By Seiji S. C. Steimetz
What Are Bubbles?
In 1996, the fledgling Internet portal Yahoo.com made its stock-market debut. This was during a time of great excitement—as well as uncertainty—about the prosperous “new economy” that the rapidly expanding Internet promised. By the beginning of the year 2000, Yahoo shares were trading at $240 each.1 Exactly one year later, however, Yahoo’s stock sold for only $30 per share. A similar story could be told for many of Yahoo’s “dot-com” contemporaries—a substantial period of market-value growth during the late 1990s followed by a rapid decline as the twenty-first century approached. With the benefit of hindsight, many concluded that dot-com stocks were overvalued in the late 1990s, which created an “Internet bubble” that was doomed to burst.
Thus, as this account implies, the definition of a bubble involves some characterization of the extent to which an asset is overvalued. Let us define the “fundamental value” of an asset as the present value of the stream of cash flows that its holder expects to receive. These cash flows include the series of dividends that the asset is expected to generate and the expected price of the asset when sold.2 In an efficient market, the price of an asset is equal to its fundamental value. For instance, if a stock is trading at a price below its fundamental value, savvy investors in the market will pounce on the profit opportunity by purchasing more shares of the stock. This will bid up the stock’s price until no further profits can be achieved—that is, until its price equals its fundamental value; the same mechanism works to correct stocks that are trading above their fundamental values. So, if an asset is persistently trading at a price higher than its fundamental value, we would say that its price exhibits a bubble and that the asset is overvalued by an amount equal to the bubble—the difference between the asset’s trading price and its fundamental value. This definition implies that if such bubbles persist, investors are irrational in their failure to profit from the “overpriced” asset. Thus, we refer to this type of bubble as an “irrational bubble.”
Over the past few decades, economists have generated a compelling amount of evidence to suggest that asset markets are remarkably efficient. These markets comprise thousands of traders who constantly seek to exploit even the smallest profit opportunities. If irrational bubbles appear, investors can use a variety of market instruments (such as options and short positions) to quickly burst them and achieve profits by doing so. Yet episodes like those of the dot-com era suggest at least the possibility that asset prices might persistently deviate from their fundamental values. Is it, then, possible that the market may at any time succumb to the “madness of crowds”?
To see how prices might persistently deviate from traditional market fundamentals, imagine that you are considering an investment in the publicly held firm Bootstrap Microdevices (BM), which is trading at fifty dollars per share. You know that BM will not declare any dividends and have ample reason to believe that one year from now BM will be trading at only ten dollars per share. Yet you also firmly believe that you can sell your BM shares in six months for one hundred dollars each. It would be entirely rational for you to purchase BM shares now and plan to sell them in six months.3 If you did so, you and those who shared your beliefs would be “riding a bubble” and would bid up the price of BM shares in the process.
This example illustrates that if bubbles exist, they might be perpetuated in a manner that would be difficult to call irrational. The key to understanding this is in recalling that an asset’s fundamental value includes its expected price when sold. If investors rationally expect an asset’s selling price to increase, then including this in their assessment of the asset’s fundamental value would be justified. It is possible, then, that the price of such an asset could grow and persist even if the viability of its issuing company is unlikely to support these prices indefinitely. This situation can be called a “rational bubble.”4
Because market fundamentals are based on expectations of future events, bubbles can be identified only after the fact. For instance, it will be several years before we truly understand the impact of the Internet on our economy. It is possible that future innovations based on Internet technologies will fundamentally justify people’s decision to buy and hold Yahoo shares at $240 each. In this light, it would be difficult to condemn those who paid such a price for Yahoo shares at a time when Internet usage was growing exponentially. Can bubbles, rational or otherwise, exist? An ex post examination of history’s so-called famous first bubbles helps to answer this question.
Famous First Bubbles
The Tulip Bubble
Tulip bulb speculation in seventeenth-century Holland is widely recounted as a classic example of how bubbles can be generated by the “madness of crowds.”5 In 1593, tulip bulbs arrived in Holland and subsequently became fashionable accessories for elite households. A handful of bulbs were infected with a virus known as mosaic, so named for the brilliant mosaic of colors exhibited by flowers from infected bulbs. These rare bulbs soon became symbols of their owners’ prominence and vehicles for speculation. In 1625, an especially rare type of infected bulb called Semper Augustus sold for two thousand guilders—about $23,000 in 2003 dollars. By 1627, at least one of these bulbs was known to have sold at today’s equivalent of $70,000. The growth in value of the Semper Augustus continued until a dramatic decline in early 1637, when they could not be sold for more than 10 percent of their peak value.
The dramatic rise and fall of Semper Augustus prices, and the fortunes made and lost on them, exhibited the symptoms of a classic bubble. Yet economist Peter Garber provided compelling evidence that “tulipmania” did not generate a bubble. He argued that the dynamics of bulb prices during the tulip episode were typical of even today’s market for rare bulbs. It is important to note that the mosaic virus could not be systematically introduced to common bulb types. The only way to cultivate a prized Semper Augustus was to raise it from the offshoot bud of an infected mother bulb. Just as the fundamental value of a stock includes its expected stream of dividends, the fundamental value of a Semper Augustus included its expected stream of rare offspring. As the rare bulbs were introduced to the public, their growing popularity, combined with their limited supply, commanded a high price. This price was pushed up by speculators who hoped to profit from the bulb’s popularity by cultivating its valuable offspring. These offspring expanded the supply of bulbs, making them less rare, and thus less valuable. Perhaps tulips’ decreased popularity accelerated this downward trend in bulb prices. Interestingly, a small quantity of prototype lily bulbs sold at a 1987 Netherlands flower auction for more than $900,000 in 2003 dollars, and their offspring now sell at a tiny fraction of this price; yet no one mentions “lilymania.”
The Mississippi and South Sea Bubbles
In 1717, John Law organized the Compagnie d’Occident to take over the French government’s trade monopolies in Louisiana and on Canadian beaver pelts. The company was later renamed the Compagnie des Indies following a series of mergers and acquisitions, including France’s Banque Royale, whose notes were guaranteed by the crown. Eventually the company acquired the right to collect all taxes and mint new coinage, and it funded these enterprises with a series of share issues at successively higher prices. Shares sold for five hundred livres each at the company’s onset, but their price increased to nearly ten thousand livres in October 1720 after these expansive moves. By September 1721, however, shares of the Compagnie des Indies fell back to their original value of five hundred livres.
Meanwhile, in England, the South Sea Company, whose only notable asset at the time was a defunct trade monopoly with the Spanish colonies in South America, had its own expansion plans. The company’s goals were not as well defined as those of its French counterpart, but it managed to gain broad parliamentary support through a series of bribes and generous share allowances. In January 1720, South Sea shares sold for 120 pounds each. This price rose to 1,000 pounds by June of that year through a series of new issues. By October, however, prices fell to 290 pounds. Were Compagnie des Indies and South Sea Company shareholders riding bubbles?
Peter Garber provided a detailed account of how market fundamentals, not irrational speculation or rational bubble dynamics, might have driven these price movements. The companies started with similar plans to finance their ventures by acquiring government debt in exchange for shares. This generated streams of government cash payments, at reduced interest rates, that could be used as leverage to finance each company’s commercial enterprises. With this came an extraordinary degree of visible privilege and support from their governments, extending all the way up to their royal families. The remarkable credibility of each company’s potential for profit and growth may well have justified their peak share prices based on market fundamentals.
The decline of South Sea share prices began with Parliament’s passage of the Bubble Act in June 1720—an act that was intended to limit the expansion of the South Sea Company’s competitors. This placed downward price pressure on competitors’ shares that were largely bought on margin. A wave of selling, including South Sea shares, ensued in a scramble for liquidity to meet these margins. As prices continued to drop, Parliament turned against the company and liquidated its assets.
In France, the fall of the Compagnie des Indies was more complex. At the peak of its market value, many investors wanted to convert their capital gains into the more tangible asset of gold. Of course, there was not enough gold in France at the time to satisfy all of these desires, just as there is not enough gold in the United States today to back each dollar. The Banque Royale intervened by fixing Compagnie share prices at nine thousand livres and exchanging its notes for Compagnie stock. Within a few months, France’s money supply was effectively doubled since Banque Royale notes were considered legal tender. A period of hyperinflation ensued, followed by the company’s stopgap deflationary efforts of reducing the fixed price of Compagnie shares to five thousand livres. Confidence in the company dissolved, and John Law was eventually removed from power.
This brief account shows how each company’s rise and fall is traceable to events that were likely to change how investors fundamentally valued South Sea and Compagnie shares, contrary to what a bubble hypothesis would suggest. These companies were essentially performing large-scale financial experiments based on prospects for long-term growth. They ultimately failed, but they could well have shown enough promise to convince even the most incredulous investors of their potential for success. It would be difficult to characterize what may have been rational behavior ex ante as evidence of bubble formation. Indeed, John Law’s operations with the Banque Royale essentially attempted to expand French commerce by expanding France’s money supply. This monetary policy is one that an entire generation of Keynesian economists promoted more than two hundred years after the Mississippi and South Sea “bubbles.” Yet few economists, even those highly dismissive of Keynesian economics, are willing to call Keynesians irrational.
The Modern Bubble Debate
The jury is still out on whether or not bubbles can persist in modern asset markets. Debates continue among economists even on the existence of irrational or rational bubbles. And there is often confusion in trying to distinguish irrational bubbles from rational bubbles that might be generated by investors’ rational but flawed perceptions of market fundamentals. Most modern efforts focus on developing sophisticated statistical methods to detect bubbles, but none has enjoyed a consensus of support among economists.
This is a split-adjusted figure. The actual trading price at the time was $475 per share.
If the asset is to be held forever, its fundamental value is just the present value of its expected dividend stream since the present value of any dollar amount to be received an infinite number of years from now is zero.
In doing so, one might say that you were applying the “greater fool theory” to your investment decision, thereby building a “castle in the air.”
Economists often refer to these types of bubble conditions as “bootstrap equilibria.” High prices are thought to be held high by self-fulfilling prophecies, just as one might attempt to hold himself high off the ground by pulling up on his bootstraps.
This section is based primarily on the influential work of economist Peter Garber.