Economic bubbles are a recurrent feature in the history of financial markets. The canonical example, of course, is the tulip mania fiasco of the 17th century in the Netherlands. The price of tulip bulbs was at one point inflated to the level of a small mansion. Since then, economists have carefully documented and modeled the dynamics of bubble formation. The popular view of bubbles is certainly correct in pointing out that prices of financial assets often diverge from any reasonable fundamental value. But there is another side of bubbles: they are also a response to market failures.
Origins of Irrationality
The phenomenon of so-called "irrational exuberance" is older than economics itself. In the fourth century B.C.E., the philosopher Theophrastus observed a boom in the price of "woolen stuffs" in ancient Greece. In the second century C.E., the Roman emperor Marcus Aurelius talked about a "mania of building" that led people to build monuments of huge expense without due regard for their utility or durability. Marcus Aurelius also complained about a "mania of borrowing" that made a large part of the population live beyond its means.
In 1637, the Dutch philosopher and jurist Hugo Grotius wrote a book on the origins of money. He was the first to recognize that the value of money depends on the general trust that people put in it. This trust, he pointed out, is more solid when money is made of precious metals. He was thus the first to give an economic theory of bubbles.
Since then, bubbles have appeared in many guises. They have been documented in the prices of tulips, of shares of the Swedish mining company, of the Mississippi Company, of the South Sea Company, of the railways of the U.S., of the German mark, of the Japanese real estate market, and of the dotcom stocks of the late 1990s.
Tulips, Tulips, Tulips
Going back to the Tulip Bubble, an early theory of this market behavior was provided by the Dutch scholar Bernard Mandeville in 1720. He argued that the high price of tulips was justified by the rarity of a certain kind of tulip that was reputed to be the most beautiful of all. In a competitive market, he argued, the price would determine the quantity of goods produced. If the price of a good is high, producers will react by increasing the supply. This is exactly what happened in the case of tulips. By a stroke of good luck, one of the growers found a method to produce a particularly beautiful tulip. He then sold the bulbs in large quantities, and many other growers imitated him. The price of tulips went up, which induced more people to produce tulips. In the end, the price fell, and the craze waned.
The problem with Mandeville’s theory is that it relies on the idea of a "rational" consumer, who produces and consumes the right amount. In the case of the tulip craze, the consumers were clearly not rational. The beauty of the flower was not enough to justify the price of the bulbs, and many people paid huge sums just to show off their wealth. This is precisely why the price of tulips rose so high.
Modern economic theory provides a better explanation of bubbles. In the 1950s, the economist Franco Modigliani developed an influential theory of bubbles. According to his theory, the price of an asset is determined by two factors: the fundamental value of the asset, and the expectations of investors about the future value of the asset. When investors expect the asset price to increase, they are willing to pay a higher price. The value of the asset will then go up, and so will the price. When investors no longer expect the price to rise, the value of the asset will go down.
This is the basic theory of bubbles. It is based on two implicit assumptions: that investors have rational expectations, and that investors are fully aware of the fundamentals of the asset.
Some bubbles, however, do not follow a simple trajectory back to the fundamental value of the asset. Investors may be irrational, and they may have a very limited understanding of the asset they are investing in.
This was the case with the dotcom bubble that burst in the late 1990s. In the late 1990s, there was a boom in internet-related stocks. Many internet companies were valued at billions of dollars, with little or no profits. In retrospect, it is clear that these valuations were completely unjustified. The internet was not a new medium, but a new way to deliver existing services. Billions of dollars were invested in internet companies that had no clear business model. Many of them lost money.
The economist Robert Shiller has developed a theory of bubbles that takes irrationality and investor myopia into account. According to his model, investors are myopic: that is, they have a short-term horizon in which they only see the last price of the asset. They do not take into account the fundamental value of the asset. Nor do they take into account the fact that they will have to sell the asset in the future.
The intuition behind this theory is that investors face a kind of quadratic loss. If they buy an asset at a high price, they will lose money when the asset price goes down. But they also lose money if the price of the asset remains stable, or even increases a little. The longer they hold on to the asset, the bigger their losses.
The problem is that the time horizon of the investors is limited, and that they are unable to take into account the fact that, in the long run, prices are determined by fundamentals.
Shiller’s model explains why bubbles are self-fulfilling. If the price of an asset increases, it generates a positive feedback mechanism. More investors start to believe that the price will increase in the future, and they buy the asset. The price goes up even more, and even more investors are attracted by the high returns. The bubble is then "proved" by the increase in the price of the asset.
If you’re an investor interested in gauging recent price movement against asset fundamentals, it is important to have a reliable source of information. Reliable lists of stocks to watch this week, for example, will provide sound advice about fundamentals as well as an explanation of recent price fluctuations.
In the world of modern finance, good advice like this is rare. Investors are bombarded by a flood of information that is frequently misleading. The best way to avoid being caught up in a bubble is knowing what you’re buying.
The Bottom Line
The most important lesson is that bubbles are a natural by-product of the market mechanism. Borrowing, lending, and investing are essential parts of the market economy. If investors expect a profit, they will be willing to take a risk. If they expect the price of the asset to go up, they will be willing to pay a high price for it.
The question is not whether there should be bubbles in financial markets. There will always be bubbles. The question is whether we can do anything about them, and how we can ensure the overall effect on the economy is positive – or at least, that any damage of bubbles that burst is contained.