Macro Aspects
No two bubbles or manias follow a path that is exactly the same, but as is later illustrated in Figs. 2.5 and 5.5, all bubbles exhibit a similarity of features that are readily identifiable by visual inspection. Bubbles and their always compel- ling underlying narratives have, moreover, appeared in politics and opinions, fashion, art, and even science.12 And all bubbles after bursting leave behind a residue of some financing, production, and service capacities that will no lon- ger ever be needed. Contraction and consolidation then follow naturally, as formerly misallocated capital flows are redirected.
Whether of a political, technological, or monetary nature, announcements and developments that are interpreted as being favorable typically provide the fertile soil in which bubbles are able to sprout and grow large. But this soil alone doesn’t necessarily assure a bubble’s presence. Additional ingredients are required. And news itself is not one of them as it is often only a coincidental trigger.13 What happens in markets depends instead on how traders react to specific news events.14
Those long-lived bubbles that do form will often, however, lead to macro- scale, productivity- enhancing innovations, with some of the historically most important ones being the introduction of canals, railways, automobiles, radios, airplanes, computers, and the Internet.
The manic market reaction to technological innovation in the 1990s was thus not unique and as unprecedented as many of the most fervid participants then believed. Something of the same sort, writes Sylla (2001), had already happened 150 years before: “Britain in the 1840s was in much the position of the United States today…It also had several years of irrational exuberance related to a new network technology, in this case, the railways.”15
That bubbles and crashes related to such innovations have regularly appeared in the last 200 years in both the United States and the United Kingdom is shown in Table 1.1. A visual overview of real US asset class returns for 1900–2016 appears in Fig. 1.1.
Table 1.1 Stock market crashes, booms, and recessions: United Kingdom and United States, 1800–1940 and 2002
Crashes Major causes Recessions Preceding booms
Peak Trough Real stock price changes (percent)
GDP contraction (percent)
Stock price changes (percent)
Banking panic Other
severe financial distress United Kingdom
1808 1812 −54.5 War – – 1810 –
1824 1826 −33.6 Latin America
mania – 78.4 1825 –
1829 1831 −27.0 Political agitation – – – –
1835 1839 −39.1 American boom −0.6 – 1837 1839
1844 1847 −30.5 Railroad boom −2.5 51.9 1847 1847–48 1865 1867 −24.5 Overend Gurney
crisis – 48.4 1866 1866
1874 1878 −19.7 European financial
crisis −2.0 – – –
1909 1920 −80.5 World War I −23.6 – 1921 –
1928 1931 −55.4 Great Depression −5.6 – – –
1936 1940 −59.9 Housing boom,
war scare – – – –
Memorandum
2000 2002 −26.7 Information
technology boom – 78.4 – –
United States
1809 1814 −37.8 War −1.6 – 1804 –
1835 1842 −46.6 Bank war −9.4 57.2 1837 1837
1853 1859 −53.4 Railroad boom −8.6 – 1857 1857
1863 1865 −22.5 Civil war −6.2 20.5 – –
1875 1877 −26.8 Railroad boom – 50.5 1873 1873–76
1881 1885 −22.2 Railroad boom – 51.3 1884 –
1892 1894 −16.4 Silver agitation −3.0 – 1893 1893–94
1902 1904 −19.4 Rich man’s panic – 29.9 – –
1906 1907 −22.3 World financial
crisis −6.9 – 1907 –
1916 1918 −42.5 War – – – –
1919 1921 −24.5 Disinflation,
disarmament −8.3 – – –
1929 1932 −66.5 Roaring Twenties
and policies −29.7 201.8 1930–33 1931–32 1936 1938 −27.0 Tight monetary
policy −4.5 – – –
Memorandum
2000 2002 −30.8 Information
technology boom – 165.2 – –
Source: Bordo (2003) and International Monetary Fund [IMF, (2003, Chap. 2)]. See also Chambers and Dimson (2016, p. 175)
Schumpeter (1939, pp. 689–91) also wrote extensively on the role in the business cycle played by innovation and described the linkages between specu- lation, credit, and central banking. As for stock market speculation, he first notes (p. 683) that it is “availability rather than cost of credit that we should look to.” He then observes (pp. 689–91) that “…speculation in stocks does not, or not to a significant extent, ‘absorb credit’…the stock exchange is not a sponge but a channel…Since stock speculation does not absorb funds, it must be extremely difficult to stop or to restrain by any of the ordinary tools of cen- tral banking.”16
However, once a bubble has burst, scapegoats are sought and legislative and political inquiries and policy initiatives are typically begun with a widespread sense of outrage and a desire that perpetrators—including also those imagined or fabricated—be punished. The larger the bubble, of course, the more intense is the urge for retribution. “The consequence of a bubble for markets is to reward winners and punish losers with a savage intensity.”17
This ought not to be surprising in that over the centuries human nature does not appear to have changed much if at all and that episodes of speculative euphoria are always led and fed by, among other things, avarice, envy, emula- tion of neighbors, and crowd psychology.18 In fact, many of the investment concepts and vehicles for speculation were devised or invented long ago.
Osaka’s Dojima Rice Exchange established in 1697, for instance, offered for- ward contracts as early as the eighteenth century.19 And behavioral/emotional finance perspectives can be respectively traced back to Dutch merchant Joseph de la Vega in 1688 and to Japanese rice merchant Munehisa Homma, who in 1755 described the role of emotions in affecting rice prices.20
1,000 100 10 1
0.1
1900 10 20 30 40 50 60 70 80 90 2000 10
2.6 9.8 1,402
Equities 6.4% p.a. Bonds 2.0% p.a. Bills 0.8% p.a.
Fig. 1.1 Cumulative returns on US asset classes in real terms, 1900–2016. (Source:
Elroy Dimson, Paul Marsh, and Mike Staunton, Credit Suisse Global Investment Returns Yearbook (2017, p. 12) and Triumph of the Optimists: 101 Years of Global Investment Returns, Princeton, NJ: Princeton University Press (2002). Copyright ©2017 Elroy Dimson, Paul Marsh, and Mike Staunton; used with permission)
Says Chancellor (1999, p. 57):
…there is really very little in our financial understanding that is actually new.
Already in the seventeenth century, both in Amsterdam and in London, we find financial derivatives being used for both risk control and speculation. We also find sophisticated notions of value, together with the idea of discounted cash flows and present values. Wagering and probability theory provided contemporaries with an understanding that the risk-reward ratio could, in certain circumstances, be calculated.
Lord Keynes also recognized the nature of speculative bubbles:
It might have been supposed that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself. – Keynes (1936, [1964], p. 154)
And even former Fed Chairman Alan Greenspan recognized that bubbles are nothing new:
Whether tulip bulbs or Russian equities the market price patterns remain much the same. – Greenspan (1999) and in Haacke (2004, p. 3)
The random-walk and affiliated efficient-market hypothesis (EMH) appro- aches that emerged from academia in the 1960s (e.g., Samuelson 1965) did provide fresh insights that ultimately led to a deeper understanding of stock price behavior and portfolio risks and rewards. These approaches posited that stock movements are unpredictable (a random walk) because the most recent share prices already presumably reflected all information related to their value and that markets are efficient because they are able to assimilate and react to the randomly timed arrival of new information rather rapidly.
No doubt, the rational-model EMH material provided a starting point and benchmark against which the subsequently discovered behavioral anomalies and psychological quirks of financial market pricing could be tested and com- pared. Better still, the financial mathematics is neat.
Yet under the EMH’s restrictive conditions—in which the real world is a bothersome special case—no bubbles and crashes can or will occur. Such extreme events do occur because the theoretical conditions are not ever even closely approximated. History suggests that many events of this kind have occurred.
Utility and Independence
The random-walk/EMH framework has been studied and debated to exhaus- tion by academics and practitioners. In the early years the random walkers
appeared to marshal virtually incontrovertible statistical evidence for the reli- ability and viability of their models. Yet despite many spirited defenses (e.g., in Malkiel 1999, 2003, 2007), other academic studies [e.g., Lo and MacKinlay (1999) and Poterba and Summers (1988)] gave weight to alternative argu- ments and interpretations.
The Long-Term Capital Management (LTCM) debacle of 1998—the single- day loss was $553 million on August 21 (CFA Magazine, March–April 2006)—had, for instance, cast doubt on the practical usefulness of the EMH theories and models.21
More specifically, for many neoclassical economists the key underlying assumption is that investors are at all times rational in independently ordering their preferences and in maximizing expected utility, which is vague jargon for the amount of psychological or physiological pleasure—perhaps monetary gain—that is expected to be derived from the outcome of events or from doing something (e.g., buying, selling, owning).22 The standard presentation of such risk-averse rationality, which results in a concave and increasing utility function, is seen in the left hand panel of Fig. 1.2.
With a utility function of this type, equal movements to either side from the average level of wealth, V0, will result in unequal changes in utility.24 According to conventional explanations and models, this is considered the normal state of affairs.25
In many spheres of life, though, it in fact appears from research into human behavior, that people are influenced by economically irrelevant factors and will often make decisions in contextual relation to what others are doing and to a personal reference point (as in prospect theory, section 7.1).26 Nowhere in economic relationships is this seen more prominently than under extreme market conditions.
Utility wealth, U(V) of
Utility wealth, U(V)of non-bubble
risk aversion
bubble greed
V0 Wealth Wealth
Fig. 1.2 Idealized collective market utility functions, non-bubble risk-averse, left, and nonrational bubble greed, right. The right panel conceptually illustrates the attitudinal conversion (or flip) of market participants from risk aversion to the obliv- iousness to risk that characterizes bubbles. It essentially portrays an accelerating attitude of “the richer I become, the more I want,” monetarily, emotionally, and psychologically23
Investors, it seems, rarely make decisions in isolation. Neither do they follow the traditional economic theories, which deal with absolute states of wealth.
Instead, behavioral and emotional economics has demonstrated that “losses sting more than gains feel good.”27
It may be readily inferred from the brief history review of the next chapters that the very formation of a bubble requires the utility functions of investors to become ever less independent (i.e., investors join herds) and that the collective emphasis contagiously shifts progressively from risk aversion to reward seeking and from fear to greed.28 If so, then there is a broader concept of social ratio- nality that describes what is seen to occur in speculative frenzies. Economic behavior is thereby society-dependent and related to the zeitgeist (which is itself also a variable).29
In the midst of a bubble, and perhaps even in its absence, there is the pos- sibility that investors may (and usually would) in addition react to actual changes in share prices, thereby creating the potential for chaotic feedback loops.30 Such feedback is an often-observed feature of speculative bubbles (and crashes) and indicates that chaos theory might be applied to the study of such events even though applications of nonlinear methods have thus far not yielded clear-cut results (Chap. 10).
Psychology, Money, and Trust
One objective is to develop methods that will make it possible to assess finan- cial bubble characteristics across all orders of economic magnitude, moving down from GDP to particular equity (or real estate) markets, to industry sec- tors, and even then perhaps to individual company share prices.31 The primary challenge is in finding explanations that are not arbitrary and model-specific and that—in addition to money and credit aspects—are also able to incorporate psychological and emotional elements which may include (sometimes simulta- neously) greed, fear, apathy, envy, aggressiveness, remorse, regret, disgust, con- fusion, and anger. It is therefore important to have some insight into not only the sequential linkage between psychology and money but also into the many nonlinear and asymmetric relationships that have been revealed by studies in behavioral finance.
Psychologists have found that possession of money confers and implies social power and becomes an index of social adequacy.32 Feelings of empow- erment and worthiness are, it appears, principal components of the social atmosphere in which bubbles will sprout and grow. To carry the matter to its extremes, all bubbles rely on a positive psychology, a certain “madness of crowds,” and, using a Keynesian figure of speech, lots of high “animal spir- its.” The general level of optimism or pessimism in a society is then reflected in the correlated and emotionally driven financial decisions of economic par- ticipants.33 By this approach, perceptions of the potential proximity and
imminence of new income-generating opportunities thus sequentially arrives prior to the shift to an overall more positive psychological framework. Once started, there is obviously also an ongoing feedback interplay of one on the other.34
A positive and relatively trustful psychological mood-influenced environ- ment—generated by and for any number of possible underlying socioeconomic reasons—must therefore be presumed to exist as a precondition for the forma- tion of an asset price bubble. That’s because the psychological environment of empowerment that leads to speculation would not or could not ignite and then evolve in the absence of underlying positive money, credit, and opportunistic conditions. There is in history no factual or anecdotal evidence for believing otherwise.
Behavioral studies of how people respond to money and prices have further suggested that anchoring to price levels is important, that relative rather than absolute prices and price changes are what stimulate emotions and motivate actions, that money illusion related to inflation is a common feature, and that the psychology toward potential risk is usually different than that toward potential rewards. All of these aspects, it appears, are what allow bubbles and crashes to occur.
But there is also a deeper relationship between money and psychology that is always operative: It is the aspect of trust and of attempts to banish uncer- tainty. Booms depend both on a “semblance of certainty” about economic and financial prospects and also on trust that the credit-related products, offered by banks and other providers, will be readily and properly serviced when they come due. If and when such fragile trust is diminished, impaired, or betrayed, the stage is then set for financial crises and crashes to fester and follow. Feedback from the ensuing tide of anger, resentment, and disillusionment will then fur- ther weaken or break the bonds of societal trust and turn the financial environ- ment toxic.
At such junctures, price changes will not so much reflect fundamental financial asset characteristics but rather instead the fortunes of potential buy- ers and how intensely they respond psychologically and emotionally to the disruptive events. “Trust is the ingredient that makes a market economy work.35
Martin (2015, pp. 27–9) writes:
Whilst all money is credit, not all credit is money: and it is the possibility of transfer that makes the difference. An IOU which remains for ever a contract between just two parties is nothing more than a loan. It is credit, but it is not money. It is when that IOU can be passed on to a third party….that credit comes to life and starts to serve as money. Money…is not just credit – but transferable credit…What matters is only that there are issuers whom the public considers trustworthy, and a wide enough belief that their obligations will be accepted by third parties.
In effect:
• “[M]oney is a social relationship of credit and debt.”36
• “[M]oney is equivalent to information… is a relation of trust…we put our trust in trust…Money creation is special…It is created from debt relations…Money is a promise…Trust is only a calculation about risk.”37
• Money “…is not a real thing at all but a social technology…the operating system on which we run our societies and economies.”38
• “When trust is lost a nation’s ability to transact business is palpably undermined.”39
• Money and finance together function as time-travel mechanisms because finance (e.g., mortgages and bonds) reallocates value, risk, and capital through time.40 In fact, despite the many centuries-old cultural and social disparagements, grudges, and hostilities often expressed by debtors toward creditors and their usually opaque money and financial dealings, “the ascent of money has been essential to the ascent of man…financial innovation has been an indispensable factor in man’s advance from wretched subsistence…money… is trust inscribed.”41
As in all aspects of life, but especially in finance, trust is thus linchpin and lubricant. It cannot be bought; only earned. Trust is everywhere the bedrock currency for all markets and transactions.
1.3 Central features
Although its characteristics have not as yet been precisely described, a market bubble is something that can be sensed by many participants while it is occur- ring. In the late 1980s, for example, popular television shows such as Wall Street Week with Louis Rukeyser actively discussed the existence of a Japanese bubble well before the peak at year-end 1989.42
Many magazines such as The Economist (Sept. 23, 1999) discussed the existence of an Internet stock bubble well ahead of the NASDAQ Index peak above 5000 (5132.52 intraday) on March 10, 2000. An article in Fortune published around the time of the peak (Rynecki 2000) concerned itself with “market madness.”43 Rynecki illustrated that in 1999, companies with the steepest income losses gave shareholders the highest gains. And in a Barron’s Big Money Poll reported in the issue of May 3, 1999, of nearly 200 respondents, 72% saw “signs of a speculative bubble in the market, particularly in certain highflying Internet stocks and some of the so-called Nifty Fifty growth stocks like Microsoft and Intel…”
Warnings in books were, furthermore, widely available. Two such examples were Shiller’s Irrational Exuberance, a play on then-Fed Chairman Greenspan’s famous (but too early) warning phrase in a speech given in December 1996, and The Internet Bubble by Red Herring magazine publishers Perkins and Perkins (1999).44 Smithers and Wright (2000), employing Tobin’s famous Q ratio (market value of a firm’s or economy’s assets divided by replacement value of those same assets), also warned at the end of 1999 of the historically extreme valuations seen in the market at that time.45
For the most part, though, after a lengthy period of gains, investors and economists have often appeared to be blind to the rising risks of investing and
speculation. Even as late as October 16, 1929, renowned Yale economics Professor Irving Fisher authoritatively and famously (or perhaps infamously) proclaimed (on October 15) two weeks before the crash that “stock prices have reached what looks like a permanently high plateau.”46 The following was as likely to have been written in late 1999 as it had been 70 years earlier:
For the last five years we have been in a new industrial era in this country. We are making progress industrially and economically not even by leaps and bounds, but on a perfectly heroic scale.47 (Forbes, June 1929)
And only a few days prior to the 1989 all-time peak of Japan’s Nikkei, there was delusional bliss.48
Tokyo’s stock market is still a ripsnorter as it heads into the 1990s. With the Japanese economy going gangbusters and the ruling Liberal Democratic Party shaking off the influence-peddling scandals that dogged it and the market earlier in 1989, investors are rushing back into stocks. The influx of fresh cash has pushed the Nikkei stock aver- age up 7% since early November, to a record high. And leading market-watchers now say the wild ride could continue into spring. “There may be some volatility,” predicts Nomura Securities Co. President Yoshihisa Tabuchi, “but prices will keep climbing.
(BusinessWeek, 25 December 1989)
Ten years later, in the TMT (technology, media, and telecom) bubble of the late 1990s, attitudes hadn’t much changed. At that top, many blindly optimis- tic chief financial officers thought their shares were “undervalued.”49 Federal Reserve Bank officials in late 1999, just prior to the peak, made speeches sug- gesting that although the rise in equity prices averaging 25–30% over the previ- ous four years was unprecedented, changes in the structure of the economy might provide justification for such moves.50 One Fed Quarterly Review study even argued that the market was then “correctly valued.”51 And in late 1999 only 1% of analysts’ recommendations on around 6000 companies were rated as “sell.”52
At the Bank of England, Governor Eddie George said in December 1999,
“…particular strengths of high-technology stocks in equity markets provided a better underpinning of equity values than perhaps had been appreciated.”
Spain’s Economics Minister also said in February 2000: “The stock market is one of the new opportunities where…everyone wins.”
Comparable sentiments were, almost as if on cue, also expressed just at the cusp of the housing and credit bubble collapse that began in 2007.53 Similar optimism was also expressed in 2012 by IMF economists and vari- ous government officials even as the Spanish banking and Eurozone crisis was imminent.54
The Shanghai/Shenzhen 2015–2017 market bubble and crash also traced what is by now a familiar pattern marked by frenzied small, new, and unsophis- ticated investors leveraging their life savings into highly speculative shares val- ued without any connection to economic fundamentals and at an average