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Inside the Market

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You call that a bubble? Add to ...

Now that investors have had to deal with the fallout from the dot-com bubble of the late 1990s and the U.S. real estate bubble of recent years, you can't look anywhere without someone spotting a new and more terrifying bubble. Gold, bonds and emerging market equities are the most often cited.

However, Paul Krugman makes some interesting observations about bubbles in his New York Times blog. There are bubbles and then there are bubbles, but the most devastating ones are those that combine big borrowing on the part of investors. He explains:

"I think we need to bear in mind that while bubbles are in general a bad thing, just how bad depends a lot on the context - in particular, whether the inflation of the bubble has been accompanied by a big increase in leverage on the part of those buying the inflated assets," he said.

The dot-com bubble vaporized $5-trillion (U.S.) in wealth, but it didn't bring the financial system to its knees because relatively few investors actually borrowed money to buy those stocks. The housing bubble was a different story, because most homeowners used borrowed money to get into the market. When the market turned, many homeowners fell into financial trouble, and the problems quickly moved on to highly leveraged financials firms.

But where does that leave gold, bonds and emerging markets?

"The moral for right now is that even if you believe that there are bubbles inflating or about to inflate, they're only a big concern if they are leading to leveraged positions for key players," Mr. Krugman said. "The alleged carry trade bubble sorta kinda mighta have met that criterion, although I never found the warnings all that persuasive. But other stuff - bubbles in BRIC equities, or gold, or whatever, don't make the grade."

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