How Do Financial Bubbles Really Work?

Team Luno
Team Luno
Sep 26, 2018 · 9 min read

This is the next instalment in our Evolution of Money series, where we look at how money has changed and developed over time, and what the future might hold. In this story, we’re looking at financial bubbles: the causes, the signs, the aftermath, and the benefits.

First, what is a financial bubble?

A financial bubble is a significant increase in the price of an asset that does not reflect an increase in its true value.

Bubbles are often based on a belief that the asset’s price will continue to rise. People pay more because they expect to sell for more. This conviction pushes up prices even more. Eventually, reality kicks in and the bubble ‘bursts.’

They’ve been around for centuries but are rare and occur infrequently enough for us to forget the last one before the next starts. That makes it easier for people to believe this time is different.

One of the earliest examples happened in the early 1700s. Stock prices for the South Sea Company exploded, despite its lack of profits. You’ll often hear about the Dutch Tulip Bubble too, which probably never happened.

If something is both finite and in demand, it has a price. If it has a price, it has the potential to set off a speculative mania.

That includes stocks, real estate, precious metals, natural resources, student loans, collectable items (like Beanie Babies), even a whole economy.

However, it’s only a bubble if it bursts. It’s common for assets to experience sudden price increases that never reverse. Although the media often imply that financial bubbles are straightforward and predictable, they’re not.

The causes tend to be complex, and the vast majority of predicted crashes never happen.

Financial bubbles happen in four stages

We can only ever identify bubbles in hindsight, but when we look back, they tend to involve four stages.

What’s the initial spark for a financial bubble? Often, it’s excitement. Something new comes along and we don’t know quite how to react. But it seems like it might change the world, so we can’t calculate its exact value.

With time, that ambiguity makes it easy to justify inflated prices.

We overestimate the short-term impact of technology and underestimate its long-term impact. This is Amara’s Law and it explains the excessive excitement around unproven concepts. Although not all bubbles are linked to new technology, the trigger is usually change.

For example:

At the Trigger stage, the market is usually small and prices low. Investors who buy at this stage profit the most, provided they sell in time.

Photo by Leo Rivas on Unsplash

A bubble is not the same as a Ponzi scheme because there’s no intentional deception or fraud. People don’t orchestrate bubbles. They just happen.

As more investors become aware of the asset, prices rise.

Once a bubble is in motion, it sets off a self-perpetuating feedback loop.

Knowledge leads to price increases, which leads to greater awareness and so on. People start speculating.

Eventually, people who don’t have much relevant understanding start buying. They expect others to pay more for it in the future, so they don’t think they need to understand its value. Significant price increases and stories of early investors getting rich are like catnip for the media. Constant coverage only fuels further price increases.

We call this irrational exuberance: the belief that prices will keep on rising forever because they rose in the past.

Although bubbles probably wouldn’t happen without this quirk of human psychology, there are plenty of enabling factors. For example, an influx of foreign investment into a country could inflate asset prices, as more money gets thrown at the same number of opportunities.

Smart (or lucky) investors sell at this stage and make a profit.

Only when a bubble bursts can we know, for sure, that it was a bubble in the first place. But the signs are indisputable: a rapid drop in the asset’s price more significant than the usual day-to-day volatility. Markets flood as everyone sells at the same time.

Depending on the size of a market and how liquid the asset is, this can take anywhere between days and years. There are subtle signs beforehand, but most investors ignore them.

When a bubble pops, it’s common for us to ask ‘why didn’t anyone do anything about this?’

Surely someone saw it coming. Surely someone could have prevented the messy aftermath. In truth, people usually do see it coming and try to warn others. But that doesn’t help much for three reasons.

First, as we’ve seen, it’s impossible to know if an asset is experiencing a bubble until after the crash. Whenever an asset price increases a lot, you’ll hear numerous people calling it a bubble. With so much noise and no easy way to validate these claims, we don’t know who to listen to.

One of the hardest truths to accept about human nature is that we see the world how we want to see it. If someone wants to believe that an asset is experiencing a bubble, they will find evidence. If someone else wants to believe the same asset is appropriately priced, they’ll find convincing evidence. You could show both the same information and they would interpret it in a way that supports their beliefs.

Second, the feedback loops that keep a bubble going are too powerful to stop.

Third, people may be aware of the bubble, but they want to keep the party going. Investing gives way to gambling. If you can’t beat them, they might reason, you might as well join them.

It’s worth noting that a crash is not the same as a market correction which is a fall of 10%+ after an unjustified increase. Corrections bring prices closer to the ‘correct’ level, not below it.

Railway Mania

Let’s take a look at one example of a financial bubble to get a sense of how it all fits together. The Railway Mania was a period of speculative euphoria in the UK throughout the 1840s.

Today, railways might seem mundane and unextraordinary. But at the time, they were revolutionary.

Their impact is sometimes compared to the internet because both allowed information to travel in new ways, connected people who wouldn’t have interacted otherwise, and opened up new ways of making money.

Railway networks have been around since the 16th centuries, with early systems consisting of lots of disconnected lines and stations run by different companies. By the 19th century, the technology had developed enough to form the basis of the first national system.

Photo by Jack Anstey on Unsplash

As existing railway companies began to make big profits, their shares shot up in price.

Investors, many of them newly wealthy from the Industrial Revolution, poured their savings into railway companies — which, for the first time, could promote their stock in newspapers. The ensuing mania provided the investment needed to build tracks across the United Kingdom.

Unfortunately, the boom in stock prices turned setting up railway companies into the get-rich-quick scheme of the day. Numerous unscrupulous companies popped up to cash in on the buzz, without the resources or even inclination to build usable railways.

Many people who foolishly put all their money into railway stocks lost everything.

But the United Kingdom arguably benefitted in the long run. The mania left behind a usable network of tracks which a few larger companies bought up at a fraction their true value.

Without the out-of-control speculation, the social and economic change that followed may have taken a lot longer.

So, do we know what causes a bubble to pop?

Yes and no.

Following the October 19th 1987 stock market crash ( prices fell by 22.6%) Nobel Laureate Robert J. Shiller surveyed 1000 investors. He wanted to know why they all sold at the same time. Logically, we’d expect a distinct catalyst for the crash, such as a news item.

But that’s not what Shiller found. No news story or rumour was responsible. The investors said that the events of that week had little to do with their decisions. Although many felt uncertain beforehand, they only sold when the price started dropping.

It was a chicken-and-egg situation: everyone sold because everyone else was selling. That’s how bubbles tend to burst.

The feedback loop reverses and although sometimes there’s a distinct cause, it’s usually just random.

Once the drop gets going, it’s as unstoppable as the rise was. The more the price falls, the more people sell, and the more people sell, the more the price drops.

The actions of lots of people making decisions and following a few rules, lead to an emergent pattern. A stock market, for example, can be envisioned as a system.

If you zoom in on the behaviour of individual investors, it can seem chaotic. But when you zoom out and look at the market as a whole, you see a more orderly pattern.

No one is controlling it — the movements emerge by themselves.

Although financial bubbles can be devastating in the short term, they have benefits in the long-term.

American economist Hyman Minsky suggested that they may be more of a feature than a failure. Minsky wrote that we tend to imagine economies as like this with steady, consistent growth:

Except, every so often there’s a big shock or disaster that disrupts everything for a while before it returns to normal:

According to Minsky’s hypothesis of financial instability, that’s the wrong way to think of it. Minsky believed that the economy is fundamentally unstable and goes through self-perpetuating cycles:

During periods of growth, individuals and organisations take more and more risks. In the short term, this further fuels the growth, which leads to even more risk-taking. So the initial stability leads to a bubble.

Although there might be severe repercussions (depending on size and contagion), the growth attracts investment.

The crash often leaves behind new infrastructure, technological developments, and other improvements. People learn from the mistakes of others and take advantage of what they left behind.

Bubbles leave behind infrastructure that may not have received funding otherwise. For example, the Railway Bubble left behind train tracks that benefitted later businesses.

For example, the dot-com boom of the early 2000s arguably had lasting benefits. It kickstarted the internet revolution by both introducing people to the idea and laying foundations for the technology we use now. Some of the most significant companies today started during that time. The change, in a few years, was enormous.

In our daily lives, we all reap the benefits of the bubbles of the past, no matter how devastating they were at the time.

Change is inevitable. It’s also, as we’ve seen, very exciting.

Sometimes that leads to overconfidence because we know something new is good, just not how good.

This is all part of the evolution of money and as we move into the new era, it’s important to recognise that cryptocurrencies are much like any other asset.

There may be runaway markets, sudden spikes, and overvalued assets (like ICOs.) Even if something does experience a bubble, it doesn’t discredit its intrinsic value. It’s important to recognise that this is a natural part of growth.

We’re all responsible for making good decisions and staying rational. Part of upgrading to a better financial system is remaining realistic about the possible challenges along the way.

It’s essential to get excited about the future, but it’s also vital to think long-term and keep out feet on the ground.

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