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Bubble, Bubble, Froth or Trouble?

Opinion Editorial
December 28, 1999

By Linda Gorman

This is the time of year traditionally reserved for contemplating bubbles, preferably those rising from the bottom of a glass of champagne. Early media predictions of a millennial champagne shortage failed to pan out and the champagne market, in yet another miracle of commerce, seems set to provide tiny bubbles to all who want and are willing to pay for them.

Economists never did worry about a bubble shortage. Because they study the remarkable results of unfettered individual enterprise, they rapidly come to regard market miracles as a routine commonplace.

Besides, they have a private reserve of very interesting bubbles. A vintage group, it includes the Dutch love affair with tulips in 1634-37, the Mississippi bubble in France in 1719, the South Sea bubble in England in 1720, and the Japanese property bubble of the 1980s. Well-made American growths include the panic of 1873 and the 1929 and 1987 stock market crashes.

Though interesting to study, economic bubbles leave a bad taste when made by greater fools. They exist, in the words of economist Joseph E. Stiglitz, when “the price is high todayonly because investors believe that the selling price will be high tomorrow,” and when “‘fundamental’ factors do not seem to justify such a price.”[1]

Like fine wines, bubbles are difficult to predict in advance. Expert prognosticators are currently speculating on the recent stock market growth. Some, convinced that paying billions for red_ink.coms shows that greater fools abound, predict that the U.S. stock market is set to harvest another fine bubble.

Others question whether bubbles exist at all. Raised in the fertile fields of the rational expectations and efficient markets hypotheses, they argue that so-called bubbles merely represent changes in the fundamentals underlying the predicted prices. Bubbles are nothing more than larger than usual adjustments in investor expectations, and the high prices for today’s red_ink.com is simply a rational response to its limitless potential.

The rational expectations hypothesis assumes that market participants hate guessing wrong about future prices because wrong guesses generally result in painful consequences like losing money. To avoid this, they attempt to use all available information, including information about how their guesses were off in the past, in their efforts to guess right.

The efficient markets hypothesis simply asserts that people don’t leave dollar bills lying around on sidewalks. If someone spots a way to make a profit, it assumes that he will act to exploit it. In other words, hot tips usually aren’t.

When economist Peter M. Garber examined Dutch tulip bulb prices he found that the prices for the bulbs on which he was able to gather data “collapsed” at an average annual rate of 32 percent. Not much higher than the 28.5 percent average 18th century depreciation rate for bulbs of new varieties, in his view, the “crash” was just a price drop of 16%–“large, but not the stuff that legends are made of” and something that had no observable effect on the Dutch economy.[2]

According to Garber, bubble connoisseurs in local taverns occupied themselves through the winter of 1636 by making a market in common bulb varieties. Payments were called “wine money.” One set of bubbles led to another, much to the amusement of tavern regulars.

Bubble enthusiasts respond that imbibing bubbles is not a necessary condition for developing speculative fever, and that people are prone to make mistakes when fundamentals are difficult to assess as is the case when there are major changes in industry.

In the 1920s, it was high-tech stocks like General Motors, RCA, the Aluminum Company of America, and electric utilities that captured the imaginations of investors. Raising money by selling stock directly to the public let many groups, like women, participate in the stock market for the first time. Women’s magazines ran articles on how to invest, and stock brokers provided women with amenities like special rooms with their own ticker tapes.[3]

Well known financial figures, among them A.P. Giannini, founder of the Bank of America, said that their companies’ stocks were too high. Others, notably economist Irving Fisher of Yale, were convinced even after the crash, that “the market went up principally because of sound, justified expectations of earnings, and only partly because of unreasoning and unintelligent mania for buying.”

In the long run, both Fischer and Giannini were right. Some of the stocks that were high-tech speculations in the 1920s are today’s boring blue chips. Others imploded, taking their investors along with them.

Bubbles are fun while they last. Avoiding a hangover after they burst makes them even better.


[1] Joseph E. Stiglitz. Spring 1990. “Symposium on Bubbles,” Journal of Economic Perspectives, 4, 2, p. 13.
[2] Peter M. Garber. Spring 1990. “Famous First Bubbles,” Journal of Economic Perspectives, 4,2, p. 38.
[3] Eugene N. White. Spring 1990. “The Stock Market Boom and Crash of 1929 Revisited,” Journal of Economic Perspectives, 4,2, p. 78.

Linda Gorman is a Senior Fellow with the Independence Institute, a free-market think tank in Golden, Colorado, https://i2i.org. This article originally appeared in the Colorado Daily (Boulder), for which Linda Gorman is a regular columnist.
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