by speculation as pointed out in several blogs (1, 2, and 3). But even in such a market, there is a true level of more-or-less guaranteed returns above which you’re just playing find-the-greater-sucker so far as fiscal realities go.

The people within the comic book market may have acted like the speculators all along, but their gambles were based upon an inherent knowledge of realistic returns gained by being part of the actual market and seeing how it moved from day-to-day. They don’t bank on being able to make more than is realistic because they actually know what is and isn’t realistic. The problem with the outsiders isn’t so much that they entered the market, but that their valuation of the products wasn’t based on much knowledge of the fundamentals of the size of the market or its capability for growth. They just knew that other people were speculating, and this they should buy in too. They didn’t know how much was reasonable to put in to the market, they just threw in however much they had lying about that they felt alright to gamble with — which is an essentially arbitrary value. If the total quantity of money invested is significantly larger than the market is worth, then everything comes crumbling down.

But then the question becomes, where did all the money go?

The only way for money to “disappear” is for it to be paid back against debt. When you over-speculate in a market, for instance by buying up comic books, that money is going to other people who (mostly) spend it on perfectly rational endeavors. Essentially, everyone who was wiser is richer for it.

The problem is that money is only spent with the expectation of more money coming back in at a later time. There is the expectation of future growth.

Say that a small money lender, Jeff, loans Tanya $50 to buy comic books. Another man, Berkley, comes to Jeff and asks for a loan to buy a bicycle so that he can travel all the way to a better job making more money. Jeff is expecting to be able to make something like $70 from Tanya. Berkley came in at this point to buy the bicycle because he’d already made $50 selling a few comics at insane prices to some crazy lady and with that $50 and a loan of $70, he’ll be able to buy the bicycle and get the job making enough money to pay off his bicycle.

Jeff checks with Tanya and finds out that she can’t find a buyer and she has to default on the loan, and subsequently he declines to give Berkley the loan for the bicycle. Jeff takes all of the comic books away from Tanya and sells them to Berkley for $10 (their true value), but Berkley still holds most of the money that Jeff needs to get out of debt — currently at a total of -$40. Berkley could still afford to pay Jeff something like $85 in exchange for a loan of $70, which would get Jeff up to only -$25 of debt, but he’s worried about worsening his debt when he doesn’t have any money sources at the moment and is already in debt himself. Berkley has enough extra money — $40 with no useful purpose since he can’t afford the bike — that he could lend or even give to Jeff to get him out of the hole, but he’s not a money lender. He doesn’t feel safe in knowing where to speculate with his money that he could likely recuperate it, nor is he set up to do so.

Now, theoretically, the government can step in and either loan Jeff money or simply clear his debt. If they loan him money, over a long enough time period, eventually Berkley’s excess $40 will trickle its way back to Jeff so that he can catch up. If they clear his debt, they are effectively printing money and devaluing the money base — which might be looked down upon by other people as if Jeff lent money to bad investments once before, he might do so again and continuing to devalue the money base leads to a loss in market confidence as well. Though as this is expanding the fundamental money supply (as I termed it), no actual debt is taken on by the government in doing this.

Essentially, the more popularly accepted answer among economists has been for the government to loan the money as this solution makes everything balance out alright in the end. Of course, it ignores the fact that you’re loaning money to someone who has lent money to bad investments once before. It’s not terribly clear why humanity seems to think that this somehow makes it better, but so it seems to do.

In truth, neither solution is particularly better or worse than the other so far as the economics go. The only question is whether Jeff istruly  safe to prop up, and whether either solution will get Berkley to get back into the game instead of holding on to his excess $40, waiting for things to clear.