Hamilton on the Bubble No One Can Name

There is a peculiar mood in your financial markets today. Prices rise, fortunes are made, speculation continues, and yet beneath the confidence there is uneasiness. Men wager enormous sums upon the future while privately suspecting that the future cannot continue indefinitely upon its present course. Valuations in certain markets depend upon years of extraordinary growth still to come; credit remains abundant; vast sums continue to flow into technology, artificial intelligence, private credit, real estate, and financial assets whose prices assume that prosperity will persist without serious interruption. The speculator continues to wager because yesterday rewarded him, today has not punished him, and tomorrow has not yet arrived. Yet speak privately with thoughtful men and the confidence changes. Few truly believe that excess can continue forever. They know that prices cannot indefinitely outrun earnings, that debt cannot increase without limit, and that speculation cannot forever substitute expectation for accomplishment. What they do not know is how the reckoning will begin.

That uncertainty has itself become a form of reassurance. Because no one can identify the precise event that will end the prosperity, men behave as though no such event is near. They speak instead of some future surprise—a war, a banking failure, a sovereign default, a collapse in technology shares, a political upheaval, or what your age has come to call a black swan: an event so unexpected that no prudent man could reasonably have prepared for it. This explanation is comforting. I am not certain it is correct. Perhaps the next crisis will not begin with something no one could see. Perhaps the danger is already before you.

The more I have examined your modern economy, the more I am struck by a contradiction. You have constructed a financial system of unprecedented sophistication upon a productive system of extraordinary interdependence. The value of trillions of dollars in securities ultimately depends upon factories continuing to operate, ships continuing to sail, energy continuing to flow, crops continuing to grow, and thousands of specialized materials continuing to arrive precisely when needed. Finance assumes production. Production assumes supply. And supply increasingly assumes that nothing important will seriously interrupt an immensely complicated global chain. That is an extraordinary assumption upon which to place so much wealth.

Consider what happens when a corporation is competently managed, its products desired, its workers productive, and its debts perfectly serviceable—until it can no longer obtain something indispensable to making what it sells. Perhaps that something is oil. Perhaps fertilizer. Perhaps copper, semiconductors, helium, an industrial chemical, or a component produced in only a handful of places. The company has committed no financial error. Its bankers may have committed no lending error. Yet production falls because the physical means of production have been interrupted. Revenue declines, while the debt remains. That distinction may prove decisive.

Your previous great financial crises often began inside finance itself. Credit became too abundant. Speculators drove the prices of houses, securities, or other assets beyond sustainable levels. Lending weakened in quality. Confidence eventually failed and asset prices collapsed. The danger I now contemplate proceeds in the opposite direction. The first failure may occur in the productive economy and only afterward infect finance. A disruption in energy raises transportation and manufacturing costs. A fertilizer shortage reduces agricultural output. A shortage of specialized materials delays production. A shipping interruption prevents manufacturers from receiving necessary components. Inventories are gradually exhausted. Companies reduce production. Revenues weaken. Workers are dismissed. Household income falls. Debts that yesterday appeared entirely sound become difficult to service. The financial system then discovers that its supposed assets are merely claims upon income that the productive economy can no longer generate.

Thus a supply interruption becomes a production crisis; a production crisis becomes an income crisis; an income crisis becomes a debt crisis; and a debt crisis becomes a banking crisis. What troubles me most is not merely the existence of these vulnerabilities, but the condition of the financial system when such an interruption arrives. A deeply undervalued market may absorb bad news. An extended market reacts differently. When investors have already begun privately questioning valuations, the triggering event need not be enormous. It need only give millions of people a reason to act upon doubts they already possess. The match may be small because the combustible material has already accumulated.

Imagine that shortages initially appear manageable. Governments release reserves. Companies draw down inventories. Markets are assured that the interruption will prove temporary. Prices decline briefly and recover. The speculator interprets recovery as confirmation that risk has once again disappeared. But the interruption persists. Inventories continue falling. Costs rise. Production is curtailed. Companies once expected to produce extraordinary earnings instead report disappointing results. Nothing resembling a depression has yet occurred, but one assumption has changed: tomorrow no longer looks quite like yesterday.

For a financial market sustained heavily by expectation, that may be enough. An enterprise valued on the assumption of uninterrupted growth does not have to become insolvent for its market value to collapse; it merely has to disappoint expectations. The fall in its price then affects leveraged investors. Collateral declines. Lenders become cautious. Credit tightens. Other assets are sold to meet obligations. Businesses postpone investment. Consumers become less confident. The disturbance begins feeding upon itself.

And so I ask whether your search for the next black swan has directed attention to the wrong place. There is nothing unexpected about the world’s dependence upon energy. There is nothing hidden about strategic shipping passages through which indispensable commodities must travel. There is nothing mysterious about relying upon a limited number of nations or companies for critical industrial materials. There is nothing unknowable about the fact that corporations must continue earning revenue if their debts are to remain sound. These vulnerabilities are visible. The uncertainty lies only in which will fail first, how severely, and whether the failure will persist long enough to expose the weaknesses elsewhere in the system. That is not ignorance of the danger. It is ignorance of its timing.

The distinction matters. A man standing beside a powder magazine need not know which spark will ignite it to understand that the powder itself presents the danger. This, then, may be the condition confronting your markets. Investors know that valuations are stretched. They know speculation has become aggressive. They know enormous expectations have been placed upon future earnings. Yet because the system continues functioning, each assumes that he may safely remain for another day. He believes he will recognize the danger when it comes. So does everyone else. And therein lies the problem, for when confidence finally changes, everyone discovers the danger at the same moment.

What if the event that produces that change in confidence is not some unforeseeable catastrophe descending from nowhere? What if it is a vulnerability already moving openly through the arteries of world commerce? What if the pin capable of puncturing the financial bubble is riding in plain sight within the supply chains upon which modern prosperity depends?

That possibility deserves far more attention than it presently receives. For if financial markets are already extended, and if corporate and household obligations assume continuing income, then the true danger is not merely that a supply interruption will make certain goods more expensive. The greater danger is that it may force the entire financial system to reconsider the assumptions upon which enormous quantities of wealth have been valued. Once those assumptions are questioned, events can move rapidly.

The statesman’s task is therefore not to predict with certainty which crisis will arrive. No serious man can do so. His responsibility is to examine the conditions that would permit an ordinary disturbance to become an extraordinary catastrophe. A prudent republic should ask where its essential dependencies lie, how long its reserves can sustain it, which industries possess no substitute for critical inputs, which debts become dangerous if production is interrupted, and which financial institutions are most exposed if corporate revenues suddenly weaken. It should diversify where diversification is possible, preserve domestic productive capacity where dependence upon foreign supply creates dangerous vulnerability, maintain adequate reserves, secure energy, and recognize that efficiency without redundancy may produce extraordinary profits in tranquil times and extraordinary weakness in moments of disruption.

Above all, it must cease confusing the absence of catastrophe with the absence of danger. Tomorrow has arrived peacefully many times. That does not constitute a promise that it will always do so. Perhaps the coming financial crisis will indeed be caused by some astonishing event no one foresaw. But perhaps not. Perhaps everyone is waiting for a black swan while the danger is already swimming directly before them. And perhaps the most consequential question confronting your markets is not whether the bubble will someday burst, but whether the instrument capable of bursting it is already embedded in the fragile supply system upon which the whole magnificent structure rests.