Bubbles Research Paper

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Bubbles occur when there is excessive investment in financial assets, such as stocks, or in real assets, such as housing. The bubble “bursts” when the value of the investment plummets. The value of the investment may plummet for several reasons, including (1) investors realizing that they previously had overvalued the investment, resulting in a massive selling of the investment, and/or (2) the price of what the investment produces falls.

One of the most famous speculative bubbles in history is Dutch Tulipmania (1634–1638), which involved people mortgaging their homes and industries to buy tulip bulbs, which they expected to resell at higher and higher prices. These expectations were based on past increases in prices. In early 1637 prices for some bulbs fell from a peak of several times a typical person’s annual income to almost nothing. The Mississippi Bubble (1719–1720) and the South Sea Bubble (1720) involved the taking over of part of (respectively) France’s and England’s national debts by powerful trading monopolies. Expected monopoly profits from expanding trade drove these bubbles. When people lost faith in those monopolies, the value of their stocks plummeted. The U.S. stock market enjoyed spectacular growth during the 1920s, and people hoping to get rich through the stock market used ever increasing amounts of credit to buy more stocks. The bursting of this stock market bubble in 1929 ushered in the Great Depression. Likewise, the bursting of the Japanese bubble in the 1980s ushered in the worst recession that Japan had suffered since World War II. The Japanese bubble was driven partially by Japanese companies using the money from selling stocks for speculative purposes rather than to produce goods and services that could be sold to the public.

Although Albert Frederick Mummery and John Atkinson Hobson only briefly mention “bubble companies” in The Physiology of Industry ([1889] 1989, p. 140), their book provides one of the earliest analyses of what causes excessive investment (bubbles). They argue that the ultimate goal of investment is to produce goods for consumption. If there is no one to consume what the investment produces, then there is no ultimate value gained by investing. A bubble occurs when excessive savings leads to excessive investment that causes excessive production of goods that will not be bought due to insufficient consumption. If one person increases his or her savings, then others must increase their consumption in order to make the first person’s savings valuable. If everyone saves more, then the goods produced by using the increased savings will not sell, making the increased savings worthless. According to Mummery and Hobson, excessive investment is synonymous with underconsumption. To produce sustainable growth, a correct mix must be found between savings, which is needed to finance investment, and consumption, which is needed to buy what the investment produces.

A global perspective can be added to the above analysis by noting that a correct mix of savings and consumption needs to be found on an international level. In a globalized world, countries with excess savings can export their extra savings to countries with excess consumption. One way to export savings is by fixing the exchange rate below its true value to another currency (such as the U.S. dollar), thereby encouraging exports and discouraging imports and thus lowering national savings.

Because bubbles involve “excessive” investment, they logically involve people making mistakes. These mistakes can be based on overreacting, following the herd (fads), decision making by inexperienced traders, viewing investments as a gamble (and enjoying the gambling), or basing future expectations solely on performance in the recent past. However, contemporary social science is built on an assumption of “rationality,” and the above explanations imply that people make “irrational” mistakes. Thus, many theorists either deny that bubbles occur, or they try to find a rational basis for bubbles.

One explanation that denies that bubbles occur is based on the premise that asset markets adjust more quickly than goods markets. Because of this, a shock in the goods markets can create what appears to be an exaggerated reaction (bubble) in the asset market; however, contrary to appearances, these reactions actually involve the entire system trying to achieve a new equilibrium as quickly as possible. Similar models have been built based on capital, money, and cash-in-advance constraints. Taking a different tack, some explanations hold that high uncertainty about the future productivity of a new technology can cause what looks like a bubble, but that it will go away once the uncertainty is eliminated.

Some explanations that attempt to find a rational basis for bubbles are based on different investors having different beliefs (or information) and on short-selling constraints. Simon Gilchrist, Charles P. Himmelberg, and Gur Huberman show that, under these conditions, firms can issue new shares at inflated prices (2005). By so doing they reduce the cost of capital and increase real investment. Furthermore, they show that even large bubbles are not eliminated in equilibrium. Another group of theories argue that the “results” of bubbles may be “rational” due to the bubbles causing dynamically inefficient states (states with excess investment) to become more efficient (i.e., to reduce their excess investment).

Despite this last group of theories, most experts agree that it is best to avoid bubbles. The chairmen of the central banks of the United States and Japan in the 1990s (Alan Greenspan and Yasushi Mieno, respectively) both emphasized reducing speculative bubbles. One way to reduce the chance of speculative bubbles is to warn investors of excessive investment; Greenspan is well known for repeatedly condemning “irrational exuberance” in the U.S. stock market in the 1990s. Other policy responses are to increase taxes on investment and, for countries with excess investment, to promote consumption. Because the rich tend to invest more than the poor and the poor tend to consume more than the rich, policies that create a more equitable income distribution help.

To the extent that some speculative bubbles are based on incomplete or misleading information, the government can play a role in improving information. Furthermore, the punishments should be severe for corporate leaders who are found guilty of misleading investors, and insider trading should be prohibited because it gives insiders an incentive to create a speculative bubble and then exit right before the bubble bursts.

Bibliography:

  1. Chancellor, Edward. 1999. Devil Take the Hindmost: A History of Financial Speculation. New York: Penguin.
  2. Chirinko, Robert S., and Huntley Schaller. 2001. Business Fixed Investment and “Bubbles”: The Japanese Case. American Economic Review 91 (3): 663–680.
  3. Gilchrist, Simon, Charles P. Himmelberg, and Gur Huberman. 2005. Do Stock Price Bubbles Influence Corporate Investment? Journal of Monetary Economics 52 (4): 805–827.
  4. Mummery, Albert Frederick, and John Atkinson Hobson. [1889] 1989. The Physiology of Industry: Being an Exposure of Certain Fallacies in Existing Theories of Economics. Fairfield, NJ: Augusta M. Kelley.

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