Three scientists explain why markets crash

Scientists have discovered why markets crash. It turns out it's what's happened in every crash there's ever been: too much credit swilling about, creating bubbles that inevitably pop.

Scientists discover what economics lacks common sense

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If you ever worry that you don't know anything about how economics or finance really work, then the latest issue of New Scientist should reassure you somewhat. Because it shows that the experts know nothing either.

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The magazine reports that some econophysicists' and other scientist-types think they've made some bold new discoveries about the financial markets.

They've figured out, using highly sophisticated computer programs, that financial crashes might just might, mind have something to do with the insane levels of credit that seem to be pumped into financial markets in the lead-up to every single recorded crash in history.

Who'd have thought it? Next they'll be telling us we're all descended from monkeys

How massive credit bubbles are linked to market crashes

So how did this group of very smart scientists come to the conclusion that massive credit bubbles might be linked in some way to the crashes that always seem to happen right after a massive credit bubble?

No, they didn't check their portfolios. What they did was come up with a sophisticated computer model stuffed full of little computerised hedge fund managers, virtual bankers and digitised ordinary investors. Each of these little artificial intelligences is programmed with its own goals, and the scientists then basically let them loose and see what they get up to.

According to New Scientist, "the model's hedge funds try to identify momentarily mispriced securities, and make a profit by buying or selling in the expectation that the price will return to a realistic value in the future. As in the real world, they leverage' their investments by borrowing from the banks."

Have a guess what happens next. That's right. They borrow too much money. And the simulation revealed that this build-up in leverage could have "alarming consequences." When a hedge fund borrows money to invest, it not only stands a chance of losing its own money, but it can "also lose money it has borrowed from a bank, possibly putting that bank into difficulties."

A certain amount of leverage was OK. But once there was more than a certain level of leverage spread throughout the system, it became "overwhelmingly likely that a single chance failure will send waves of trouble through the entire market." Why? Because "increasing levels of credit create stronger links between market players, heightening the chance that the failure of one can put an unsustainable burden on others." In other words, the more debt there is in the system as a whole, the greater the chance that if person A goes bankrupt, the amount that he owes person B is enough to drive that person into bankruptcy too, and so on down the line.

It must really gall the scientists in question (who include an ex-hedge fund manager turned physicist) that they spent all their time programming this computer simulation, when they could just have sat on the backsides and watched the business news unfold for the past year or so.

Investors across the world borrowed too much money to invest in property, and to buy securities backed by loans made to people who never had enough money to buy a property in the first place. The first signs everything was going wrong were when a couple of hugely leveraged Bear Stearns hedge funds detonated back in the middle of last year, after a large chunk of the people who'd been given money to buy property simply didn't pay it back. Suddenly everyone panicked that everyone else was over-exposed to the property market. They stopped lending against property, and to each other. Property prices fell harder, and thus the bubble burst.

But I'm being unfair to the scientists here. It's easy to have a laugh at their expense, but the fact that their research can be seen as some sort of breakthrough proves just how devoid of any common sense the rarified world of economics is. It shouldn't be difficult to grasp that if you throw an infinite amount of money at a finite resource, then the price of the resource is going to rise. Not because it's worth anything more but because the money is worth less and less, the more there is of it. And yet, with every bubble, there's a new, structural reason to justify why "it's different this time".

The only way stop future financial crises

So how did the scientists conclude we could stop these bubbles building in the first place? Pretty simple really the only way to stop future crises is to prevent the level of leverage in the system from reaching the point where it becomes dangerous. But that's where the key problem arises human nature being what it is, no one wants to stop a party when it just seems to be getting started.

Bubbles particularly house price bubbles are a lot of fun for those involved, and governments love them because they spread great dollops of feel-good factor' among the electorate. For example, central banks should have called a halt to proceedings in the property market by hiking interest rates sharply while they had the chance. But instead they looked for all sorts of reasons to ignore the surge in asset prices, and focus instead on worrying about keeping the price of clothes and PCs from China from falling too far.

The only way to put any kind of limit on rampant credit creation is to find some way of controlling the money supply. That's not so easy to do - for more on this, you should read my colleague Dominic Frisby's potted history of money from Wednesday's Money Morning (click here to read it: A brief history of money).

In the meantime, perhaps our scientists could turn their attention to other pressing matters such as finding out just why it is that horrendous hangovers always seem to be preceded by copious amounts of alcohol intake

Turning to the wider markets

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UK shares rallied 2.6% in the biggest one-day gain since 1 April as the FTSE 100 index gained 136 points to 5286. Housebuilders recovered strongly on the back of UBS removing the sector from its sell' list, with Taylor Wimpey bouncing 25%, Bellway 20%, Redrow 16% and Persimmon 13%. Banks also had a good day, with Standard Chartered, Barclays and Royal Bank of Scotland all adding 9%, and Lloyds up 6%. Pub stocks Punch Taverns and Mitchells & Butlers joined in the fun with rises of 14% and 16%, though one sour note came from power station Drax which dropped 5% on lower oil prices.

European markets also recovered, with the German Xetra Dax up 1.9% to 6,272 and the French CAC 40 adding 2.8% to 4,226.

US stocks climbed for a second day running as better-than-expected results from JP Morgan and those lower oil prices cheered traders. The Dow Jones Industrial Average advanced 207 points, 1.8%, to 11,447, while the wider S&P 500 and the tech-heavy Nasdaq Composite both gained 1.2% to 1,260 and 2,312 respectively.

Overnight the Japanese market fell back with the Nikkei 225 down 84 points to 12,804, while in Hong Kong the Hang Seng was almost flat, just 8 points off at 21,726.

Brent spot was trading this morning down at $132, while spot gold was at $960. Silver was trading at $18.54 and Platinum was at $1867.

In the forex markets this morning, sterling was trading against the US dollar at 1.9913 and against the euro at 1.2566. The dollar was trading at 0.6309 against the euro and 106.31 against the Japanese yen.

And this morning, Barclays' attempts to raise more money have been somewhat lacklustre. Shareholders bought just 19% of the shares they were offered as part of the group's £4.5bn fundraising, reports Bloomberg. It's not a huge surprise the shares were offered at 282p a pop which is pretty much where they are just now. The remainder will be sold to an investment group that includes the Qatar Investment Authority.

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John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.