FOREVER BLOWING BUBBLES

We’ve had an intense fascination with blowing bubbles since the day we’re born. Whether it’s soap bubbles, balloons, bubble gum, we’re forever blowing them, the more the better, the bigger the better. We watch in awe and anticipation as the bubble gets bigger and bigger, and we snap back in excitement (and a little surprise) as the bubble bursts, often in a messy and dramatic fashion. Did we not expect it to blow up? Then we blow another one. and another.

It’s quite the similar story with adults in the financial world: we create, often through breakthrough financial engineering advances, investment opportunities that look too good to pass up, we fuel the bubble with a toxic mix of greed, cheap credit, intense lobbying, and minimal regulation, we market the opportunity as a low risk/high return affair (as if this concept actually ever existed in real life), and we feed it to the people who can least afford it, sometimes forcefully, sometimes fraudulently. And finally, when the bubble bursts, we borrow the government’s bailout mop to clean up the mess left behind. History is riddled with financial boom-bust-bailout episodes, and one does only need to look in the recent past for some of the more striking examples of leveraging and excess gone wild. It has even been shown in a rather comprehensive and thorough way by Reinhart and Rogoff in their excellent seminal treatise on the history of financial crises that this boom-bust cycle has been getting shorter and shorter, with more devastating consequences and spilovers on the global economy (you can download the entire excellent dataset of the book for free here).

So you wake up every morning and you wonder “What is the next financial bubble, how big is it, and who’s blowing it?”. Or maybe you don’t, but you should, since we’ve already experienced in very stark detail (and still do) how someone else’s big messy pile can quickly turn into your own sour bill to pay. And like with every other question I have, I turned to Google search to get started on an answer. I typed “next financial bubble” in the search box and got the following random candidates for the US economy, in no particular order: derivatives, student loans, credit card debt, the stock market (and more recently social media stocks), and healthcare. There are many more bubbles outside the US market, like commodities, China, emerging markets, and other lurking risks, but we can examine those in a different post.

The the $1.2 quadrillion (one thousand trillions) derivatives market has been dubbed “one of the biggest risks to the world’s financial health”. It’s complex, it’s unregulated, and it ought to be of concern that its notional value is 20 times the size of the world economy (note though that we’re talking here about notionalvalues, not net values). U.S. commercial banks currently hold a notional value of $244 trillion in derivatives, with Net Current Credit Exposure of commercial banks to derivatives of $353 billion (due to bilateral netting), and that’s the number we’ll use for the US market. See the latest OCC report for further details. College tuition costs are soaring and forcing the young to bear obscenely high levels of student loan debt, while a ballooning $1 trillion student loan bubble shares a strikingly scary resemblance to the toxic subprime mortgages of six years earlier (and are just as likely to be repaid). Credit card debt is as american as apple pie, and rising healthcare costs prompted ObamaCare, while stock market bubbles are a recurring and familiar scene. While the U.S. Higher Education, credit cards, and healthcare bubbles aren’t an asset bubble like stock or real estate bubbles, it is a bubble-like phenomenon with very similar risks and implications as asset bubbles.

I couldn’t quite seperate media hype from real risk, so to test the claim that a particular phenomenon is a bubble or not, and to compare the claims side-by-side, I resorted to a simple visualization technique called (what else?) the bubble chart, whereby I plot the bubble phenomena on a three-dimensional graph according to 1. overall growth since 2001 (in multiplier form), 2. latest yearly growth rate vs average yearly growth rate (also in multiplier form), and 3. with the size of the chart bubble indicating it’s relative size to US GDP in real life. These dimensions basically illustrate the total amount of growth in the past 10 years (vertical), the most recent rate of growth relative to the 10-year average growth rate (horizontal), and the size of the “problem” relative to GDP (size and color of bubble). The crude and preliminary results look something like this:

Three basic observations: the fastest growing recent trend can be observed in college debt, the biggest increase in the past 10 years has been in the derivatives market, and the biggest exposure to the overall size of the economy can be found in the stock market, albeit at a much slowing pace (due mostly to the great correction of 2008).

The current price to earnings ratio of the overall U.S stock market stands near its long-term historical average of 15, so it seems that overall valuation is where it should be. I’ll go on a limb and say that credit card debt seems to be under control, owing to a recent 3 year episode of consumer credit deleveraging following the shock of 2008. The derivatives market looks like a runaway train on the chart above, but it relatively small in net terms, and considering that the derivatives market is in its infancy pretty much, and hence starting from a low base, such great rates of growth are expected. Which leaves us with skyrocketing healthcare and education costs, among other things, to get alarmed about.

The cost of healthcare, like college education, has exploded in recent years, far outpacing wage growth and the overall rate of inflation:

Healthcare spending as a share of the US economy reached an all-time high of 18.2 percent in 2011, an incredible threefold increase since 1960. The sad fact is that Americans spend twice as much on healthcare compared to other developed countries, but get lower quality care and less efficiency. Like any other industry, the healthcare industry is tied to the health of the overall economy and when their services become even more unaffordable for vast portions of the population, such as in the next recession, the industry will experience some form of a collapse. The popping of the healthcare bubble will cause all levels of the U.S. healthcare industry to downsize in the form of layoffs, salary cuts, hospital and medical office closures. As with housing, healthcare will always be needed, but the US healthcare industry’s current levels of largesse and parasitic profits cannot be sustained.

On student loans and the alarming, crisis-like levels it reached, I point you to this succint piece in the Pulse, and this cartoon:

Bubbles this big simply have to be closely monitored and kept in check. The government should seek sharpening of monetary policy and macro-prudential tools to deal with these, due to their implications for the economy and the strength and stability of the financial system, as well as the overall well-being of the society.

-Samer