How are economic or financial bubbles formed?

Bubbles are like pornography: Everyone has his or her own opinion as to what qualifies, but it is impossible to pen a precise definition. If you wish to push the metaphor further, both are also fun for a while, if you like that sort of thing, but apt to end up making you feel deflated and embarrassed.

Bubbles are also embarrassing for the economics profession. It’s not that we have no idea what causes bubbles to form, it’s that we have too many ideas for comfort. Some explanations are psychological. Some point out that many bubbles have been stoked not by markets but by governments. There is even a school of thought that some famous bubbles weren’t bubbles at all.

The psychological explanation is the easiest to explain: People get carried away. They hear stories of their neighbors getting rich and they want a piece of the action. They figure, somehow, that the price of stocks (1929) or dot-com start-ups (1999) or real estate (2006) can only go up.

A symptom of this crowd psychology is that the typical investor displays exquisitely bad timing. The economist Ilia Dichev of the University of Michigan has recently calculated “dollar-weighted” returns for major stock indexes; this is a way of adjusting for investors rushing into the market at certain times. It turns out that “dollar-weighted” returns are substantially lower than “buy and hold” returns. In other words, investors flood in when the market is near its peak, tending to buy high and sell low. The herd instinct seems to cost us money.

That is awkward for economists, because mainstream economic models do not really encompass “herd instinct” as a variable. Still, some economists are teaming up with psychologists and even neurophysiologists in the search for an answer.

These psychological explanations are likely to help us understand what goes on as bubbles form and how they might be prevented. Yet they make me nervous: It is too easy to blame a bubble on the mob psychology of the market when a closer look at most bubbles reveals that there is much more to the story than that.

Warren Buffet believes so as well. Back in 2010, in an interview with the Financial Crisis Inquiry Commission, Buffett answered several questions about what he thought caused the housing and credit bubble.

The government played its own part in the current credit crunch, too. For all the scapegoating of deregulation, thoughtful commentators also point to the Federal Reserve’s policy of cheap money, and Fannie and Freddie’s enormous appetite for junk mortgages–urged all the way by politicians trying to make credit available to poor and risky borrowers. Market psychology was part of the story, but not the whole story.

The idea that ordinary people have a tendency to be caught up in investment manias is a powerful one, thanks in part to Charles Mackay, author in 1841 of the evergreen book Extraordinary Popular Delusions and the Madness of Crowds. Mackay’s most memorable example was the notorious Dutch tulip bubble of 1637, in which–absurdity!–tulip bulbs changed hands for the price of a house.

It is the quintessential case study of financial hysteria, but it’s not clear that there was ever an important tulip bubble. Rare tulip flowers–we now know that their intricate patterning is caused by a virus–were worth huge sums to wealthy Parisian gentlemen trying to impress the ladies. Bulbs were the assets that produced these floral gems, like geese that laid golden eggs. Their value was no fantasy.

Economists are going to have to get better at understanding why bubbles form from a heady mix of fraud, greed, perverse incentives, mob psychology and government incompetence. What we should never forget is that underneath the apparent hysteria, there is often a cold rationality to it all.

So when the mood is there and people are getting excited, maybe it’s time to get out. Trade safe.


Interesting reads:

https://www.gsb.stanford.edu/insights/brief-history-financial-bubbles

https://www.forbes.com/2008/10/21/why-bubbles-economy-markets-bubbles08-cx_th_1021harford.html

https://www.forbes.com/2010/06/17/guide-financial-bubbles-personal-finance-bubble.html

http://www.businessinsider.sg/warren-buffett-explains-how-bubbles-formed-2017-8/

https://www.thebalance.com/asset-bubble-causes-examples-and-how-to-protect-yourself-3305908

https://en.wikipedia.org/wiki/Economic_bubble

6 comments

  1. I believe bubbles have one underlying cause and thats debt – specifically, money owed that cannot be paid back quick enough. It is usually short term financial oligations coupled with not enough cashflow that sink businesses and individuals. For markets, mix in a little greed and recklessness, and boom, you have your bubble.

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