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

  • Didier Sornette
  • Ryan Woodard
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    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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    File URL: http://arxiv.org/pdf/0905.0220
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    Paper provided by arXiv.org in its series Papers with number 0905.0220.

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    Date of creation: May 2009
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    Publication status: Published in in Proceedings of APFA7 (Applications of Physics in Financial Analysis), "New Approaches to the Analysis of Large-Scale Business and Economic Data,'' Misako Takayasu, Tsutomu Watanabe and Hideki Takayasu, eds., Springer (2010)
    Handle: RePEc:arx:papers:0905.0220
    Contact details of provider: Web page: http://arxiv.org/

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    7. Sornette, D & Takayasu, H & Zhou, W.-X, 2003. "Finite-time singularity signature of hyperinflation," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 325(3), pages 492-506.
    8. Thomas Lux & Didier Sornette, 1999. "On Rational Bubbles and Fat Tails," Discussion Paper Serie B 458, University of Bonn, Germany.
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    10. 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.
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    12. Kaizoji, Taisei & Sornette, Didier, 2008. "Market Bubbles and Chrashes," MPRA Paper 15204, University Library of Munich, Germany.
    13. Zhou, Wei-Xing & Sornette, Didier, 2006. "Is there a real-estate bubble in the US?," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 361(1), pages 297-308.
    14. Ide, Kayo & Sornette, Didier, 2002. "Oscillatory finite-time singularities in finance, population and rupture," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 307(1), pages 63-106.
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    17. W. -X. Zhou & D. Sornette, 2003. "2000-2003 Real Estate Bubble in the UK but not in the USA," Papers physics/0303028, arXiv.org, revised Jul 2003.
    18. D. Sornette & H. Takayasu & W. -X. Zhou, 2003. "Finite-Time Singularity Signature of Hyperinflation," Papers physics/0301007, arXiv.org.
    19. Johansen, Anders & Sornette, Didier, 2001. "Finite-time singularity in the dynamics of the world population, economic and financial indices," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 294(3), pages 465-502.
    20. Yuliya Demyanyk, 2009. "Quick exits of subprime mortgages," Review, Federal Reserve Bank of St. Louis, issue Mar, pages 79-94.
    21. 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.
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