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Why Diversification Fails During a Credit Bubble

March 4th, 2009

John Plender’s recent article in the Financial Times discusses the failure of diversification with regards to the current economic bust. I thought it was interesting because his thesis has an “Austrian” element1:

A more fundamental point is simply that diversification cannot work well in a credit bubble because virtually all asset categories are driven up by leverage. Then when the bubble bursts, deleveraging affects asset categories indiscriminately.

I tend to agree that diversification cannot work well in a credit bubble, although I’m not sure “indiscriminate” is the appropriate way to describe the havoc wrought. When Plender says “indiscriminately”, what he means is that no amount of entrepreneurial insight was sufficient to avoid losses, and that only dumb luck could’ve kept investors above water.

But losses aren’t exactly “indiscriminate”, instead, effects of deleveraging ought to be strongly correlated with the amount of leverage, so highly levered “assets” should experience the largest losses; this much is elementary. Although not stated explicitly, Rothbard touches on the apparently “indiscriminate” nature of losses during the bust phase, while describing the “cluster of error” characteristic of capitalist boom/bust cycles2:

How, then, do we explain the curious phenomenon of the crisis when almost all entrepreneurs suffer sudden losses? In short, how did all the country’s astute businessmen come to make such errors together, and why were they all suddenly revealed at this particular time? This is the great problem of cycle theory.

Expanding on Hayek’s framework, Rothbard concludes that the eventual “bust” is “generated by monetary intervention in the market, specifically bank credit expansion to business,” and that the “’crisis’ arrives when the consumers come to reestablish their desired proportions [of savings and consumption]” and the banks can no longer credibly augment the money supply.

The last point is key: as long as the money supply can be continually and credibly expanded (i.e., no risk of hyperinflation), banks can continue to increase the amount of credit available, and business borrowers will remain “one step ahead”, able to bid prices ever higher, further exacerbating the eventual bust. At some point, however, credit is no longer issued in sufficient quantities or at the right time, and this is the point in time where the house of cards is revealed for what it is.

It’s of paramount importance to understand that although an economic “bust” destroys, dislocates, or otherwise consumes some real wealth through malinvestment, mostly, what’s happening is that the Ponzi-scheme illusion of wealth, credit, is being destroyed, and consequently every asset the “value” of which was determined (in whole or in part) by credit, needs to be reassayed.

Wherever economic growth is not driven by previous savings and capital accumulation, but instead mortgaged by future productivity, a “bust” is inevitable.

  1. Plender, John. Investment and the crisis: an error-laden machine, Financial Times, March 2, 2009.
  2. Rothbard, Murray N. How the Business Cycle Happens.

no third solution

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