Best of the Week
Most Popular
1. Investing in a Bubble Mania Stock Market Trending Towards Financial Crisis 2.0 CRASH! - 9th Sep 21
2.Tech Stocks Bubble Valuations 2000 vs 2021 - 25th Sep 21
3.Stock Market FOMO Going into Crash Season - 8th Oct 21
4.Stock Market FOMO Hits September Brick Wall - Evergrande China's Lehman's Moment - 22nd Sep 21
5.Crypto Bubble BURSTS! BTC, ETH, XRP CRASH! NiceHash Seizes Funds on Account Halting ALL Withdrawals! - 19th May 21
6.How to Protect Your Self From a Stock Market CRASH / Bear Market? - 14th Oct 21
7.AI Stocks Portfolio Buying and Selling Levels Going Into Market Correction - 11th Oct 21
8.Why Silver Price Could Crash by 20%! - 5th Oct 21
9.Powell: Inflation Might Not Be Transitory, After All - 3rd Oct 21
10.Global Stock Markets Topped 60 Days Before the US Stocks Peaked - 23rd Sep 21
Last 7 days
Ravencoin RVN About to EXPLODE to NEW HIGHS! Last Chance to Buy Before it goes to the MOON! - 21st Oct 21
Stock Market Animal Spirits Returning - 21st Oct 21
Inflation Advances, and So Does Gold — Except That It Doesn’t - 21st Oct 21
Why A.I. Is About To Trigger The Next Great Medical Breakthrough - 21st Oct 21
Gold Price Slowly Going Nowhere - 20th Oct 21
Shocking Numbers Show Government Crowding Out Real Economy - 20th Oct 21
Crude Oil Is in the Fast Lane, But Where Is It Going? - 20th Oct 21
3 Tech Stocks That Could Change The World - 20th Oct 21
Best AI Tech Stocks ETF and Investment Trusts - 19th Oct 21
Gold Mining Stocks: Will Investors Dump the Laggards? - 19th Oct 21
The Most Exciting Medical Breakthrough Of The Decade? - 19th Oct 21
Prices Rising as New Dangers Point to Hard Assets - 19th Oct 21
It’s not just Copper; GYX indicated cyclical the whole time - 19th Oct 21
Chinese Tech Stocks CCP Paranoia, VIES - Variable Interest Entities - 19th Oct 21
Inflation Peaked Again, Right? - 19th Oct 21
Gold Stocks Bouncing Hard - 19th Oct 21
Stock Market New Intermediate Bottom Forming? - 19th Oct 21
Beware, Gold Bulls — That’s the Beginning of the End - 18th Oct 21
Gold Price Flag Suggests A Big Rally May Start Soon - 18th Oct 21
Inflation Or Deflation – End Result Is Still Depression - 18th Oct 21
A.I. Breakthrough Could Disrupt the $11 Trillion Medical Sector - 18th Oct 21
US Economy and Stock Market Addicted to Deficit Spending - 17th Oct 21
The Gold Price And Inflation - 17th Oct 21
Went Long the Crude Oil? Beware of the Headwinds Ahead… - 17th Oct 21
Watch These Next-gen Cloud Computing Stocks - 17th Oct 21
Overclockers UK Custom Built PC 1 YEAR Use Review Verdict - Does it Still Work? - 16th Oct 21
Altonville Mine Tours Maze at Alton Towers Scarefest 2021 - 16th Oct 21
How to Protect Your Self From a Stock Market CRASH / Bear Market? - 14th Oct 21
The Only way to Crush Inflation (not stocks) - 14th Oct 21
Why "Losses Are the Norm" in the Stock Market - 14th Oct 21
Sub Species Castle Maze at Alton Towers Scarefest 2021 - 14th Oct 21
Which Wallet is Best for Storing NFTs? - 14th Oct 21
Ailing UK Pound Has Global Effects - 14th Oct 21
How to Get 6 Years Life Out of Your Overclocked PC System, Optimum GPU, CPU and MB Performance - 13th Oct 21
The Demand Shock of 2022 - 12th Oct 21
4 Reasons Why NFTs Could Be The Future - 12th Oct 21
Crimex Silver: Murder Most Foul - 12th Oct 21
Bitcoin Rockets In Preparation For Liftoff To $100,000 - 12th Oct 21
INTEL Tech Stock to the MOON! INTC 2000 vs 2021 Market Bubble WARNING - 11th Oct 21
AI Stocks Portfolio Buying and Selling Levels Going Into Market Correction - 11th Oct 21
Stock Market Wall of Worry Meets NFPs - 11th Oct 21
Stock Market Intermediate Correction Continues - 11th Oct 21
China / US Stock Markets Divergence - 10th Oct 21
Can US Save Taiwan From China? Taiwan Strait Naval Battle - PLA vs 7th Fleet War Game Simulation - 10th Oct 21
Gold Price Outlook: The Inflation Chasm Between Europe and the US - 10th Oct 21
US Real Estate ETFs React To Rising Housing Market Mortgage Interest Rates - 10th Oct 21
US China War over Taiwan Simulation 2021, Invasion Forecast - Who Will Win? - 9th Oct 21
When Will the Fed Taper? - 9th Oct 21
Dancing with Ghouls and Ghosts at Alton Towers Scarefest 2021 - 9th Oct 21
Stock Market FOMO Going into Crash Season - 8th Oct 21
Scan Computers - Custom Build PC 6 Months Later, Reliability, Issues, Quality of Tech Support Review - 8th Oct 21
Gold and Silver: Your Financial Main Battle Tanks - 8th Oct 21
How to handle the “Twin Crises” Evergrande and Debt Ceiling Threatening Stocks - 8th Oct 21
Why a Peak in US Home Prices May Be Approaching - 8th Oct 21
Alton Towers Scarefest is BACK! Post Pandemic Frights Begin, What it's Like to Enter Scarefest 2021 - 8th Oct 21
AJ Bell vs II Interactive Investor - Which Platform is Best for Buying US FAANG Stocks UK Investing - 7th Oct 21
Gold: Evergrande Investors' Savior - 7th Oct 21
Here's What Really Sets Interest Rates (Not Central Banks) - 7th Oct 21

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

Can the "Mimetic Effect" Explain Speculative Bubbles?

Stock-Markets / Liquidity Bubble Jun 25, 2009 - 08:23 AM GMT

By: MISES

Stock-Markets

Best Financial Markets Analysis ArticleJeremie T.A. Rostan writes: For the enemies of freedom in general , and of the economy in particular, the recent crash has been the occasion to re-assert that markets in general, and financial ones in particular, are inherently unstable — and thus dangerous — because they are driven by irrational behaviors such as the "mimetic effect," which, according to many experts and politicians, explains how Wall Street booms and then busts.


The idea, put a little simplistically, is this: when one investor speculates on the rise of a financial asset, he bids up its price, thus enticing more investors to speculate on its rise; they, in their turn, bid up its price, thus inflating a frantic speculative bubble that totally disconnects the market value of the financial asset from the real value of the underlying real asset.

This notion of speculation as a (temporary) "self-fulfilling prophecy" does not withstand even a thirty-second rational examination.

First, it does not even meet the formal requirements of a logical explanation.

Indeed, if the "mimetic effect" were true, every buying of a financial asset by an investor should lead to an exuberant rise in its price. This theory offers no criterion explaining why some speculations lead to bubbles and why others do not.

Second, if the instigator of the mimetic speculation initiates a bad speculation, he should be losing money. The problem, in fact, is not so much the "mimetic effect" in and of itself. Carl Menger, for instance, explained how money was established thanks to imitative behavior in which market participants follow the path opened by successful pioneers.

Three Problems

There are 3 problems to address in accounting for any speculative bubble:

  1. There is a lag in time between the bad speculation and the financial losses that reveal it. The "mimetic effect" does not account for this.
  2. If the prices of certain financial assets are to be greatly inflated, it must be because investors anticipate great profits. Now, what, except a sudden and collective mania, explains such exuberance?
  3. How is a speculative bubble fed? Where do investors get the limitless means they waste in irrational ventures?

In order to solve these three problems and get a rational explanation of the formation of speculative bubbles in financial markets, let's examine two cases.

First Case: The Misallocation of Capital

In this first case, we consider investors as financial intermediaries with capital limited to actual savings. In this scenario, it is not only plausible but even necessary that some investors make bad investments, thus misallocating capital to low- and even negative-return assets.

This answers problem 2: because of uncertainty, speculation will happen to be deceptive. However, under such conditions, individual imperfect information concerning the future state of the economy is the only reason for false expectation.

Speculating on an asset and buying some of it, an investor can entice fellow market participants to join in his fate. However, the supply of capital being limited to net savings, from one period to another, the supply of funds which can be misallocated is strictly limited; and, since the return on investment will increase in the assets from which they are taken, the simple pursuit of profit will both reveal and correct the malinvestment.

Second Case: Credit Expansion

What happens when financial intermediaries have access to actual savings and newly created credit funds?

As explained by the Austrian business-cycle theory, newly created funds imply a decrease in interest rates. This decrease will have various effects on various financial assets, and thus on their relative prices.

Generally speaking, all future goods appear cheaper, and more profitable, than they really are — considering the real interest rate. But they appear even more so according to parameters such as the position of their underlying real assets in the structure of production, the period of production of their products, their durability, or the risk entailed in their offering.

As a consequence, we have here a reason for a collective error, since the manipulation of interest rates makes it appear more profitable to all investors to invest in certain assets.

And we also have an answer to the question concerning the origin of the flow of funds invested in these particularly interest-rate-sensitive and risky financial assets: the newly created credit.

Finally, the hypothesis of a monetary expansion also explains the time lag between the bad speculation on those assets and the losses they imply. Because of the injection of new liquidities in the economy, the structure of prices is loosened and, just like the structure of production, becomes distended. Misallocated funds do not have to be taken from other assets, and their overinvestment in sensitive and risky assets can go on up to the point to which their illusory rise in profitability is superior to that of less interest-rate-sensitive and risky investments.

Thus, speculative error can go on at no cost as long as that limit is not reached.

In fact, there are two other limits. First, the rate of interest tends to rise to its real value, undermining the pseudoprofitability of the real assets underlying sensitive and risky assets. Thus, new credit has to be created constantly.

Second, the injection of liquidity will have to be stopped at some point, or else hyperinflation will take place.

Conclusion

The "mimetic-effect" explanation of speculative bubbles fails to distinguish between two radically different cases: on the one hand, the misallocation of a limited supply of savings by financial-market participants; on the other hand, the investment of a supply of funds superior to actual savings, i.e., of artificial credit created by a deceptively low rate of interest.

Only the latter can lead to speculative bubbles.

A good explanation of a phenomenon, such as the formation of speculative bubbles on financial markets, demonstrates itself in that it also explains bad explanations: verum index sui et falsi.

What then is the so-called "mimetic effect," really? When new liquidities are injected in a financial system, asset prices vary. They do so differently, according to various parameters, and only step by step. The "mimetic effect" does not reveal the intrinsic irrationality of speculation: it is nothing but the process by which artificial credit is being channeled, through a distorted price structure, to interest-rate-sensitive and risky assets.

If there is a mimetic behavior, it is the one of central bankers who constantly inflate the money supply in order to re-inflate bubbles and "stabilize" financial markets.

Jérémie T.A. Rostan is "agrege de philosophie." He teaches philosophy in San Francisco, California. He wrote a study guide to Carl Menger's Principles of Economics, prepared in 2008 for distribution through Mises.org. Send him mail. See his article archives. Comment on the blog.

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in