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Tuesday, November 18, 2008

The Economic Bubble And Spill Over To Real Economy

Series of reports about bubble burst, over and underpriced of assets, bankruptcies, margin calls on hedge funds and so on dominated the financial press. What lacks are the down to earth analysis of the causes and the implications on the real economy.

The understanding of the causes and the possible implications on the real economy warrants our attention due to the repetition or recurrence that we witness in the commodities bubble now. As one is still licking his wound of the losses made in the mortgage speculation, episode of another speculative buying on range of commodities is unfolding its fervor. This new chapter of speculation could cause more harms as it affects global developments, derails developmental policies, causes widespread hungers, and reduce central banks' capability.

The main cause of the recent hike in crude oil, copper, steel, iron ore, gold and etc, is depreciation of dollar. Since the announcements of interest rate reduction to combat the possible recession in U.S, these dollar denominated commodities have been the safe havens for the speculators, as they are perceived as tools to hedge against the dropping dollar. Spiraling down of dollar has no depth due to determination of Fed to fight the recession and slow down, investors will continue to park their money in other assets which could garner higher yields, this include foreign assets, and commodities. Thus the dollar run explains that the recent hike in commodities, and the subsequent global inflation is just beginning.

Although the price of oil is now in USD109 - USD110 range, one notice that the supply in fact is increasing. Although China and India pose large demand from the industrial development, the overall supply is still ample to cater to the needs. And although the demand usually will peak in summer, the oil inventories are still high. The decision not to increase production by Opec members did not bid well to the price level, it further fueled the risk aversion behavior among investors; run away from dollar and to invest in commodities which could promise higher returns.

This speculative buying is another round of bubble in the making and which has spilt to real economy. Economies throughout the world, be it commodity, property, manufacturing, export, are undergoing though the fear of inflation. Companies which are accounting the high price which has eaten into their profits are those exposed to export market.

These very sectors are facing another constraint; the rising local currency. When the dollar depreciates, the exports become more expensive abroad. Sending the products manufactured suddenly not competitive in the foreign markets. Countries which pose challenge to the global market are from Eastern European countries, China, India and Russia.

In any literature one may find the speculative buying is mainly caused by herd behavior of the investors. It originates from the investors who follow closely the sentiments of the mass. Investors will have his own opinion on the price level, reflecting the preference level exhibited by every investor. However, the preference is formed based on quantity rather than quality of a asset. In other words, investors are exposed to information spread from his peers, friends or relatives about the possible price level in the future. If the number of peers' investment decisions exceed his preference; the number of people invested is large, then he will invest. Under this environment, the statistics become the main reference point of the investors. We call this uninformative herd cascade as the sentiment of the investors is mainly buoyed by the quantity information (number of investors) rather than quality information of the assets concerned.

The sentiment, in this case, will spread like wild fire, as everyone is propelled by feel good sentiment and are highly averse of missing the bandwagon. Normally, the spread is caused by a threshold level exhibited by the crowd, or the total number of followers. Each investor has his own threshold level, above which he will take action. Just like boiling water, 0 and 100 are two threshold levels which could transform the physical form of the water. If total number of investors (which in equity market or other speculative markets are reflected in the price) exceeds a investor's threshold level, he will invest. Other investors in the same market will wait and will jump on the bandwagon if the subsequent price exceeds his threshold. This process will go on to converge more and more investors to follow the crowd. This very process is very dangerous in the sense that in view of the interaction and the interconnection of the investors through media, any arrival of new information will convert many investors without evaluating the information. And the investors behave in a chain reaction method, the conversion of the investors will automatically convert more investors in the subsequent times.

The quantity cascade formed among the investor society in this case is very fragile, as any new arrival information which suggests different trend could reverse the sentiment all together, dragging the whole process and sending early predecessors into down ward spiral. This chain reaction again will take its form again, but in different direction; converting many late investor or new comers to drive the price lower. This new information could be the default rate of house owners, the margin calls on hedge funds, and credit squeeze in the market. The cascade built up its steam when troops of investors suddenly shied away from the mortgage market when the first default surfaced in 2001-2002.

Similarly the depreciating dollar drives many investors to park their money in other assets such as commodities. Having said that the sentiment played a more important role than the fundamental news, the quality information is being manipulated and interpreted according to the investors' sentiment, which further fueled the speculative activity.

Obviously the price level does not reflect the true fundamental of a commodity, rather the sentiment of the mob is brought to the front as the main mover of an economy. Hunger in Afghanistan due to spill over effect of the high crude oil price, sudden shoot up in unemployment rate in countries which are exposed to U.S market, wastage and misallocation of funds due to concentration of resources to develop oil related production (resource curse), increasing cost of living as price hikes in property, food, and other necessities, and the drop of economic growth in countries which are insulated by the mortgage crisis but in the network of globalization. Although the idea of decoupling of global markets with U.S is far fetched, the coupling of real economy to the capital market is very real. This unfairness to the developing countries will go on as long as the global capital market is porous, and therefore whatever economic policies to uplift the poor will be offset by the sentiment of the global investors, which are monopolized by certain group of hedge fund managers.

John Chng at economic partnership agreement

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