Don't get caught in one.

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Easy Money Creates the Most Dangerous Bubbles

Mark Buchanan, a physicist and science writer, is the author of the book "Forecast: What Physics, Meteorology and the Natural Sciences Can Teach Us About Economics."
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Economists finally seem to be recognizing what most people have long considered obvious: Overconfident investors can drive the prices of everything from tulips to Chinese stocks far above their intrinsic value, leading to busts that can cause lasting economic damage.

The hard part is figuring out which bubbles are the most threatening, and what to do about them. New research suggests that the most dangerous element may be debt -- something the world currently has in abundance.

QuickTake Watching for Bubbles

Economists have long been interested in bubbles, even if the profession as a whole largely ignored them in building theories about how the economy worked. In the 1990s, before he became chairman of the Federal Reserve, Ben Bernanke started a sort of bubble laboratory at Princeton, exploring mathematical models inspired by pioneering theorist Hyman Minsky. Last year, economists Steven Gjerstad and Vernon Smith argued in a weighty book that economic history, as well as evidence from two decades of laboratory experiments, points to speculation in property markets, amplified by mortgage financing, as a persistent central factor driving economic cycles.

Now, with more data, researchers are beginning to think that they can identify different kinds of bubbles, and that some may be much more damaging than others. In a new paper, economists Oscar Jorda, Moritz Schularick and Alan Taylor study housing and equity markets in 17 countries over the past 140 years. They find that the worst bubbles -- those that inflict the most economic pain -- tend to involve not just speculation, but a surge in easy lending and increasing leverage.

The idea isn't new. In their 2009 book "This Time Is Different," Carmen Reinhart and Kenneth Rogoff looked at roughly 800 years of financial crises and found that economic downturns following credit bubbles were generally worse and lasted longer. Others, from Irving Fisher through Hyman Minsky to figures today such as Ray Dalio, have drawn similar lessons from the history of financial disasters. John Geanakoplos at Yale has long warned of the dangers of what he calls the leverage cycle.

Jorda and colleagues advance this understanding by taking a detailed look at events in the years since 1870. Their research covers most modern, advanced economies during the era of finance-intensive capitalism, and uses long time series and data from many countries to get useful statistics on rare events.

They find that economies easily weather episodes such as the dot-com bust, when speculation set up the stock prices of high-tech companies for a fall. It's another matter entirely when a surge in easy credit encourages people to use borrowed money -- also known as leverage -- to buy assets. Such bubbles, the authors argue, grow out of an amplifying feedback among credit growth, asset prices and increasing leverage. When they burst, the repercussions are worse, because businesses and individuals must either restructure or pay off all the debt they have amassed, spreading losses and leaving less money for consumer spending and investment.

Such research exemplifies a growing trend in economics to eschew pure theory in favor of studies based on actual data. Very few economists today would deny the existence of bubbles just because the phenomenon doesn't fit into their theoretical models. The profession is finding the courage to acknowledge things that it vehemently ignored for decades. Consider, for example, Paul Romer's ongoing attack on "mathiness" in economic theory, or the growing recognition that economists need a much more empirically based picture of how people think and behave, to replace the assumption of perfect rationality and foresight that has long dominated their mathematical models.

This is progress, even if it comes with misgivings -- and perhaps a little gnashing of teeth in some quarters over the loss of beautiful and comforting illusions, especially of markets as wonders of perfect self-regulation. Economics is becoming messier, less certain of itself. In doing so, it will also become more useful.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author on this story:
Mark Buchanan at buchanan.mark@gmail.com

To contact the editor on this story:
Mark Whitehouse at mwhitehouse1@bloomberg.net