These days commentators near and far are announcing booms and bubbles in Treasury securities, gold, China – perhaps even a bubbles. Vikram Mansharamani is in the China camp, but his arguments stand out from the others. If you can get past the title of his book – Boombustology – you will be rewarded with a thorough, well-documented, yet mercifully brief and readable exposition of a theory of booms and busts applied to past events and China’s future.
Most macroeconomists see the boom-bust cycle as an unsolved problem. Like physicists in search of a Grand Unified Theory, they long for a model that accounts for all the major aspects of the business cycle. Perhaps they are hampered by looking through the wrong end of a telescope. Mansharamani uses not just one but five “lenses” to examine the subject. In addition to micro- and macroeconomics, they include psychology, politics, and biology. He is not the first economist to invade these fields. Rather his accomplishment lies in assembling ideas from each of those areas, applying them to past boom-bust cycles, and putting his ideas on the line by issuing a brave prediction of a forthcoming Chinese economic train wreck.
Austrian Business Cycle Theory
The author’s macro lens includes Austrian business cycle theory. That theory says inflation of the money supply causes a drop in interest rates, which is misinterpreted as an increased aggregate preference for saving over consumption, leading to investments in more roundabout means of production. When it becomes clear that there has been no such preference shift, these undertakings are seen to be at least partial mistakes, requiring write-offs and retrenchment – a bust. The boom is the problem, not the bust, which is the market’s attempt to realign itself to the realities of time preference. Austrian business cycle theory has great merit but leaves some things unexplained.
Mansharamani’s micro lens includes the concept of reflexivity. Market participants don’t just observe prices but also influence them. Reflexive dynamics occasionally give rise to instabilities in which rising prices lead to increased demand. A simpler term would be a “bandwagon effect.” I recall an office party in 1980 where one of the secretaries asked about buying gold – precisely at the peak, as it turned out. All she knew about gold was that it was way up and therefore must be going higher. I should have realized that when you see financially unsophisticated people like her climbing on a bandwagon, you can be pretty sure there’s no one left to sell to and nowhere for prices to go but down, which is where gold and silver prices went in 1980, and in a big hurry.
From psychology Dr. M. borrows ideas and data about cognitive biases. For example, subjects asked to guess some bland statistic, like the number of African countries that belong to the UN, are influenced by the spin of a wheel of fortune: When the wheel lands on a high number, they guess higher. He translates this and a dozen other cognitive biases into irrational market behavior that can foster booms and busts.
He introduces his biology lens with an analogy to the spread of an infectious disease. When the prevalence of a disease reaches a high level, the infection rate necessarily slows and the disease begins to wane, just like the 1980 gold market. But it is devilishly difficult to “inoculate” oneself against infectious ideas. Individual investors who can do so have a decent chance to beat the market averages over time, I believe. (Those who would pursue these ideas in greater depth would do well to find James Dines’s quirky and expensive but worthwhile book, Mass Psychology.)
Turning to politics, Mansharamani illustrates unintended consequences of taxes and regulations. The U.S. Tax Code (Title 26, Subtitle A, Chapter 1, Subchapter B, Section 179) allows businesses to expense purchases of vehicles heavier than three tons, a provision aimed at helping farmers. Guess what. The BMW X5, a luxury SUV, weighs 3.003 tons! On a more serious note, he cites the mortgage interest deduction as a magnifying factor in the housing boom and bust.
Mansharamani examines the tulip mania, the Great Depression, the Asian financial crisis, and other past cycles. For each he cites a dozen or so aspects of the cycle and categorizes them under his five lenses. He summarizes the housing boom, for example, with 14 observations on things including reflexive credit/collateral dynamics, anchoring on prices, perverse tax policies, and popular media. None of these is particularly surprising, but I found it instructive to see them listed and categorized.
When I was young a book appeared called Are the Russians Ten Feet Tall? It was the post-Sputnik era when Paul Samuelson’s economics textbook pronounced Soviet socialism a workable alternative to markets and CIA “intelligence” analysts projected that Soviet GDP would overtake ours. We know how that worked out. Fast forward to the 1980s when the Japanese were paying top dollar for iconic U.S. real estate. We know how that turned out too. Now it’s China. I can’t help thinking: I’ve seen this movie before.
Mansharamani goes far beyond my gut feeling, marshaling evidence of a Chinese bubble from each of his lenses. He gathers tidbits such as garlic fanatics bidding prices up 10- 30-fold in 18 months; the skyscraper indicator – starting with the Empire State Building, record high buildings are consistently started in a boom and finished well into the subsequent bust — and the $230,000 that a Chinese man paid for three bottles of 1869 Château Lafite. Then there’s Ordos, a massive new city meant to house one million souls but left incomplete and unoccupied.
Mansharamani looks at Chinese state-owned enterprises through his political lens, reporting that if they had to pay a market rate of interest, their reported profits would be wiped out. Through his reflexivity lens he saw Chinese steel production exploding from 23 million tons in 1977 to 650 million through the first half of 2010 — with up to 20 percent being used to construct more steel mills! “Truly a reflexive dynamic if ever there was one,” he gasps.
Boombustology is a worthwhile read for anyone who seeks a better understanding of booms and busts. I especially recommend it to individual investors.
[Editor’s note: this essay first appeared in the Freeman on May 25 2011]