Abstract
Circumstantial and anecdotal evidence of speculative bubbles and subsequent crashes can be traced as far back as ancient Rome and Greece and Babylon (Mesopotamia). The presence of mere speculation alone, which was clearly an aspect of trade in the ancient world, is not however sufficient to make an asset price “bubble.” Throughout history, bubbles and crashes have been common and complex events that always involve money, credit, trust, psychology, and emotions. This chapter introduces readers to these elements.
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Notes
- 1.
Speculation, Brunnermeier (2001, p. 48) writes, is when “A trader is only willing to buy or hold an asset at a price which is higher than its fundamental value if he thinks that he can resell the asset at an even higher price in a later trading round…A trader speculates if his foremost interest is in cashing in capital gains rather than enjoying a future dividend stream. Consequently, one might think the fundamental value might be the price which an investor is willing to pay if he is forced to hold the asset forever, that is, if he is not allowed to re-trade.” This follows Harrison and Kreps (1978) who in turn follow Keynes (1936 [1964], Ch. 12, VI). And Lefèvre (1923, p. 280) writes, “Speculation in stocks will never disappear. It isn’t desirable that it should. It cannot be checked by warnings as to its dangers…The game does not change and neither does human nature” (p. 180). Keynes also said, “It is safer to be a speculator than an investor…a speculator is one who runs risks of which he is aware and an investor is one who runs risks of which he is unaware.”
- 2.
In the Babylonian period, some 4000 years ago, Oates (1986, pp. 10–15) explains that “Babylonia, though potentially rich in agricultural products lacked such essential commodities as stone, timber and metal ores…For this reason, trade was of crucial importance…Writing was invented in Mesopotamia as a method of book-keeping.” Dunbar (2000, p. 25) notes that in Hammurabi’s time, some 3800 years ago, there were crop loans and option-like arrangements and that “recent archaeological research has shown that there was a thriving loan market in ancient Babylon where borrowers could search for the best rate, just as homebuyers do today.” See also Samuels et al. (2007), which contains articles about economic circumstances in earlier centuries, and Neal (2015, p. 16) who writes that the first recorded financial crisis occurred in 1788 BC after the king of ancient Uruk in Mesopotamia declared all debts null and void. Goetzmann (2016b, pp. 58–72) also covers this and presents a chart of barley prices.
- 3.
- 4.
Even with only a rudimentary coinage system as a basic medium of exchange, it might be inferred, for example, that speculation was a part of every Athenian fishmonger’s daily function. As Davidson (1999, p. 8) discusses, “…the undisputed master of the fishmonger’s stall was the eel.” Eel were regarded as irresistible delicacies (pp. 186–7) and were much sought after and “the price of fresh fish was generally high at Athens.” Indeed, as De Soto (2006, p. 51), citing Rostovtzeff (1953, p. 405), writes of the period around 300 BCE, “[T]he Hellenistic period, especially Ptolemaic Egypt, was a turning point in the history of banking because it marked the creation of the first government bank.” Rostovtzeff linked this development to “[R]efined accounting, based on a well-defined professional terminology.” Also, around 600 BCE, Greek philosopher Thales was said to have cornered the market for olive presses and profited greatly. See Aristotle (1944) Politics, section 1259a at www.perseus.tufts.edu
- 5.
The Annals, Book VI, pp. 16–17, authored by Tacitus in 109 ACE, describes events circa 33 AD that began when Emperor Tiberius enforced a ceiling on interest rates: “Hence followed a scarcity of money, a great shock being given to all credit…Creditors however, were suing for payment in full…usurers had hoarded up all their money for buying land. The facilities for selling were followed by a fall of prices, and the deeper a man was in debt, the more reluctantly did he part with his property, and many were utterly ruined. The destruction of private wealth precipitated the fall of rank and reputation…” As noted by Calomiris and Meltzer (2016), “Tiberius responded …by making large, interest-free, three-year loans to Roman banks.”
- 6.
In response to my email inquiries to Professor Richard Saller of the University of Chicago and Professor Walter Scheidel of Stanford University, both experts on the economic aspects of these eras, neither could readily point to any specific bubble incidents in ancient Greece and Rome. Their writings, however, suggest the presence of significant price variability and cycles of economic activity.
- 7.
Donkin (2003, p. 92) writes that Indian spice exports were mentioned in written works as early as the year 850. See also Keay (2006, p. 46). In an email exchange (June 24, 2008), Keay writes that price speculation can be “taken for granted throughout the history of the spice trade…in the early days of the London and Dutch East India Companies the price of pepper plummeted dramatically every time a fleet returned. Speculators needed to hang on to stocks as long as they could, creating a bubble, but to sell smartly before the bubble burst with reports of returning ships. Intelligence was everything.”
- 8.
Benholz (2003).
- 9.
Ferguson (2009, pp. 50–53).
- 10.
On the tulip mania and the South Sea Bubble, Chancellor (1999, pp. 19 and 89) indicates that “the number of mercantile bankruptcies in 1721 did not increase significantly from the previous year and the economy recovered quickly.” The economic effects of crashes were also classified by Mishkin and White (2003), who after studying 15 crash episodes of the twentieth century were able to fit them into four categories ranging from no discernable stress on the financial system (e.g., 1940 and 1946), to stress mitigated by Federal Reserve actions (e.g., 1987), to episodes in which minor widening of interest-rate spreads was seen (e.g., 1969–1970, 1990), and to episodes in which large widening of interest-rate spreads was seen (e.g., 1907, 1930–1933). As they note, “one cannot make the case that crashes are always the main cause of financial instability.” And market crashes may or may not be accompanied by financial instability. Posen (2003) contains data on the subsequent economic impact after bubbles have burst.
Detken and Smets (2004) classify “booms” as being either high-cost or low-cost, saying, “Not all booms lead to large output losses…High-cost booms are clearly those in which real estate prices and investment crash in the post-boom periods.” Asset price booms are defined “as a positive deviation of an aggregate asset price indicator from its recursively estimated trend by at least 10 percent.”
- 11.
The aim is to provide a statistical foundation on which all asset price bubbles (and crashes) can be defined, described, identified, and compared.
- 12.
Hendricks (2015) studies bubbles of all types.
- 13.
Ferreira and Karali (2017) found that “global financial markets are resilient to shocks caused by earthquakes even if these are domestic.”
- 14.
Kindleberger (1989, p. 24) has suggested that although no two speculative manias are identical, manias develop along similar lines and have changed little from the distant past to the present. Chamely (2004, p. 359) adds that “examination of famous bubbles in the past shows that they always originated in some genuine good news.” 1930s 68 and early 1940s, “Current news and political developments are…soon forgotten; their presumed influence on market trends is not as weighty as is commonly believed.” See also Cutler et al. (1989).
- 15.
Chancellor (1999, pp. 125–126) writes that “journals and pamphlets proclaimed the railways as a revolutionary advance unparalleled in the history of the world. They not only focused on the economic benefits of railway transport, but concerned themselves with its more widespread effects on human civilization…There was no limit to the imagined effects of this revolution…From an investment point of view, it was argued that railway shares would remain ‘safe’ in midst of panic…The public was gripped by a railway vogue.” Nairn (2001) covers technology manias; Oliver (2007) and Kaplan (2011) write that tech stock valuations in 2011 had reached “bubble” dimensions. Pastor and Veronesi (2008) present a general equilibrium model in which stock prices of innovative firms operating in technologically revolutionary sectors exhibit “bubbles.”
- 16.
- 17.
Greenwald et al. (2001, p. xii).
- 18.
Arnhart (2003) says that “natural selection has shaped human nature to express at least twenty natural desires that are manifested in diverse ways in all human societies throughout history. Human beings generally desire a complete life, parental care, sexual identity, sexual mating, familial bonding, friendship, social ranking, justice as reciprocity, political rule, war, health, beauty, wealth,…” And from Dewey (1922, p. 107): “…human nature remains from age to age the same.” However, as noted in http://en.wikipedia.org/wiki/Human_nature, there are many different views and schools of religious, psychological, ethical, economic, political, and philosophic thought on the subject. Of course, human nature of 2000 years ago is documented in the Old and New Testaments. See also Amhart (1998) and Olson (2006) for a review of core personality traits and implications for financial and economic behavior.
- 19.
- 20.
See Gray and Vogel (2016, pp. 3–5). “De la Vega vividly described excessive trading, overreaction, underreaction, and the disposition effect well before they were documented by modern finance journals… Homma described the role of emotions and how these could affect rice prices…[T]he psychological aspect of the market was critical to …trading success.” Corzo et al. (2014) show Vega’s knowledge, 300 years ago, of herding, overconfidence, and regret aversion.
- 21.
The principal trading strategists and/or partners at Long-Term Capital included several well-known economists and Nobel Laureate proponents of EMH-based theories. Capie and Wood (2007, p. xiv) also note that LTCM’s solvency was impaired because the derivatives contracts “had clauses that give the counterparties the right to terminate the contract in the event of a default of any kind by a counterparty…counterparties had the right to liquidate any of the defaulting counterparties’ assets…even if the assets are not directly related to the derivatives contracts in question.” Triana (2009, pp. 253–4) notes that LTCM had been selling volatility so sizeably and aggressively as to have been nicknamed the “Central Bank of Volatility.” Each percentage point increase in implied volatility was estimated to have cost LTCM $100 million, and in total, the equity index volatility trades had generated losses of $1.3 billion.
- 22.
Černý (2004, p. 56).
- 23.
In this, transitivity of choice—that is, if A>B and B>C, then A>C—provides the theoretical cornerstone of rationality. A whole school of thought, as described in Werner (2005) and Cassidy (2006), sees the rational expectations hypothesis (REH) as a neoclassical axiom that should not be taken as an established fact and thus not as a given starting point for analysis. Along the same lines, Anand (1993) goes so far as to say that the normative interpretation of subjective expected utility (SEU), which is equivalent to the REH, is empirically false. He cites studies by Rapoport and Wallsten (1972), Schoemaker (1982), Machina (1987), and Baron (1988). Anand explains that: “It is an essential feature of SEU that it specifies a mathematics of decision, but it is open whether we use it for normative or positive purposes (p. 17)…SEU is false… SEU uses independence in a sense that amounts to requiring that utility is linear with respect to probability…However…agents consistently violate the assumption” (p. 73).
- 24.
Constant absolute risk aversion (CARA) is part of a family of risk aversion utility functions that also includes constant relative risk aversion (CRRA) and hyperbolic absolute risk aversion (HARA). Černý (2004, p. 57) indicates that in evaluating distributions of wealth relative to an initial level of wealth V0, a proper expression is U(V)/ U(V0) = f(V-V0) for all V and V0 and the undetermined function, f. The only utility function that meets all the conditional requirements turns out to be exponential.
- 25.
Ariely (2008, p. 240).
- 26.
This effect was first identified by Brickman and Campbell (1971) and in psychology is called the “hedonic treadmill.” As such, this utility function representation is probably discontinuous and of the jump variety for individuals but is continuous in the aggregate. It is not the mathematical inverse of the conventional description. From Gao and Schmidt (2005): “…economic agents do not always choose what they really want…[A]lthough such ‘irrational’ behavior may decrease economic utility, it gives agents psychological satisfaction and subjective comfort, thus increasing their immaterial utility. In this sense, agents remain rational when conducting such behaviors, even though they run directly contrary to neoclassical rationality concepts.” See also Taleb (2004).
- 27.
As behavioral economist Kahneman said in a post-Nobel Laureate interview in Schrage (2003): “…the market cannot be completely efficient, because people act irrationally when they are afraid.”
- 28.
Tuckett (2011, pp. x–xiii) writes: “traditional economic approaches, including the recent development of behavioural economics, do not capture the essence of what happens in financial markets and why they produce crises…[W]hatever else goes on in an asset boom and bust, it looks primarily like an emotional sequence.” See also Poundstone (2010, p. 102).
- 29.
- 30.
Cohen (1997, p. xvii) writes that “…many speculative bubbles share a cluster of common features, even when they are separated by centuries and occur on different continents…there is an underlying similarity in the way events unfold that belies the disorderly antics of a frenzied crowd of get-rich-quick speculators.” Mantegna and Stanley (2000, p. 5) have noted that “[F]inancial markets exhibit several of the properties that characterize complex systems. They are open systems in which many subunits interact nonlinearly in the presence of feedback.” See also Jovanovic and Schinckus (2017).
- 31.
Economists have not generally referred to the notion of a GDP bubble and so there is no specific evidence or literature using this terminology. Such a bubble would, however, be described as an “overheating” economy, which has been studied at length within the context of business and economic cycles. A GDP bubble could also be defined in terms of overall price changes (inflation/deflation) of goods and services rather than through changes of share prices. Treynor (1998) suggests relating a bubble to its own statistical dynamic features—that is, autocorrelating its features.
- 32.
Furnham and Argyle (1998, p. 102) write that “[M]oney confers social power…[and] can easily be seen as an index of social adequacy or worthiness (or, indeed, its opposite).”
- 33.
- 34.
If so, this at the least inherently suggests that, loosely speaking, the outer skin (i.e., container) of a financial bubble, its outer limit, is determined or defined in part by both the amount of money and credit available and by the collective psychological state of investors, of speculators, and of the population as a whole. The opposite extreme of such a state of collective euphoria—a crash or a panic—would then be tantamount to being what might be called an “inverse” or negative bubble . Shiller (2000) uses the term “negative bubble” several times beginning at page 62. And Shiller (2002) discusses bubble characteristics of US real estate prices. On social mood influences on financial behavior, see Olson (2006) and especially Prechter (2016). Negative bubbles are also discussed in Allen and Gale (2007, p. 247).
- 35.
King (2016, pp. 18–22).
- 36.
Fragment is from Ryan-Collins et al. (2011, p. 9).
- 37.
- 38.
Martin (2015, p. 33).
- 39.
Greenspan (2007, p. 256).
- 40.
- 41.
Ferguson (2009, pp. 4 and 30–31).
- 42.
Wall Street Week with Louis Rukeyser, December 4, 1987, and December 2, 1988.
- 43.
See The Economist, September 5, 1999, and April 18, 1998. Warnings about bubbles also came from famed investors Warren Buffett and John Templeton . On ABC’s Nightline in 1999 Buffett said, “You know that valuations are high, by historic standards. You know that the level of speculation is high, by any historic standards, and you know that it doesn’t go on forever…but you don’t know when it ends.” And Sir John Templeton told Nightly Business Report in December 1999 that “Internet stocks were a bubble” (He was shorting them). Around the same time, economist Henry Kaufman warned, “The bubble is already very, very big…The question is not if the asset bubble will burst, but when.”
- 44.
Fed Chairman Greenspan, however, had wavered a bit on the subject of bubble visibility . In a speech in August 2002 he said, “As events evolved, we recognized that, despite our suspicions, it was very difficult to definitively identify a bubble until after the fact – that is, when its bursting confirmed its existence…Human psychology being what it is, bubbles tend to feed on themselves, and booms in later stages are often supported by implausible projections of potential demand.” See www.federalreserve.gov and Stout (2002). Greenspan also later suggested, in a December 19, 2002, speech to the Economic Club of New York, that even if a bubble could be reliably identified in advance, bursting it might require raising interest rates so high as to crush the economy, and that bubbles might be an unavoidable by-product of long economic expansions with low inflation and hence act as “tinder for asset price speculation.”
In this speech, Greenspan said,
If the bursting of an asset bubble creates economic dislocation, then preventing bubbles might seem an attractive goal. But whether incipient bubbles can be detected in real time and whether, once detected, they can be defused without inadvertently precipitating still greater adverse consequences for the economy remain in doubt… nothing short of a sharp increase in short-term rates that engenders a significant economic retrenchment is sufficient to check a nascent bubble. The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble is almost surely illusion.
O’Driscoll (2007) opines that this speech is the source of “what can be best described as the Greenspan Doctrine.” Hayford and Malliaris (2005) argue that “the Fed has paid significant attention to valuation of the stock market…valuation was an important variable in the Fed’s decision-making and its conduct of monetary policy.” More on Greenspan’s strategies of the time appears in Ip (2004) and Mallaby (2016). Rebello (2005) reviews the Fed meeting transcripts of 1999 which show that although “the Fed’s staff forecasters regarded U.S. stock prices as irrationally high, they underestimated the size of the bubble.” At the peak, tech and telecom issues represented more than 41% of the value of the S&P 500. Public perceptions and attitudes in the Internet bubble are discussed in Browning and Dugan (2002).
See also “The Great Market Bubble Debate,” BusinessWeek, May 29, 2000, in which Andrew Smithers, co-author of Valuing Wall Street (who was bearish), debates bulls, Professor Jeremy J. Siegel and Kevin A. Hassett, co-author of the book Dow 36,000. Hassett says, “Nobody has ever made a convincing case that there’s been a stock market bubble in the U.S.” Smithers says, “The evidence for a bubble is in the economy as well as the stock market. What bubbles do is create unrealistic expectations for future returns from equities and other assets. Therefore, they tend to depress savings…when you get a bubble in the stock market, it produces profound disequilibrium in the economy.” Siegel says “I really am concerned with these companies that have P/E ratios of 90, 100, and above. I still think stocks, as a diversified portfolio, are the best long-run investment.”
- 45.
Chernow (2009) refers to economist Roger Babson, “whose gloomy forecasts were mocked even as the economy stagnated in the sweltering summer of 1929. On Sept. 5, 1929, Babson reiterated his doomsday cry: ‘Sooner or later a crash is coming, and it may be terrific’.” Similarly, Akerlof and Shiller (2009, pp. 66–7) recall a quote from New York Times reporter Alfred Noyes, who in writing of the speculative mania of 1929 said: “It was not in all respects an agreeable task to point out in the Times what seemed to me the very visible signs of danger. Expression of such comment had to meet the denunciatory comment that the writer was trying to discredit or stop American prosperity.”
Similar early recognition of the great housing bubble that began to deflate in late 2005 appeared in Shiller (2002), in Barron’s (Abelson 2005), in the New York Times (Rich and Leonhardt 2005), and in Witter (2006) who noted that:
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32.6% of new mortgages and home-equity loans in 2005 were interest-only, up from 0.6% in 2000.
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43% of first-time home buyers in 2005 put no money down.
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15.2% of 2005 buyers owed at least 10% more than their home is worth.
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10% of all home owners with mortgages had no equity in their homes.
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$2.7 trillion dollars in loans would adjust to higher rates in 2006 and 2007.
The impact of the US housing bubble’s collapse on employment is covered in Byun (2010).
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- 46.
New York Times and Milwaukee Journal, October 16, 1929. In the month prior, Fisher foreclosed the possibility of any crash, saying on September 5, 1929, “There may be a recession in stock prices, but not anything in the nature of a crash…the possibility of which I fail to see.” Similarly, as told by J.K. Galbraith in The Great Crash, 1929, p. 70, around the same time economics writer Joseph Lawrence confidently stated that “stocks are not at present over-valued.”
- 47.
From Harman (2000, p. 10).
- 48.
The Economist magazine in April 1989 said in regard to the Japanese market that “…The implication is that shares may be underpriced.” See also Voth (2000). The delusional bliss was similar with regard to housing and the role of derivative securities circa 2007. BusinessWeek (February 19, 2007, p. 34) wrote, “…derivatives let financial institutions and traders manage their risks with mind-blowing precision.” Even after two Bear Stearns funds had already collapsed and Countrywide Financial had warned of broader credit problems, BusinessWeek (August 6, 2007, pp. 23–4) in its Outlook section wrote: “…a severe financial crunch is unlikely….The extent of the subprime problem remains small…The squeeze in the credit markets as a result of the subprime mess is far from a severe one…the widening of risk spreads has not been great…the yield spread on corporate bonds rated BBB…had increased to 1.5% from 1.25% at the end of June. That’s little different from the 1.47% average for all of 2006.” However, in fairness to the magazine, the same issue carried an article (“The Subprime Mess: Let the Blame Begin,” p. 32) critical of the role played by ratings agencies such as S&P, which was owned by McGraw-Hill, the publisher.
- 49.
Zweig (2008) writes that according to surveys of hundreds of companies conducted by Duke University economist John Graham , “[D]uring the week of March 13, 2000, the absolute peak of the market bubble, 82% of finance chiefs said their shares were cheap, with only 3.4% saying their stock was overvalued”.
- 50.
Lee (2004, pp. 20–1).
- 51.
McGrattan and Prescott (2000), using a standard macroeconomic growth model, found that “the market is correctly valued” and, barring any institutional changes, predicted a small future equity premium.
- 52.
According to Zacks Investment Research data. The percentage of “buys” was 69.5%.
- 53.
Hale (2007), in a Wall Street Journal op-ed piece entitled “The Best Economy Ever,” said that the entrepreneurial energy unleashed in developing countries “set the stage for extraordinary economic growth.” In a Fortune magazine interview entitled “The Greatest Economic Boom Ever” that was summarized by Kirkland (2007), then-US Treasury Secretary Hank Paulson , albeit in a somewhat hedged and cautious manner, and advising vigilance, said, “This is far and away the strongest global economy I’ve seen in my business lifetime.” Sorkin (2009, p. 49), however, reveals that in a meeting with President Bush, Paulson actually had expressed concerns about the markets and that “the economy was overdue for a crisis,” as early as August 2006.
- 54.
In Thomas (2012), “Spanish financial leaders in influential positions mostly played down concerns that something might go terribly wrong.” And, the 2007 IMF Global Financial Stability Report declared that weakness in US housing prices posed no systemic threat.
- 55.
Sharma (2015a). Hong and Xie (2018) write of government surveillance and warnings against aggressive selling.
- 56.
- 57.
- 58.
In a stock market bubble people act with what might readily be called “infectious” greed, and in a crash with, “infectious” despair in which no such physical containment is possible. Shiller (2006) says, “Bubbles are not purely psychological phenomena. They are an epidemic, and an epidemic requires contagion. An epidemic (bubble) can exist only if conditions favor contagion…One reason financial bubbles are mysterious is that their time pattern depends on the contagion rate of the enthusiasm, the spread of optimism and excitement for the market.” The analogy is with biological models as described by Daley and Gani (1999). However, this approach is probably too great a stretch for a financial market theory in which investors and speculators have all types of objectives and time horizons and are of different sizes and levels of sophistication and knowledge. See also Shiller (2000, [2005] p. 257), Bailey (1957), and Kenourgios et al. (2011) on market contagion. On contagiousness see also Gladwell (2002, pp. 9–11), Berger (2016), and Porras (2016).
- 59.
For example, the Perfect Gas Law defines an ideal gas which behaves at all pressures in the same way that real gases behave at low pressures. Isenberg (1992) describes the physics of soap bubbles.
Ultimately the only such possible price/valuation container for share prices is—using the real risk-free rate of interest—the point at which the equity risk premium is zero (see Fig. 8.1) and at which the presumed law of one price (LOOP), if it is actually operative, ensures through arbitrage that share prices cannot possibly go any higher for more than a relatively brief time. Noguchi (1994) and Werner (2005) have already shown that credit availability (in the case of the Japanese land and equity inflations of the 1980s) is thus far the closest that an economist can come to capturing, isolating, and measuring the “gas” that collectively fills a bubble’s balloon.
- 60.
The large and long-lasting aspects are emphasized by Blinder (2013, p. 29), from where this description appears. Goetzmann (2016a) defines “a bubble as a large price decline after a large price increase (i.e., a crash after a boom).” He finds that the frequency of bubbles is quite small (i.e., bubbles are rare), with the unconditional frequency being 0.3–1.4%. The definition of a market boom is a doubling in a one-to-three-year period. See earlier version at www.nber.org/papers/w21693
- 61.
Shiller (2000 [2005], p. 5) defines a speculative bubble as “an unsustainable increase in prices brought on by investors’ buying behavior rather than by genuine, fundamental information about value,” with Kindleberger (1987), who sees a bubble as “attracting new buyers – generally speculators – interested in profits from trading in the asset rather than its use or earning capacity,” and with Stiglitz (1990), who says: “if the reason that the price is high today is only because investors believe that the selling price will be high tomorrow – when fundamental factors do not seem to justify such a price – then a bubble exists.” According to Kindleberger, a typical bubble evolves in five stages: displacement, boom, euphoria, peak, and bust. From Kindleberger (1996 [1989], p. 13) and Kindleberger and Aliber (2011, p. 30), “The word mania emphasizes the irrationality; bubble foreshadows the bursting.” Schwartz (1986, p. 255), however, notes that “the word ‘bubble’ has supplanted the pejorative ‘mania’.”
Another practical definition of a bubble also appears in Fleckenstein and Sheehan (2008, p. 189), where Jeremy Grantham , Chairman of Boston money management firm, GMO, says: “bubbles are definable events when the price action is two standard deviations from a long-term trend.” Based on this criterion, Grantham’s research found that the US stock market (peak in 2000) and real estate bubbles (peak 2005–2006) were the 28th and 29th bubbles, respectively, in financial history beginning with the Dutch tulip craze. Grantham’s definition also appears in Grant (2008, p. 385), in which he says that such an event might be expected once in 40 years or so. See also the GMO Quarterly Letter, Q1 2014, available at www.gmo.com and Grantham (2014).
In Fleckenstein and Sheehan (p. 94), John Makin , in the American Enterprise Institute’s Outlook of November 9, 2000, is quoted as saying that “A stock market bubble exists when the value of stocks has more impact on the economy than the economy has on the value of stocks.” Martenson (2011, p. 80) writes that “a bubble exists when asset prices rise beyond what incomes can sustain.” Roubini and Mihm (2011, p. 17) explain that “asset bubbles develop even before the credit supply booms, because expectations of future price increases are sufficient to foster a self-fulfilling rise in the asset’s price.”
From Case and Shiller (2004): “A bubble occurs when exaggerated expectations of future price increases generate unusual demand either by people who fear being priced out of a market or by investors hoping to make a lot of money fast. A bubble is a self-fulfilling prophecy for a while, as successive rounds of buyers push prices higher and higher. But…bubbles carry the seeds of their own destruction. Only time is needed for the bubbles to end.” Shiller (2002) discusses feedback and bubbles and in Shiller (2015, p. xv) calls bubble episodes as “speculative epidemics.” Brunnermeier (2008) provides a formal and detailed modern definition for the New Palgrave Dictionary of Economics, in which he refers to bubbles as “asset prices that exceed an asset’s fundamental value because current owners believe that they can resell the asset at an even higher price in the future.” Brunnermeier’s article further observes that:
[T]here are four main strands of models that identify conditions under which bubbles can exist. The first class of models assumes that all investors have rational expectations and identical information. These models generate the testable implication that bubbles have to follow an explosive path. In the second category of models investors are asymmetrically informed and bubbles can emerge under more general conditions because their existence need not be commonly known. A third strand of models focuses on the interaction between rational and behavioral traders. Bubbles can persist in these models since limits to arbitrage prevent rational investors from eradicating the price impact of behavioral traders. In the final class of models, bubbles can emerge if investors hold heterogenous beliefs, potentially due to psychological biases, and they agree to disagree about the fundamental value.
Garber (2000, pp. 4–12) notes further that “bubble” is “a fuzzy word filled with import but lacking a solid operational definition…The definition of bubble most often used in economic research is that part of asset price movement that is unexplainable based on what we call fundamentals. Fundamentals are a collection of variables that we believe should drive asset prices…we truly cannot know if the speculation was unsound until after the fact.”
In the 1992 version of the New Palgrave Dictionary of Money and Finance (edited by Newman et al.), Kindleberger says,
The theoretical literature uses the assumption of the market having one mind and one purpose, whereas it is observed historically that market participants are often moved by different purposes, operate with different wealth and information and calculate within different time horizons…the theoretical literature has yet to converge on an agreed definition of bubbles, and on whether they are possible.
Hassett (2002, p. 21), for instance, says “a financial bubble is a period when the price of an asset (stocks, real estate, tulips, etc.) suddenly soars for irrational reasons and then collapses.” But then, “what are irrational reasons?” In a Barron’s interview of September 1, 2011, Jim Grant said: “A bubble is a bull market in which the user of the word, ‘bubble’ has not fully participated.” See also Brown (2008), Dholakia and Turcan (2014), and Barlevy (2015) who writes on the greater fool theory. It’s also been quipped that a bubble is when people are making money that’s greatly disproportionate to their knowledge, skills, and work ethics.
- 62.
The following also pertains:
…whether with hindsight the run-up in asset prices in the late 1990s was a result of bubble behavior. …this question is quite difficult to answer…The inability to identify asset price bubbles ex ante should be sufficient reason for policymakers to be cautious about taking pre-emptive actions…The inability to identify asset price bubbles ex post…should cause policymakers to take pause… Kroszner (2003, p. 7)
But McGrattan and Prescott (2003, p. 274) wrote that there was no asset bubble in 1929: “…the reason for the 1929 crash was not that the stock market was overvalued relative to fundamentals…”
Bierman (1991, pp. 5–7) even suggested some 60 years after the event that the stock market was not obviously too high in 1929 and that it perhaps wasn’t too high at the 1987 peak either. “[T]here will always be a reasonable scenario that will justify the level of prices. Prices go up because many people are betting that the expected value, based on some scenario, justifies the current price.”
- 63.
The quotation continues “…Diba and Grossman (1988) suggest that, in the case of a rational bubble, the first-order difference of stock prices will be nonstationary . Campbell and Shiller (1987) argue that, if dividends and stock prices fail to co-integrate, there is evidence of a bubble; a unit root in the price-dividend ratio implies ‘irrational exuberance’ (Craine 1993).”
- 64.
Articles in Colander (2006) show that there is a growing body of what is called post-Walrasian analysis in which information is the source of differences between the older and newer approaches. For post-Walrasians, as Mathews writes in the Colander volume (p. 80), “rationality, equilibrium, and greed are replaced with purposeful behavior, sustainability, and enlightened self-interest.” See also Lansing (2010).
- 65.
Sornette (2003, p. 285).
- 66.
Keuzenkamp (2000, p. 116) writes : “All models are wrong: Kepler’s, Tinbergen’s, Friedman’s, and ‘even’ those of contemporary econometricians. Some, however, are useful. Kepler’s clearly were, as were Tinbergen’s and Friedman’s. They shared a common respect for simplicity.” Usefulness is the aim of the current project. Einstein’s maxim, as recalled in Medio (1992, p. 3), was that “things must be made as simple as possible, but not simpler.” A sign in Einstein’s office at Princeton also said: “Not everything that counts can be counted, and not everything that can be counted counts.”
- 67.
Total market cap-to-GDP, according to a Fortune magazine interview in 2001, is Warren Buffett’s favorite long-term predictive indicator. As seen in Fig. 1.4, once it sustainably rises above one standard deviation it suggests that a peak is near. However , Lleo and Ziemba (2015) suggested that this MV/GNP ratio is of limited usefulness as a crash forecasting tool. An almost identical line is traced by taking Wilshire 5000 total market cap as a multiple of US domestic final sales for the entire US economy (not shown). Final sales is one of the cleanest (i.e., least adjusted and manipulated) series from which to form ratios.
- 68.
Surowiecki (2004, p. 250).
- 69.
- 70.
Empirical studies are from Allen and Gale (2000), Stiglitz and Greenwald (2003), and Werner (2005). Werner (2005, pp. 181–245) demonstrates that if monetary policy is correctly measured as it is applied to the credit creation mechanism of a nation’s banking system, it explains speculative capital flows into stocks, real estate, and the nonfinancial sectors of the economy.
- 71.
Roehner (2002, pp. 167–72) uses price multipliers and dispersion criteria.
- 72.
The summary partially follows the phases described in a chart by Hofstra University Professor Jean-Paul Rodrigue available at http://en.wikipedia.org/wiki/File:Stages_of_a_bubble.png
- 73.
Lognormal is used instead of normal because, in the random-walk approach, adding or subtracting a random change might result in a stock price eventually and impossibly wandering below zero. As noted in Poundstone (2005, p. 122), Samuelson found a simple fix to the problem in Bachelier’s original thesis of 1900. The idea was to multiply by a random percentage change instead of adding or subtracting a random amount. This works because a stock within this framework might over a certain time be as likely to double as to halve. The lognormal is thus a geometric random walk.
- 74.
Taylor (2005, p. 51).
- 75.
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Vogel, H.L. (2018). Introduction. In: Financial Market Bubbles and Crashes, Second Edition. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-319-71528-5_1
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