In this post I’m going to build on my previous post on how autocatalytic processes can give rise to bubbles in financial markets, starting with a brief discussion of the ‘Boredom Market Hypothesis’, and propose that US retail investors putting their stimulus checks into the stock market is a predictable consequence of the current market frenzy.

After this, I’m moving on to the role of speculation in financial markets and economies; drawing parallel between speculative bubbles as they happen in both financial markets and other inflationary situations, as it’s possible that inflation and bubbles are both fuelled by similar speculative tendencies—only that one takes the form of asset-price inflation while the latter takes the form of goods-price inflation.

In the end, I conclude that the importance of speculative elements to the run-on of inflationary processes suggests that we shouldn’t expect inflation to accelerate in an economy where an autocatalytic inflationary process is already raging as there simply might not be enough speculative temperament around to fuel both processes at the same time.

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In yesterday’s edition of Matt Levine’s Money Stuff(which is a newsletter worth reading if you’re interested in an informative and humorous take on capital markets news [link]), there was a section on ‘The Stimmy Markets Hypothesis’, where Levine provided some examples of how Americans are using their stimulus checks to stimulate not the economy, but the bull market that’s raging in equities:

Here’s what happened in the market around the time the government sent people $600 earlier this month. Penny share volume mushroomed. […] Coincidence? Maybe — though a lot of people doubt it. They can’t help notice how tiny traders with money to spend keep turning up in the vicinity of almost every market spectacle these days. Now, more federal aid may be on the way, and Wall Street pros are bracing for what comes next.

“If the additional $1,400 goes to the same income levels it did before, we are highly likely to see additional speculation in stocks, which could continue to inflate an already-existing bubble,” Peter Cecchini, founder and chief strategist of AlphaOmega Advisors LLC, said in an interview. …

The sums would be hitting bank accounts at a time of full-blown mania in the market. Volume in penny stocks regularly tops 40 billion shares a day lately, up sixfold from a year ago, with day traders venturing off-exchanges and into the speculative over-the-counter markets. The options market saw the second-busiest day ever for bullish equity calls this week. Meanwhile, Goldman Sachs data show that a basket of retail-favored stocks has surged 10% since the end of December, beating both the S&P 500 and returns on hedge-fund favorites by more than 9 percentage points.

And:

Given the number of Americans eligible to receive the payments, some of the $1,400 checks will inevitably land in the pockets of people who will either save it or invest it, rather than spend it on essentials. Such was the case with 23-year-old Ava Frankel of Boston, who works in the financial services sector.

“I told my friends, if you’re going to spend your stimulus check on shoes, you might as well just put it in Robinhood instead,” Frankel said in an interview. “The $600 check was just something extra I didn’t need so I just threw it in the stock market.”

Levine proposes that this is a “version of the boredom market hypothesis”, which he has expanded on in previous newsletters, where he proposes that:

people will trade stocks to the extent that (1) trading stocks is fun and (2) other things are less fun; it suggests that stocks have gone up a lot in a pandemic because it’s now hard to see friends or do stuff, so trading stocks on Robinhood is now relatively more entertaining. You don’t need shoes if you never leave the house, so a lot of people who would otherwise spend their stimulus money on goods and services are spending it on penny stocks instead. In a pandemic, perhaps, a lot of fiscal stimulus goes to inflating asset bubbles, but not in the assets that professional investors like. The combination of economic stimulus and having nothing to do means that people are spending their stimulus checks on the experiences that are still available, specifically the experience of buying SPACs.

I’m citing Levine (and his citations) at length because I find the Boredom Market Hypothesis interesting (and amusing; the Money Stuff newsletter is one of few financial market newsletters that regularly have me laughing out loud), but I’d also like to take this hypothesis further.

In my previous post on the blog [link], I wrote about the sort of self-organising, autocatalytic processes that we can see at play in financial markets:

[Here] we have the beginnings of a simple model for the formation and persistence of speculative bubbles in markets, where, (1) they form when economy money-flows favour financial markets over other parts of the economy (creating a strong flow of money into the market); (2) they pick up steam as they start growing by attracting more money into the market, which allows them to persist; and (3) they deflate (gently or catastrophically) when there is not enough money entering the market for them to continue to grow.

[…]

From the first part of our simple model, we see that market bubbles are formed when money-flows favour the market instead of other parts of the economy. (Of course, money-flows favouring non-market assets can lead to bubbles forming in non-market parts of the economy.) Normally, you’d think that economy money-flows would balance themselves out, where too much money flowing into one part of the economy would incentivise less money to flow into those parts in the future. There are, however, circumstances when this is not the case, and both economic and social factors can incentivise the disproportionate flow of money into one part of the economy, creating the conditions for a bubble to start to form.

(Click through on the link above to read the rest of the post, where I draw parallel between financial market bubbles, hurricanes, and other ‘organisms of physics’.)

In this previous post, I also alluded to the possibility that part of the current US financial market might be host to at least one of these autocatalytic processes. The implication of such an autocatalytic process going on is that the ‘bubble’ so-formed has the potential to divert money-flows from elsewhere in the economy, and for these money-flows to go into the bubble and keep feeding it. This model maps onto the Boredom Market Hypothesis as cited above (where Levine suggests that stock prices are booming because retail investors are bored, putting their money into their Robinhood accounts rather than goods), but with the added twist that if we’re in a bubble, then it’s likely that the bubble is ‘sucking’ money from the rest of the economy as if it was an ‘economic vampire’, of sorts. The reason for why a bubble can suck money from the economy is (ergodicity economics aside), that people will be putting their money where they think their investment will yield the greatest return.

In an efficient economy, good investment opportunities will be spread reasonably well across the economy, which will avoid money pooling in any particular part thereof. However, in the situation where good-enough investment opportunities are not available at a high-enough frequency, the few opportunities that remain will show a higher propensity for going autocatalytic and maturing into bona fide bubbles. These bubbles will be hard to predict ahead of time, but once started, they will contribute to an increasing misallocation of assets throughout the economy, as they’re attracting far-greater investments than what is justified by the underlying fundamentals. These resultant investment inflows are however themselves justified on the secondary level, because the more money that is invested in the bubble, the bigger the bubble will grow, and the greater the potential returns for the brave investor who’s willing to give the bubble a ride.

As such, when there is a bubble raging in the economy, it is likely to attract a disproportionate amount of marginal money flows. Indeed, it would be silly for people to forego investing in a bubble when it’s happening, because the potential returns (if you ride the bubble well) will far outweigh any returns that you would have made by investing more risk-aversely. This, however, means that giving out stimulus checks to people who don’t need such checks to survive (i.e. by using the money to buy goods), you won’t be ‘stimulating the economy’ as much as you’re feeding the bubble-vampire. For this reason, if you were to want to use stimulus checks as a tool for stimulating the economy, you may not wish to do so when an autocatalytic process is running, as it otherwise becomes likely that your stimulus money will just end up there and not in the economy proper (which would effectively defeat the purpose of the stimulus in the first place).

(Interestingly, this dynamic might also help explain why we’re seeing increasing levels of wealth inequality across large swathes of the industrialised world, where the more money is being sucked up by bubbles (in whatever market), the less money should be expected to circulate through the economy and make its way back into the pockets of people at lower, more productive levels in the economy [link].)

Furthermore, this also prompts the interesting question of under what conditions that the economy would be ‘stimulated’, and intriguingly, the bubble dynamic does map beyond financial markets and onto the economy in the form of inflation, where, if you go rooting around the academic literature at the intersection of physics and economics, you do find the occasional paper (e.g. [link], [link]; both titles available on arXiv.org) that suggests that inflation shares quite a few similarities with other autocatalytic speculative processes. Now, this has been shown to apply mainly to hyperinflationary regimes, but this also suggests that normal inflation would be to hyperinflation what normal stock-market price-appreciation is to bubble-driven stock-market price-appreciation.

This view of inflation (that hyperinflation is an autocatalytic process) traces its roots all the way back to 1956, when the economist Phillip Cagan suggested that (hyper)inflation happens as the result of ‘inflationary expectations’ that develop when the observed inflation rate exceeds the expected inflation rate. As a result of this subjective divergence, people start to over-compensate and end up expecting more inflation to happen; effectively allowing the inflationary regime to not only continue, but also to pick up momentum. Over (not even long periods of) time, even mild inflation can, in such cases, develop into more rapid inflation. What this implies is that inflation is a form of speculation in the price of goods, and from this, it should be clear that the speculation in prices that happens during inflation is much like the speculation in prices in a bubble regime. 

For this reason, it’s probably not a coincidence that bubbles are characterised by inflation in the price of assets rather than goods. Indeed, if we were to run with this model, and recall how bubbles are vampires that ‘suck’ money up from elsewhere in the economy, we shouldn’t expect an inflationary regime (in the broader economy) to take place when a bubble is raging in one corner of the economy: For one, there might not be enough fuel (as money is limiting), and the different inflationary regimes (in goods vs assets) also require opposing speculative mindsets; with inflation requiring people to expect the purchasing power of money to keep going down (as goods-prices are appreciating) and bubbles requiring people to expect that the purchasing power of the asset-based quasi-currency to keep goingup (as goods-prices are going down in comparison). 

With regard to the factors that kick-start these speculative processes, I covered some of them in my previous blog post, pointing to uncertainty as being an important factor (where, the greater the uncertainty in asset-prices becomes, the greater asset-prices should be expected to appreciate). This type of uncertainty would also be particularly common during times of New Economy-type thinking or during periods of rapid social change.) This applies to inflationary regimes in the broader economy as well. 

Indeed, the periods in which high inflation or hyperinflation have occurred, have all been preceded by large shocks to the economy in the form of wars, the collapse of empires or nation-states (e.g. the fall of the Weimar Republic in 1920s), or large price-shocks to the economy (e.g. the 1973 oil crisis). When these large, economy-wide events occur, the uncertainty that is injected into the economy as the result of the external shock, is enough to unbalance the economy and allow speculative processes to fester. (While in my previous blog post I floated the possibility that the 2016 election of Donald Trump caused stock prices to start appreciating and seeding the bubble that we’re likely in the midst of, where COVID has poured further fuel on the fire, exogenous shocks like OPEC dramatically raising the price of oil in the 1970s allow similarly strong speculative processes to take root and spread through the economy as the impact of a price shock in oil feeds into all goods where oil is a meaningful input.) Seen from a physics perspective, the speculation that underlies inflationary processes in economies and markets also fulfils an important purpose as the speculation is the process by which the economy regains its balance and returns to a new equilibrium state, eventually allowing the economy to settle on a new price level and proceed from there. 

Altogether, this interpretation of the inflationary dynamic also helps explain why the money supply doesn’t always correlate with the level of inflation in the economy. While in standard economic theory, we’d expect the price of goods to equilibrate with the amount of money in the economy (where more money equals higher prices, with everything else staying the same), inflationary periods have however rarely coincided with increases in the money supply historically, and even popular examples of such situations (e.g. the 1600s price revolution) turn out to be more complicated once you take a more holistic view (e.g. [link]).

As such, when we see low levels of inflation in the economy, we should consider this a sign of potential certainty; where people feel comfortable that prices will not be going up (and the low levels of inflation that we’d still be seeing being the result of low ‘economic noise’). As a result, it’s possible that low interest rates don’t give rise to either high or low levels of inflation on their own, and, indeed, if you start digging into the really esoteric parts of economic and financial history, you will soon find that interest rates (and inflation) seems to equilibrate around 1 – 2 %—whether you’re looking at interest rates in Italian city-states during the Renaissance [link], interest rates over the last 700 years [link], or interest rates across today’s developed economies. Instead, we should probably see these low rates as an indication that things are going well (as interest rates typically scale with the inflation rate), and that we’re living in a world where the major industrialised economies are enjoying low levels of uncertainty.

Of course, if you’re a believer in Schumpeterian ideas like the power of creative destruction, perhaps these certain times are also indicative of a more general economic and innovative lull. Obviously, the world’s financial markets would disagree with this interpretation somewhat, but what’s going on there will have to form the topic of a blog post some other day…