Flostock News#8 about Bubbles

Understanding bubbles

Thinking in bubbles

A bubble is a runaway effect that takes place when the lid, a limiting factor, the balancing feedback loop, is temporary taken away from the system and only a reinforcing feedback loop remains. Examples are the removal of the mortgage ceiling for the housing market and Clinton allowing savings banks to merge with investment banks if people get rewarded for taking risk and the balancing loop of downward consequences is gone, a bubble will result.   This is now under repair by the Volcker Rule

Ponzi schemes (e.g. Madoff) are bubbles where the feedback loop (loss due to bad investment) is artificially  and maliciously hidden for the participants. Hypes like the Dutch Tulip mania of the 1630s, the South Sea Bubble the 1720s, the Florida real estate boom in the 1920s or the Bitcoin bubble of the 2010s have a lot in common with Ponzi schemes, except that the participants themselves unknowingly hide the feedback loop for a while. When the hype cools down, the feedback loop comes in with a vengeance and the value collapses. 

Extrapolating bubbles

Some bubbles bigger than others

Most people have a linear view of the world. E.g. journalists bemoan the lost wealth since the economic bubble burst in 2008, thereby completely overlooking the fact that in the period 2001- 2008 we lived in an inflated world, in a bubble. You have to look at a much longer period to understand what the real economic trend is, and to be able to see the rest as a wave and/or bubble. The problem is aggravated by the fact that a bubble is the wrong word for the phenomenon (see blog)

When you see something as a wave, so non-linear,  you know that you should not extrapolate  the upward (or downward) slope but the trend.  When you look at the current situation in said light, we are not doing too bad. We are still in the down part of the wave around the long term trend, but when all positive signs materialize, we will soon cross the trend line again. 

Pro-cyclic or anti-cyclic government

Pro-cyclic toolbox

If government applies a new ceiling, thus a so-called balancing feedback loop, into a system when the wave is at the bottom, it will slow down the recovery of the wave. This happened after the 1930 crisis and this happened in Japan in the nineties. Instead it would be wiser to activate new feed-back mechanisms when a wave is really taking off and before it reaches its inflexion point, that is before it goes through its equilibrium. Restricting the availability of credit at the bottom of the cycle is a pro-cyclic action. The Basel-III accords in this view are somewhat pro-cyclic, as is cancelling the mortgage deduction in Dutch tax system. Alas the very nature of people is to respond pro-cyclic. Governments are almost like real people.

Bubbles and volatility

A calm ride in the park?

Since the Lehman bankruptcy the world has become a lot more volatile. On top of the volatility, in some markets, there are clear signs of repeated bubbles in pricing and demand. When the logistic driven volatility crosses a certain threshold, it apparently results in stockpiling, rising prices, more shortage and further stockpiling. Flostock has found a way to model these exponential phenomena and predict their course, including their collapse. If you want to know more, give us a call.   

A Bubble, a Wave or an S-curve?

Many bubbles become foam

How can you see the difference between a Bubble, a Wave and an S-curve? Good question, and there is no easy answer, but let me try.  A bubble is characterized by an uncontrolled, stimulating, exponential feed-back loop, but sometimes it is difficult to identify this loop. You could also say it is the absence of a regulating, balancing feed-back loop. A bubble bursts when in some variable the limit is reached, but that variable can be different from the immediate feed-back loop . In most bubbles, people involved are exceptionally positive and confident without good cause.

A Wave by definition has an equilibrium, and the things that are increasing in an upswing have the characteristic that they also can  go down, without an external push and without bursting. Most waves are dampened. As long as the variable in question is within the amplitude of an earlier wave peak, it should be ok.  The upward peak in the Lehman Wave for example was not a bubble, because it was caused by the same variable (inventory) that had gone down in the dip: so it was a wave. Otherwise we should have called it the Lehman Bubble, shouldn’t we?  Only in some industries there was an additional bubble, when suppliers were sold out and panic ordering took place.

An S-curve in the beginning is similar to a bubble, but it reaches a stable plateau . When the plateau comes closer, it puts a limit to the growth, i.e. it introduces a balancing feedback loop. For this reason a Ponzi-scheme is never an S-curve. For Bitcoins I have difficulty imagining the plateau, so for the time being I consider Bitcoins a bubble.  

Inflow = Growthflow + Outflow, according to Flostock’s 8th Law.

Capital Goods coming in

This law says that the inflow into a fleet or stock is the sum of what needs to be replaced, so the outflow, plus what is needed to adapt the fleet to the growth: the growthflow. “So what?”, you may ask.

This law explains car sales in the world, trucks, machinery, any fleet. Suppose capital goods need replacement every 20 years and the growth in demand is 5% per year. In such case, in equilibrium, Growthflow = Outflow. Another example: because global production went through a peak in 2008, the capacity now is still big enough for current demand and there is little growthflow in capital goods.

The 8th law is the integration of Flostock’s  Laws 4 – 6 about Fleets . The Growthflow is based on the 4th Law. Outflow is based on the 5th Law. The 6th law explains a regulation mechanism of the Outflow. And the 7th Law warns that a change in Outflow can strongly influence the Inflow. Readers will understand that these effects together are too complicated to be understood by thinking alone. A good system dynamics model is needed to calculate the effects. 


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