Mansharamani, Boombustology

Vikram Mansharamani’s Boombustology: Spotting Financial Bubbles Before They Burst (Wiley, 2011) is based on a residential college seminar he gave at Yale. As such, it is structured to fit a thirteen (or so)-week semester, with an introduction, twelve chapters, and a conclusion. It presupposes no knowledge of economics or the markets but is directed at quick, foxlike learners. (No hedgehogs need apply.)

The book’s primary thesis is that it is only by adopting a multidisciplinary perspective can we hope to understand boom-bust cycles. The reason is that financial booms and busts are mysteries as opposed to puzzles. Unlike a puzzle, which (to use Malcolm Gladwell’s words) “grows simpler with the addition of each new piece of information, … mysteries require judgment and the assessment of uncertainty.” In trying to understand boom and bust mysteries “we need a framework for connecting the dots in a manner that helps extract insight from the tremendous amounts of information and data that are already available.” (p. 5)

The author describes five lenses through which to view, and identify, bubbles before they burst: microeconomics, macroeconomics, psychology, politics, and biology.

The first offers a model that seeks an ad hoc reconciliation of the efficient market hypothesis with Soros’s doctrine of reflexivity. “Most of the time, efficiency logic works and deviations from equilibria tend to self-correct. However, there are instances in which reflexive dynamics are able to overcome the self-correcting force and creative self-fulfilling extremes.” (p. 22)

The second lens focuses on the impact of debt and deflation on asset markets and prices. The author gives a pedagogically brilliant account of the fates of three sets of homeowners—the Safe Smiths, the Optimistic Osbornes, and the Carefree Carrolls—in happy times and sad times to illustrate the point that “the relationship between debt, collateral (i.e., down payment or equity amount), and asset prices has the potential to create a toxic cocktail that can greatly improve or deteriorate one’s financial condition quite rapidly.” (p. 30) He then attempts to combine the Austrian cycle, Minsky’s financial instability hypothesis, and debt-deflation theory into one theoretical construct, “with debt and its magnifying power as the primary drivers of the cycle.” (p. 42)

The third lens is psychology, primarily the findings of behavioral economics that unearth our consistently nonrational biases. Fourth, the author tackles the problem of distortions that occur as a result of government decisions regarding private property rights, price floors and ceilings (e.g., minimum wage and rent control), and tax policy (e.g., the mortgage-interest deduction). The fifth lens is in effect a bifocal biological lens, an epidemic lens and an emergence lens (as in swarm intelligence or uninformed consensus).

The author uses these five lenses in concert to demonstrate how observers might have been able to identify past bubbles before they burst. The bubbles in question are tulipomania, the Great Depression, the Japanese boom and bust, the Asian financial crisis, and the U.S. housing boom and bust.

One intriguing point, seen through the lens of macroeconomics, is that financial innovation was involved in each case. Consider the purchase of tulip bulbs in seventeenth-century Holland. “Physical tulip bulbs could only be uprooted and exchanged between May and September. To accommodate the need for speculators to trade these bulbs throughout the year, contracts were developed and notarized for purchasers to commit to buying (and sellers to commit to selling) bulbs at an arranged price at the end of the growing season. Because these futures contracts did not require full payment, they effectively enabled purchasers to obtain economic and financial exposure to tulip prices with leverage.” (p. 105) But regulators went a step further, in effect converting futures contracts into option contracts and thereby creating “asymmetric reward for limited risk.” (p. 108) Apparently this regulatory change accounted for the massive surge in prices; when several months later the regulators opted to return to the futures-contract structure the bust followed.

Mansharamani has developed a compelling set of analytical tools that seem to work well in retrospect. But will they have predictive power? The author is loath to go that far. Nevertheless, the book ends with an evaluation of a possible bubble in the Chinese economy.

Boombustology is an enjoyable, well organized read. Critics might consider it superficial in places; it is certainly not on the level of This Time Is Different. But, with all due respect to Reinhart and Rogoff, I’d rather take an undergraduate course based on Mansharamani’s book.