The tulip mania discussed in Chapter 6 exhibited many of the characteristics typical of a reflexive dynamic. Higher prices generated more demand, and, following the bursting of the bubble, lower prices generated more supply. Aside from these price-based indicators of reflexive dynamics, there appears to have been the possibility of foreign inflows (i.e., hot money) into the Netherlands as it became the financial center of the world. Foreign capital inflows seeking higher returns often cause the very returns they are seeking, thereby creating a very unstable situation.

The Florida land boom that preceded the Great Depression provides a spectacular example of the two reflexivity indicators in action. As is typical in most property-related booms, credit provided the fuel for the asset boom with banks. Liquidity was rampant and credit ubiquitous. Remember the total U.S. money supply during the 1920s? One can also note that credit was expanding at the same time as asset prices were rising and although evidence on the methodology of bank approvals is hard to come by, it seems conceivable that banks were finding comfort that as asset prices rose, the collateral pledged against their loans made the loans (seem) less risky. It was only once the music stopped that banks realized their comfort was unwarranted.

Given that land was the centerpiece of the Japanese boom and bust sequence, it should come as no surprise that reflexive credit and collateral dynamics were present. The mere existence of mortgage products with a 100-year term (see the following section on financial innovation) indicate that leverage was being extended on terms other than ability to repay as banks could not have reasonably expected individuals to live long enough to repay their loans. Many of these loans simply must have been extended by banks operating under the assumption that asset values would protect them against this inability to repay the loan from income. Further, Japanese credit grew rapidly during the 1980s, simultaneous with the boom in asset prices. It seems highly unlikely that this was coincidental.

The Asian Financial Crisis was in many ways a story of hot money inflows and outflows. The reflexive dynamic created by such money flows was not dissimilar to those generated in other unsustainable booms. Money came into East Asia seeking higher returns, but the very arrival of such money at least partially created those returns. As long as the flows continued, the story remained in tact. Once the money flows stopped, and reversed, the virtuous cycle rapidly turned vicious. This is exactly the dynamic that took place in Thailand and the rest of Southeast Asia during the Asian Financial Crisis.

The housing boom that took place in the early to mid-2000s in the United States was a period that definitively exhibited telltale signs of reflexive dynamics. To begin, the multitude of mortgage innovations that took place were specifically designed to extend leverage and mortgage power to those who had been previously unable to access such credit. Such innovations included subprime, Alt-A, and NINJA (No-Income, No-Job or Assets) loans. Securitization (see the following financial innovation section) was the enabling force behind banks willing to look beyond historical warning signs (i.e., bad credit in the case of subprime and Alt-A mortgages, or unemployment in the case of NINJA loans) of potential losses. By not having to (directly) worry about the ramifications of extending inappropriate credit, banks felt empowered to change the historical basis upon which mortgages were extended. Additional confidence was gained by rapidly rising collateral values. Further, it should come as no surprise that the amount of outstanding credit rose alongside asset values.

Two of the primary criteria for identifying the onset of destabilizing reflexive dynamics in asset markets thus seem to be the modification of the standards by which credit has historically been granted (i.e., affordability) toward collateral-based lending and the simultaneous growth in credit and asset values. A third indicator is the presence and growth of "hot money" inflows seeking outsized returns, which usually enable the very returns sought. Table 11.1 summarizes these indicators.

The structure of the tulip market in the 1630s was one based on futures. Because the actual tradable bulb market only existed for several months, most trading that took place in tulip bulbs took place in derivative markets that effectively enabled (via down payments that enabled control of larger values) leverage. Richard Bookstaber, while reviewing the perils of financial innovation, notes that the Tulipomania "reached full bloom only with the innovation of forward contracts and the leverage these contracts afforded, which allowed traders to buy and sell commodities they did not own, had no intention of owning, and indeed did not even have the money to purchase outright."^[278] Further, ubiquitous money and liquidity (see Table 6.1) provided monetary fuel for tulip prices.

Here again, the use of effective leverage was prevalent. It was the "pay only 10 percent to get economic exposure to 100 percent of an asset" mind-set. By simply putting down a deposit that was 90 percent less than the actual price, speculators in Florida were able to achieve 10× leverage on the price movement of the properties they had supposedly committed to purchasing. Not dissimilar to the Bookstaber quote above, it was later revealed that many ofthese properties were held by individuals who had no intention of owning them and likely lacked adequate resources to own them outright. The result, like the events that had transpired almost 290 years prior, was identical. The house of cards, which was built on a precarious foundation of extreme leverage, eventually imploded.

In a series of articles published in the Saturday Evening Post, Garet Garrett described the bubble of the 1920s as follows: "An ephemeral, whirling, upside-down pyramid, doomed in its own velocity. Yet it devours credit in an uncontrollable manner, more and more to the very end; credit feeds its velocity."^[279] From brokerage margin provided to eager speculators to credit fueling the purchases of automobiles, radios, and other new devices, much of the boom of the 1920s took place with borrowed funds. Ultimately, as noted in "Whirlwinds of Speculation," a 1931 article published in The Atlantic magazine, the credit fueled its own demise by producing a supply response in the "units of speculation" (i.e., stocks, bonds, and developments in Florida) creating the inevitable crash.

Finally, the lowering of interest rates in 1925 to assist the British in fighting the outflow of gold from their country was unintended fuel on top of the already existing speculative fire. This spurred credit growth, and by the early 1930s, U.S. existing credit to GDP reached an all-time high of 299 percent.^[280]

Macroeconomic policy during the Japanese boom was marked by tremendous growth in credit. In fact, it has only been in the years following the bust that the magnitude of the credit overhang has been made patently evident. By encouraging the use of credit to facilitate asset-gain wealth effects, the monetary authorities of Japan were hoping to alleviate the pain that would likely be felt by exporters due to currency appreciation. The result was a cheap money credit explosion that resulted in the final vertical ascent of Japanese asset markets.

The lethal combination of debt and deflation has since plagued the island nation and resulted in what has been labeled by Richard Koo as a balance sheet recession. Traditional economic incentives like profit maximization were effectively brushed aside in a quest for balance sheet repair. This act of deleveraging generated a reflexive dynamic of its own, in which debt deflation firmly took hold.

Perhaps the most dramatic innovation that enabled the inflow ofportfolio investments into Southeast Asia was the emergence of emerging markets funds. As highlighted in Chapter 9, the fact that increasing pools of global capital were organized into common funds focused on emerging economies enabled the rapid transmission of economic hardships in one country into capital flight from another. As fund managers began taking significant losses in Thailand, they found themselves overly exposed to other countries and hence began selling them as well. Further, redemptions by the fund's investors led to a general selling pressure across all emerging markets as fund managers indiscriminately sold stocks in an effort to meet requests for the return of capital.

Although the topic of cultural homogeneity and crony capitalism will be touched on below, it is worth noting here that the development of financial intermediaries such as the Thai finance companies spurred the disbursement of credit. The crony capitalism that led to inefficient and risky lending made for the ultimate in moral hazard. Banks and others freely lent inappropriate amounts of capital to connected individuals with the belief that relationships in the government would ultimately protect them. Thus, capital flowed more freely than it otherwise might have.

If one had to focus on only one cause of the U.S. housing boom and bust, it would likely be the ease of leverage and credit that enabled a slew of individuals—unable to afford the homes they purchased—to enter the market and thereby bid up the prices of real estate. There were many contributing factors to this plot, but central to it are the innovations in securitization and collateralization that created the mortgage-backed securities, collateralized debt obligations, and a host of other credit-derived securities that were served up to yield-hungry global investors seeking the comfort of highly rated and supposedly safe securities.

Another enabling factor in the housing boom was the inappropriately low interest rates that were in effect to combat the ramifications of the Internet bubble bursting. By keeping rates extraordinarily low for an extended period of time, the U.S. Federal Reserve unintentionally fueled the next bubble, a far larger and wide-reaching credit-fueled housing boom with significantly greater ramifications.

Finally, the predominant role played by government-sponsored enterprises such as Fannie Mae and Freddie Mac in the housing markets created a sense of comfort on the part of those buying housing securities guaranteed by these organizations. After all, the U.S. government would not allow a default on mortgage-backed securities, would it?

The signposts for unsustainable credit conditions fall under three primary indicators: financial innovations that enhance or enable leverage, inappropriately (and often unintended) cheap money, and the issuance of credit to non-creditworthy borrowers due to implicit government guarantees (moral hazard–inspired lending). See Table 11.2 for a summary.

The 1600s in Amsterdam felt like it was indeed the beginning of a new era. As noted in Chapter 6, the political economic context supported such a view and the virtual domination of world trade by the Dutch basically confirmed this new-era belief for even the most ardent of doubters. Holland had just won a hard fought war, was reaping fantastic economic gains from the redeployment of resources from military pursuits to commercial endeavors, and was now reaping the economic rewards of a dominating position in world trade. This perspective, combined with the conspicuous display of rare bulbs and the broad participation of amateur investors, provided ample evidence of a broad, Holland-wide (over)confidence in the existence of a new era. Indeed, to many participants and observers, the time seemed to have come for a Dutch domination of the world in matters of economic and non-economic consideration. Why wouldn't the world's wealthy flock to Amsterdam to procure bulbs of the most beautiful flower?

The Western world had just won World War I and new technologies were promising a new era in American convenience and modern living. Just as the war had accelerated the mobilization of rural resources into industrial efforts, the ending of the war resulted in the redeployment of resources from military to economic pursuits. Automobiles and radios, both newly accessible by the presence of previously unavailable consumer credit, promised a different life in the years and decades ahead. Roads were connecting previously faraway places and a burgeoning aerospace industry enabling human flight was being formed. Lindbergh's solo crossing of the Atlantic Ocean made this new-era belief all the more real.

In a spectacular manifestation of the confidence (and hubris) of the times, speculative and competitive juices were flowing rapidly in the development of New York City's skyscrapers. Shortly after 40 Wall Street was completed and deemed the world's tallest tower, the Chrysler building chose to erect a spire tall enough to claim the title. Not to be outdone, the Empire State Building opened shortly thereafter, transferring the "world's tallest tower" title for a third time in less than three years.

The postwar economic miracle exhibited by the transformation of a completely devastated Japan into a world-leading economic superpower provided the new era belief so representative of overconfidence. The comparisons of real estate values in Japan and the United States, several of which were detailed in Chapter 8, highlight one manifestation of this confidence.

Trophy asset purchases such as those described in Chapter 8 also typify the extreme overconfidence that accompanied the Japanese economic success story. Paying hundreds of millions of dollars more than asking price for a trophy building in Manhattan simply to get into the Guinness Book of World Records is the quintessential embodiment of overconfidence and hubris. Equally reflective of the times was the Japanese role in driving the art market to new heights.

The 1979 publishing of Harvard professor Ezra Vogel's book Japan as Number One provided an argument that a new era of prosperity was coming. Although the book seemed correct in the 1980s, it has since come to represent folly. Interestingly, Jon Woronoff published a compelling Japan as (Anything But)Number One in 1991, very close to the top of the Japanese bubble. But as is so often the case in situations of overconfidence, contrary evidence to the prevailing "wisdom" was not well received at the time.

For a decade-long period leading up to the mid-1990s, Thailand was one of the fastest growing economies in the world. Similar dynamics took place across many of the Southeast Asian emerging economies. Despite the fact that much of this increase in economic output came from a growth in inputs, virtually no commentators (Paul Krugman being a notable exception) were willing to question the region's economic sustainability. Popular books on the subject included the World Bank's The East Asian Miracle and Ezra Vogel's Four Little Dragons. With such global infatuation with the export-led development model and the success of Southeast Asia, overconfidence was effectively preordained.

Another manifestation of overconfidence was the rampant and widespread currency mismatches that left Thai (and other) borrowers extremely vulnerable to currency movements. By earning in local currency but borrowing in U.S. dollars (or other currencies), currency depreciations created a debt–deflation-like dynamic in which the effective (i.e., local currency–valued) amount of debt ballooned. The dynamics that inspired so many borrowers to undertake such a risk are at least partially clarified through a behavioral decision-making lens. As noted in Chapter 9, perhaps the likelihood of currency moves was underestimated due to a lack of recently available data regarding adverse currency moves (i.e., availability bias). Or perhaps the analogy of another country borrowing in a different currency proved more vivid (i.e., representative bias). Regardless, it does seem that borrower beliefs underweighted the probability of adverse outcomes.

As a final indicator of overconfidence (and easy money), Malaysia took the crown for the world's tallest skyscraper with the completion of the twin Petronas Towers in Kuala Lumpur in 1997.

Aided in great part by low-cost financing and increasingly flexible mortgage terms, many homebuyers and investor participants in the U.S. housing boom and bust were operating under the false belief that "real estate prices don't fall." Despite the elevated levels of objective measures of value (measures such as median price to median income, percent of income for debt service, etc.), many borrowers (and lenders for that matter) failed to note the rising risks.

Consider the art market of 2006, considered by many to be the year during which the U.S. housing market peaked. The three highest prices ever paid for paintings took place during 2006 art auctions. In June of 2006, cosmetics magnate Ronald Lauder paid a record-breaking $135 million for a Gustav Klimt painting. Only months later, a new record was set when U.S. hedge fund mogul Steven A. Cohen of SAC Capital paid roughly $137.5 million for a de Kooning painting titled "Woman" in November 2006.^[281]

Table 11.3 provides a summary of ways in which overconfidence can signal the presence of an unsustainable boom.

Recall from Chapter 6 that the political dynamic of having prominent public officials suffering substantial personal financial losses led to a modification of the "rules" and the proposed conversion of futures contracts (in which the buyer had purchased the asset for future delivery) into call options (in which the buyer had the right but not the obligation to purchase the asset in the future). By modifying property rights as transactions were taking place, government inspired investor reevaluations of the risk–reward trade-offs.

It was this action that whipped speculation into a powerful fury and led to the last upward surge in tulip prices. Thus, proposed political legislation and the subsequent political theater in which planters and buyers negotiated prices were among the key causal factors driving the extreme volatility in tulip prices.

The flow of money into Florida during the land boom may in fact have been the unintended consequence of Prohibition. Banks were flush with money from the brisk commerce in liquor that was present in Florida due to its somewhat porous borders with countries that did not prohibit alcohol. In many ways, one can therefore think of American money flying into Florida as a form of interstate "hot money" that, due to the fact that many of the banks had state (rather than national) charters, resulted in excessive lending within Florida. Might some of this capital have helped fuel the Florida land boom?

Although several policy distortions, such as the adherence to the gold standard, confounded policy actions during the early stages of the Great Depression, few policy distortions were responsible for the onset of the bubble. Many policy shifts took place in the aftermath of the bust that laid the groundwork for future busts (consider the fact that the homeownership society was a political goal set out during the 1930s in America, or that FDIC insurance on bank deposits—a prototypical example of policy-induced moral hazard—was a policy that emerged from the Great Depression).

Chapter 8 described in detail the punitive taxation on short-term real estate sales in Japan. By artificially suppressing supply from hitting the market and decreasing the effectiveness of the price mechanism due to depressed liquidity, policy makers had inadvertently provided pricing support while intending to minimize speculative short-term trading. It was precisely by seeking to minimize speculation that they created price dynamics that attracted speculators and led to dangerously high levels of debt and real estate values. Additional complications arose from the inheritance tax and the demand it created for highly-leveraged transactions, as discussed in Chapter 8. Given that Japanese tax policies effectively decreased supply and increased demand, might the government have inadvertently fueled the real estate boom?

Further, the rapid deregulation of the financial sector led to significant competition in risk-taking by banks. Credit boomed in no small part because of these shifting regulations. Further, credit controls specifically implemented to cool the housing market contributed to the ultimate bursting of the property bubble.

Among the many policy distortions that ended up fueling the fire of the U.S. housing boom and bust were the mortgage interest deduction and an overarching political belief that homeownership was a right to which every American was entitled. The involvement of government-sponsored enterprises such as Fannie Mae and Freddie Mac further bolstered the belief that the government was prepared to underwrite mortgages to facilitate the conversion of this objective into reality. The Community Reinvestment Act (CRA) went on to further encourage lending to the least creditworthy of borrowers.

A virtuous (which later turned vicious) cycle soon ensued, with Freddie and Fannie issuing bonds to global investors seeking effective U.S. government guarantees with greater reward than U.S. Treasuries. The proceeds of these offerings were then used to purchase mortgage-backed securities. This facilitated banks lending more money, knowing a ready and willing market existed for unloading the mortgages to pseudo-government entities. This enabled banks to worry less about the quality of the mortgages because they were not going to bear the risk of default or nonpayment. Thus, the whole house of cards was built on a belief that the government would not tolerate a failure of Freddie or Fannie.

Further fueling the housing boom were advantageous tax policies available to those who utilized mortgages to finance the purchase of their property. Because interest is deductible against earned income, the net result of mortgage interest deductibility is a subsidy to homeowners in the form of reduced taxes. Thus, in the case of an individual in a 35 percent tax bracket (and assuming no other special circumstances), the government agreed to pay 35 percent of the individual's interest payments.

Table 11.4 summarizes the findings of this subsection. Although policy is usually a politically motivated outcome of legislative processes, it is unfortunately often accompanied by unintended consequences—many of which are likely to enhance the probability of booms and busts.

As discussed in Chapter 6, a telltale indicator of the boom's unsustainable progression was found in the mass participation of "nobles, citizens, farmers, mechanics, seamen, footmen, maid-servants, even chimney sweeps and old clotheswomen"^[282] in the tulip markets. Further, the involvement of prominent—and therefore seemingly knowledgeable—individuals in the market for tulips provided the impetus for beelike silent leadership of the speculating swarm.

According to Allen, participation in the stock market in 1929 was characterized not only by professional and traditional investors, but also by "grocers, motormen, plumbers, seamstresses, and speakeasy waiters."^[283] Allen goes on to note how the "Big Bull Market had become a national mania..... The speculative fever was infecting the whole country. Stories of fortunes being made overnight were on everybody's lips." If the entire population of potential investors was already active in the market, who else might be attracted to it so as to help propel it higher?

The silent leadership of seemingly informed individuals in leading the uninformed is perhaps best demonstrated by Yale professor Irving Fisher who is unfortunately^[284] most remembered for noting that "stocks have reached what looks like a permanently high plateau" just weeks before the 1929 stock market crash. Further, the involvement of JP Morgan and others on the Thursday before the market crash helped bring a swarm of speculators "back to the honey" that afternoon.

Once again, we find the relative maturity of the Japanese boom revealed quite blatantly in 1988 with a notation by the Far Eastern Economic Review that "stocks have become a national street-level preoccupation." The broad participation of Japanese housewives in the market also indicated that the universe of individuals yet to be infected had dramatically shrunk.

Further, the consensus-oriented nature of Japanese society led to a particular susceptibility to herd behavior. Combined with popular media such as the economy-focused comic book bestseller or the publication of Japan as Number One, the collectivist Japanese instincts were channeled into a herd focused exclusively on upside. Just as the dramatic shift from a long-term oriented savings-focused society into a collective of speculators demonstrated emergent group behavior, so too did the rapid dejection that ensued following the bust.

Although the epidemic model did not provide immediate or obvious stories to highlight the maturity of the boom, the opening of many capital markets to "hot money" or portfolio inflows might be seen as one extreme form of infection. If global risk appetites had clearly extended to the least developed economies of the world, how much greater might risk appetite grow?

As for herd behavior emanating from consensus beliefs, here too the Asian philosophical mind-set is a factor as it has been deemed to be more collectivist and consensus oriented than the individualistic Western models. If everyone else was borrowing in U.S. dollars, why shouldn't I? Further, collective confidence was surely bolstered by the publication of books such as the World Bank's The East Asian Miracle.

The most important form of herd behavior, however, might have originated from outside the region with the proliferation of emerging markets funds. By diversifying exposure to many countries in a common pool, managers would indiscriminately sell if one country suffered economic woes. Further, because emerging markets managers were compared against a common benchmark (such as the MSCI Emerging Markets Index), many behaved quite similarly in effectively replicating the index and mimicking each other. Emerging markets funds thus became an efficient mechanism through which the economic woes of one country were transmitted to others.

An epidemic interpretation of the U.S. housing boom logically begins with a focus on the quality of mortgages (i.e. prime vs. subprime). In the quest to "infect" more and more potential homeowners with mortgages, several financial innovations enabled the participation of a greater population of infectable individuals. Using this lens, subprime and other mortgages to individuals with poor credit history represent the epidemic equivalent of a very mature stage. The rapid rise of risky mortgages as a percentage of total mortgage lending, as shown in Chapter 10, provided powerful evidence that the pool of potential participants was being exhausted. After those with good and bad credit histories have mortgages, to whom else might a mortgage be sold? Further evidence of the boom's maturity was found in the boom in real estate salespeople.

From a consensus-oriented perspective, the political goals of broad homeownership were manifested into a common belief that everyone had a right to buy a home. Further, history suggested that home prices did not fall nationally and as such, money was to be made. Low interest rates provided a spectacular tailwind to this belief, and soon shows like "Flip This House" and "Flip That House" were popular on television. Magazine covers highlighted the ease with which real estate fortunes were being made, and the formerly bankrupt property mogul Donald Trump reemerged, this time writing bestselling books such as How to Get Rich.

Table 11.5 lists several indicators related to the biological lens. The table attempts to provide specific examples illustrating the evidence.