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Why do markets create bubbles?

October 24, 2008 14:13 IST

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.

Cambridge economist John Coates is one of them. He used to manage a Wall Street trading desk and was struck by the way the (male) traders changed as the dot-com bubble inflated. They would pump their arms, yell, leave pornography around the office and in general behave as though they were high on something. It turns out that they were: It was testosterone.

Many male animals--bulls, hares, rutting stags and the like--fight with sexual rivals. The winner experiences a surge of testosterone, which makes him more aggressive and more likely to take risks. In the short run that tends to mean that winners keep winning; in the long run, they take too many risks.

Dr. Coates wondered if profitable traders were also running on testosterone, and a few saliva samples later it appears that he is right. Profitable trading days boost testosterone levels and tend to encourage more risk-taking, more wins and more testosterone.

When the risks didn't pay off, the testosterone ebbed away to be replaced by a stress hormone, cortisol. The whole process seems likely to exaggerate peaks and troughs.

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.

For example, one famous early "mania" was the Mississippi bubble, in which countless investors poured their money into the Compagnie des Indes in France in 1720, and lost it. Yet there was more going on than a free-market frenzy: The government could hardly have been more closely involved.

The Compagnie des Indes had effectively taken over the French Treasury and legal monopolies on French trade with much of the rest of the world (including Louisiana--hence "Mississippi bubble"). Investors were hardly insane to think that such a political machine might be profitable, especially since the king of France personally held many of the shares. But the king sold out near the top in 1720; within two years, the Compagnie was bankrupt and its political power dismantled.

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.

Peter Garber, a historian of economic bubbles, points out that a single bulb could, over time, be used to produce many more bulbs. The price of the bulbs would, of course, fall as more were cultivated. A modern analogy would the first copy of a Hollywood film: the final copies may circulate for a few dollars, but the original is worth tens of millions.

Garber points out that rare flower breeds still change hands for hundreds of thousands of dollars. Perhaps we shouldn't be quite so sure that the tulipmania really was a mania.

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.

Tim Harford is a columnist for the Financial Times and author of The Logic of Life: The Rational Economics of an Irrational World.

Tim Harford, Forbes
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