Lessons Learned from Historic Booms and Busts



  • Professor Sheridan Titman summarizes his research and teachings on economic factors including catalytic and pecuniary investment models
  • The Internet is a catalyst for other investments -- it encourages innovation by allowing companies to build on one another
  • Real estate is an example of the pecuniary model, in which investment affects price, and the change in price has other consequences
  • Shocks to debt and equity markets have fundamentally different consequences

In his address as outgoing president of the American Finance Association, McCombs Finance Professor Sheridan Titman reviewed the factors that led up to the two most significant financial events of the last 20 years: the dot-com boom and bust of the 1990s, and the boom and bust in residential housing in the mid-2000s.

The lessons learned in each case have implications on economic policy decisions in the future. Below are highlights from the speech, including his discussion of catalytic and pecuniary models of investment; and the difference between productivity shock and participation shock.

The full video of Titman’s presentation follows.

The Catalytic Model: The Rise of the Internet

“The catalytic model is a story about an investment — I’ll use the example of the Internet — which is a catalyst for other investments. This is an investment that is a strategic complement to lots of other investments that complement other investments still.”

 “These investments are all strategic complements, which means the more that Cisco invests in the pipeline, that’s going to imply more investment by Amazon, and the more that Amazon invests, that’s going to lead to more investment by Cisco. These things build on each other.”

“We like encouraging these emerging investments. Emerging investments are a good thing. We like the idea of creative destruction. We’ve got new innovations, these are complementary, they feed on each other, but they destroy the old, and overall, that’s good for the economy.”

The Pecuniary Model: Residential Real Estate

“The pecuniary model is a model in which the investment affects price, but then the price affects other decisions that themselves have externalities.”

“This is again a story about supply and demand: If I build more houses, then obviously the price of the houses will be lower. That’s the idea of a pecuniary externality: You build more, and prices are going to be lower. If you under-build, prices go up.”

“Most new businesses are funded by individuals that borrow on their home equity loans, and they’re able to do that if the prices are higher.”

Productivity Shock and Participation Shock

Editor's Note: Incumbent firms (older publicly traded companies like IBM) must compete with emerging companies entering the market, which often go public when stock prices are high. Titman explains that a productivity shock occurs when an increase in incumbent productivity leads to an increase in incumbent cash flow, which in turn drives up those companies’ stock prices. However, more emerging companies start to enter the market when stock prices are on the rise, which eventually reduces the incumbents’ cash flow due to the increased competition. In participation shocks, increased investments lead to higher incumbent stock prices, prompting more emerging companies to enter the market. Again, this reduces the incumbents’ cash flow.

“Positive shocks to the stock market actually cause economic growth — participation shocks cause economic growth because they increase investments that are strategic complements and have positive externalities. … But it may not cause an increase in the dividends of incumbent firms.”

What Caused the 1990s Bull Market?

“In the 1990s, there was a big change in how individuals traded stocks, and how people invested in general. We had this onslaught of discount brokers and online brokers. That had a big influence on how people are investing.”

“Even more important might be the death of defined benefit plans and the birth of defined contribution plans — 401(k), 403(b), and so on.”

“The participation shock in the 1990s was potentially as important as the productivity shock.”

“What’s causing the bull market of the 1990s? Is it being caused by productivity? Is the world really getting to be a lot more productive, and companies are going to be more profitable as a result, and that’s why the stock market is booming? Or is it because of this participation shock? Is it because individuals are buying more stocks and pushing prices up?

“We really didn’t know at the time. If we had known at the time that it’s a participation shock, we would have said the markets are too high, and we would probably allocate less. If we know it’s a productivity shock, we’re probably going to allocate more. The fact of the matter is that we don’t know for sure.”

Mid-2000s Credit Boom

“China and other Asian countries were saving a lot, and they were investing in U.S. debt. There was a big flow from Asia into the U.S. debt markets.”

“At the same time, we had financial innovation that could transform BBB debt (like mortgages) into AAA debt. So we had this new magic that allowed us to reduce the supply of BBB debt and increase the supply of AAA debt, right when we had a lot of people from Asia wanting to buy that AAA debt.”

“Suppose investors underestimated the shock to the credit supply. They would believe the credit spread reduction reflected reduced uncertainty. That’s going to lead to tighter credit spreads. That’s going to lead to a higher value for collateralizable assets. So things like houses, which are financed through credit, their values will increase relative to assets that cannot be financed with debt.”

Differences Between Equity and Debt Market Shocks

“Shocks to the equity markets are going to affect the types of investments that are strategic complements, while shocks to the debt markets are going to affect investments in these assets that have this pecuniary externality issue — the strategic substitutes.”

“Emerging technologies tend to be strategic complements, which is going to imply under-investment. They require equity financing. Things like real estate and capacity expansions tend to generate pecuniary externalities, implying over-investment. These are investments that can be financed with debt. Therefore, shocks to debt and equity markets have fundamentally different consequences.”

Framing the Policy Debate

“Should the policymakers offset the participation shocks? I think if they observe them, they obviously do. They should do that.”

“This was something that came up a lot in 2008 and 2009. Some people were saying, ‘Gee, financial economists should have been able to foresee this collapse that was going to happen.’ And our answer was, in efficient markets, we can’t foresee what’s going to happen in the future. That’s the whole point of these markets. You can’t have a theory where I know what’s going to happen in the future and, in some sense, do something about it.”

“But there are some observables that are related to what I call the fragility of markets, and even though we can’t predict the direction of the market, we should be able to predict instances where, because of the complementarities, we have some sort of fragility, and there may be policy implications to that."

See video

Mentioned in this Article

Sheridan Titman

Walter W. McAllister Centennial Chair in Financial Services McCombs School of Business

Sheridan Titman is a professor of finance at The University of Texas at Austin and a research associate of the National Bureau of Economic...

About the Author

Rob Heidrick

Writer, McCombs School of Business

Born and raised in Austin, writer Rob Heidrick has spent several years as a contributor and editor at local magazines and community newspapers. He...