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Financial Bubbles, Real Estate bubbles, Derivative Bubbles, and the Financial and Economic Crisis

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  • D. Sornette

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  • R. Woodard
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    Abstract

    The financial crisis of 2008, which started with an initially well-defined epicenter focused on mortgage backed securities (MBS), has been cascading into a global economic recession, whose increasing severity and uncertain duration has led and is continuing to lead to massive losses and damage for billions of people. Heavy central bank interventions and government spending programs have been launched worldwide and especially in the USA and Europe, with the hope to unfreeze credit and boltster consumption. Here, we present evidence and articulate a general framework that allows one to diagnose the fundamental cause of the unfolding financial and economic crisis: the accumulation of several bubbles and their interplay and mutual reinforcement has led to an illusion of a ``perpetual money machine'' allowing financial institutions to extract wealth from an unsustainable artificial process. Taking stock of this diagnostic, we conclude that many of the interventions to address the so-called liquidity crisis and to encourage more consumption are ill-advised and even dangerous, given that precautionary reserves were not accumulated in the ``good times'' but that huge liabilities were. The most ``interesting'' present times constitute unique opportunities but also great challenges, for which we offer a few recommendations.

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    Bibliographic Info

    Paper provided by ETH Zurich, Chair of Systems Design in its series Working Papers with number CCSS-09-003.

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    Handle: RePEc:stz:wpaper:ccss-09-003

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    For corrections or technical questions regarding this item, or to correct its listing, contact: (Claudio J. Tessone).

    Related research

    Keywords: Financial crisis; bubbles; real estate bubble; derivatives; super-exponential;

    References

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    Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
    1. Philippon, Thomas & Reshef, Ariell, 2009. "Wages and Human Capital in the U.S. Financial Industry: 1909-2006," CEPR Discussion Papers 7282, C.E.P.R. Discussion Papers.
    2. Thomas Lux & D. Sornette, 1999. "On Rational Bubbles and Fat Tails," Quantitative Finance Papers cond-mat/9910141, arXiv.org.
    3. Yuliya Demyanyk, 2009. "Quick exits of subprime mortgages," Review, Federal Reserve Bank of St. Louis, issue Mar, pages 79-94.
    4. John Y. Campbell & Joao F. Cocco, 2004. "How do house prices affect consumption? Evidence from micro data," 2004 Meeting Papers 304, Society for Economic Dynamics.
    5. M. Serrano & Marián Boguñá & Alessandro Vespignani, 2007. "Patterns of dominant flows in the world trade web," Journal of Economic Interaction and Coordination, Springer, vol. 2(2), pages 111-124, December.
    6. D. Sornette & A. Johansen, 2001. "Significance of log-periodic precursors to financial crashes," Quantitative Finance Papers cond-mat/0106520, arXiv.org.
    7. Freixas, Xavier & Parigi, Bruno & Rochet, Jean Charles, 1999. "Systemic Risk, Interbank Relations and Liquidity Provision by the Central Bank," CEPR Discussion Papers 2325, C.E.P.R. Discussion Papers.
    8. J. Doyne Farmer, 1999. "Market Force, Ecology, and Evolution," Computing in Economics and Finance 1999 651, Society for Computational Economics.
    9. W. -X. Zhou & D. Sornette, 2003. "2000-2003 Real Estate Bubble in the UK but not in the USA," Quantitative Finance Papers physics/0303028, arXiv.org, revised Jul 2003.
    10. A. Corcos & J. -P. Eckmann & A. Malaspinas & Y. Malevergne & D. Sornette, 2001. "Imitation and contrarian behavior: hyperbolic bubbles, crashes and chaos," Quantitative Finance Papers cond-mat/0109410, arXiv.org.
    11. Yuliya Demyanyk & Otto Van Hemert, 2008. "Understanding the subprime mortgage crisis," Proceedings, Federal Reserve Bank of Chicago, issue May, pages 171-192.
    12. B. M. Roehner & D. Sornette, 2000. ""Thermometers" of Speculative Frenzy," Quantitative Finance Papers cond-mat/0001353, arXiv.org.
    13. D. Sornette & H. Takayasu & W. -X. Zhou, 2003. "Finite-Time Singularity Signature of Hyperinflation," Quantitative Finance Papers physics/0301007, arXiv.org.
    14. Kaizoji, Taisei & Sornette, Didier, 2008. "Market Bubbles and Chrashes," MPRA Paper 15204, University Library of Munich, Germany.
    15. D. Sornette & A. Johansen, 2001. "Significance of log-periodic precursors to financial crashes," Quantitative Finance, Taylor and Francis Journals, vol. 1(4), pages 452-471.
    16. Skreta, Vasiliki & Veldkamp, Laura, 2009. "Ratings shopping and asset complexity: A theory of ratings inflation," Journal of Monetary Economics, Elsevier, vol. 56(5), pages 678-695, July.
    17. D. Sornette, 2008. "Nurturing breakthroughs: lessons from complexity theory," Journal of Economic Interaction and Coordination, Springer, vol. 3(2), pages 165-181, December.
    18. Florian Wagener & Cars Hommes & William Brock, 2006. "More hedging instruments may destabilize markets," Working Papers wp06-11, Warwick Business School, Financial Econometrics Research Centre.
    19. Alan Greenspan & James Kennedy, 2008. "Sources and uses of equity extracted from homes," Oxford Review of Economic Policy, Oxford University Press, vol. 24(1), pages 120-144, spring.
    20. D. Sornette & J. V. Andersen, 2001. "A Nonlinear Super-Exponential Rational Model of Speculative Financial Bubbles," Quantitative Finance Papers cond-mat/0104341, arXiv.org, revised Apr 2002.
    21. M. Angeles Serrano & Marian Boguna & Alessandro Vespignani, 2007. "Patterns of dominant flows in the world trade web," Quantitative Finance Papers 0704.1225, arXiv.org.
    22. A. Johansen & D. Sornette, 1998. "Stock market crashes are outliers," The European Physical Journal B - Condensed Matter and Complex Systems, Springer, vol. 1(2), pages 141-143, January.
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