Buying into the Boom

Crises Economics, Roubini

As it became apparent that the crisis was real, many commentators tried to make sense of the disaster. Plenty of people invoked Nassim Nicholas Taleb’s concept of the “black swan” to explain it. Taleb, whose book of that title came out on the eve of the crisis, defined a “black swan event” as a game-changing occurrence that is both extraordinarily rare and well-nigh impossible to predict. By that definition, the financial crisis was a freak event, albeit an incredibly important and transformational one. No one could possibly have seen it coming.

In a perverse way, that idea is comforting. If financial crises are black swans, comparable to plane crashes—horrific but highly improbable and impossible to predict—there’s no point in worrying about them. But the recent disaster was no freak event. It was probable. It was even predictable, because financial crises generally follow the same script over and over again. Familiar economic and financial vulnerabilities build up and eventually reach a tipping point. For all the chaos they create, crises are creatures of habit. Most crises begin with a bubble, in which the price of a particular asset rises far above its underlying fundamental value. This kind of bubble often goes hand in hand with an excessive accumulation of debt, as investors borrow money to buy into the boom.

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What is described above is a big problem, because money = debt, and debt is “hoped” to represent new enterprises being formed in which people create value to pay back their debt. If, instead, a pyramid of debt is created that has no basis in terms of creating value, then after the music stops the whole system is in danger of going bust.