Fraud, greed, ignorance, and corruption. Financial bubbles and markets

AutorLuis Ferruz Agudo/Francisco Javier Rivas Compains
Cargo del AutorUniversidad de Zaragoza/EAE Business School
Universidad de Zaragoza
EAE Business School
Price and value are the main concepts and key issues in this paper, since
it is impossible to understand the nature of a bubble if we do not distin-
guish clearly between price and value. The first, in essence, is a conse-
quence of the market responding to the forces of supply and demand,
but the second is a little more complicated. In many respects, value is
subjective and fluctuates with the vagaries of experience, not to men-
tion personal taste.
As Brunnermeier and Ohemke (2012) explain: “the term bubble refers
to large, sustained mispricing of financial or real assets. While an exact
definition of what exactly constitutes a bubble varies, not every tempo-
rary mispricing can be called a bubble. Rather, bubbles are often asso-
ciated with mispricing that has certain features. For example, asset val-
uation in a bubble, when the price of an asset exceeds fundamentals
because investors believe that they can sell the asset at an even higher
price to some other investor in the future”.
Classical Economics in the 19th century featured much discussion of
price and value, a question already treated in the Classics of ancient
Greece and Rome. Aristotle had already distinguished between value
of use and value of exchange. Value of use involves an ability to satisfy
human needs, so it means utility, or satisfaction. In that sense, a real
asset can have zero price, but it may have a great value in terms of use
- for instance, climbing a mountain. Value of exchange is connected
more with commerce and price, and it can be matched (or not) with
fundamental, inherent value, taking into account the basic Financial
paradigm related to Discounted Cash-Flow or future measurable capital
(dividends, interests, rentals, fruits …). This can be done more compre-
hensively using C.A.P.M., Capital Assets Pricing Model.
Bubbles, of course, arise from distortions of market price, but the mar-
kets themselves are not abstract concepts; they are made by financial
decision makers, and private or institutional investors, along with, in
loan and mortgage markets, lenders and borrowers. In Economics and
Finance, academics and practitioners use sophisticated mathematical
models in a normative conceptual framework, usually built from data,
but in the end it comes down to people, and people are not always ra-
tional, and sometimes they send wrong signals to the markets, fre-
quently connected with greed, fraud, ignorance, and corruption. Eco-
nomic and Financial ignorance is a key factor in understanding Behav-
ioral Finance and the real behavior of market participants, but the real
danger for major Macroeconomics or Macrofinance destabilization
comes from Fraud, Greed, and Corruption – often involving some very
powerful and important financial decision-makers.
According to Vernon Smith, 2002 Nobel Laureate, many investors em-
body high levels of greed and ignorance, and are always on the lookout
for short-term, very high returns, involving great volatility amid sce-
narios of potentially huge losses. Smith conducted certain laboratory
experiments showing irrational financial behavior that took no account
of such basic financial foundations as clear, short-term dividend returns
and low price-to-earnings ratios, as well as paying no attention to the
principles of discounted cash flow.
It seems clear that the investor prefers to seek short-term returns (some-
thing that cannot be guaranteed with equities) and this leads them to
seek speculative investments that can provide it. It is difficult for human
beings to plan long, preferring a thousand times the smoke that a spec-
ulative action offers to the solid fundamentals of a long-term invest-
ment, because for many investors the long term is outside the desired
investment horizon.

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