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Do financial Bubbles exist?

Financial bubble, sometimes also referred as speculative bubble or mania is defined as a situation where asset prices deviate from the corresponding asset’s intrinsic value (Investopedia 2016). In simple terms, a financial bubble is a price movement that is inexplicable based on fundamental as explained by Peter Garber. The concept of bubbles stirs quiet a controversy because there is a lot debate regarding whether bubbles actually exist (Quinn 2016). The term bubble originated in 1600s and was used to describe British South Sea and the Dutch Tulip mania where the prices of stock and tulips inflated based on nothing but air resulting in a sudden burst (Quinn 2016). Later commentators expressed that bubbles don’t burst suddenly; debt-deflation and financial instability hypothesis suggests that bubbles burst progressively with most vulnerable assets falling first and then spreading into the economy (Casey Research 2013). More mainstream economists Garber and Eugene Fama reason that economic bubbles don’t exist in the sense that market price is an accurate reflection of value and that asset prices don’t rise far above their true economic value (Garber 1990). They explain that price changes are not irrational, instead, just a notable change in fundamental expectation about an asset’s return. The aim of this essay is to illustrate that financial bubble don’t exist by proposing market fundamental explanations for three most famous bubbles Tulip Mania, British South Sea and Mississippi Company.

Tulip Mania

Tulip Manila is one of the most typical examples of financial bubbles that have been conventionally known as a speculative bubble when in fact there are market fundamentals that explain the reason behind the sudden decrease in tulip bulb prices. Tulip mania, an event popularized by Charles Mackay, was a period in Dutch Golden Age during which the prices of Tulip bulbs reached extraordinarily high levels and then suddenly collapsed (Garber 1990). During the peak of Tulip mania, single Tulip bulbs sold for more than 10 times the annual income of a skilled craftsman (Garber 1990). By 1635, the value of 40 bulbs was 100,000 guilders, which is equivalent to gold worth $16,000 (Garber 1990). Mackay detailed that the price of tulips increased because “crowds of people often behave irrationally”.  He asserted that people purchased bulbs at higher and higher prices intending to re-sell them for a profit; however, ultimately peoples’ willingness to pay such high prices started to decrease. As a result, the demand for tulips collapsed, prices plummeted and the bubble burst. Mackay’s account of inexplicable mania went unchallenged until Eugene Fama introduced the efficient market hypothesis (Quinn 2016). Garber challenges Mackay’s research by stating that Mackay neglected what the market fundamental price of bulbs should have been. Garber reports that Mackay utilized inaccurate data because Mackay recorded tulip prices 60 to 200 years after the collapse of the tulip mania, implying that the prices reported by Mackay were in fact much lower than the actual tulip prices. Secondly, Mackay reported the prices of regular tulip bulbs when in actuality the tulip mania developed a market for rare bulbs – deceased bulbs that formed a particular pattern that could not be reproduced through seed breeding (Garber 1990). Thirdly, Garber was skeptical of Mackay’s explanation of price decline of tulip bulbs, which was that the prices of tulip bulbs decreased faster than they should have - meaning that prices decreased faster than the rate of depreciation. In order to test this, Garber collected data on 18th century bulb prices, which measured typical rate of price decline of tulip bulbs. He explains that by 1707, such an enormous variety of tulip bulbs had developed that the demand for tulip bulbs had been replaced by hyacinth, which led to average annual rate of depreciation being 28.5% before bulb prices reached the lowest values (Garber 1990). Further, Garber explains that the annual rate of depreciation of bulbs was not very different from the 18th century depreciation rate implying that price decline of bulbs accounted for the depreciation in the economy. Had the price decrease just accounted for the crash and not to the recession in the economy, the price decrease would have accounted for no more than 16%. Lastly, Mackay informed that the burst of the Tulip mania led to economic collapse of the Dutch economy for years afterwards. Garber contests Mackay’s statement by stressing that there “is no evidence of serious economic distress arising form the tulip mania and all histories treat it as a golden era in Dutch history”.

The Mississippi and South Sea Bubble

The South Sea Company was a British joint-stock company, which was established to reduce the cost of national debt (Garber 1990). The Company was granted monopoly to trade with South America, which led to the increase in company’s stock value. The company stocks crashed a little after 1720.  Earlier economists regarded the crash of South Sea Company stocks as a Ponzi scheme where speculators bought the asset knowing that the price of stock was far above its fundamental value and that the prices will continue to rise (Garber 1990). However, Garber argued that the crash was not based on “psychology” or “irrational exuberance” but in fact corrupt allocation of shares to influential individuals and misleading informational issued by the company about its prospects in the New World.

The first point Garber makes is that intrinsic value of an investment or stock is often decided by its newest investor. If the original investor falsely declared that the investment would result in high dividends, then naturally, the new investor would base their decisions on the original investor’s word. Similar situation occurred in the South Sea Bubble; asymmetric information led to the crash of stock prices (Garber 1990). The company itself spread “the most extravagant rumors” of the value of its stocks and trade in the New World and expounded the view that there were increasing returns to scale in investment. This was followed by a speculative frenzy where all types of people started investing in the South Sea stocks. This led the share prices to rise from £128 in 1720 (start of the scheme) to £1000 by August, the peak (Garber 1990). Because of asymmetrical information, investors believed that the investment had high rates of returns – the value of shares was much higher than its intrinsic value when in actuality this was not the case. Finally, there was a liquidity scare, which led to the collapse of share prices. This contributed to the bankruptcy of the South Sea and Mississippi Company. 

The second factor that Garber raises in his analysis is the fact that both companies sold equity to buy up questionable debt and negotiated debt payments with the governments. The king was one of the largest shareholder of the Mississippi Company and similarly, the South Sea company generously bribed members of the parliament with shares (Garber 1990). Both companies practiced monopoly power on various kinds of trade and used equity to commercially expand the trade (Garber 1990). By January 1720, John Law’s company controlled government finance, taxation, expenditure and money creation. Additionally, he held monopoly power on all of France’s overseas trade. The companies went bankrupt not because of the crash of their stock prices but instead because the governments turned against them (Garber 1990). The French king sold his shares. Because the government support was now missing, the share values collapsed and this triggered the bankruptcy of both companies (Garber 1990). In conclusion, corrupt government regulation and false promotion of successful venture are examples of market fundamentals that explain the fall in stock prices of the Mississippi and South Sea Company.

Asian Financial Crisis

The debate whether bubbles exist extends to the 1997 Asian financial Crisis as well. On one hand, researchers contend that the root cause of the crisis was the panic stimulated by speculative behavior. They argue that the crisis started in Thailand where there was a lack of foreign currency to keep the Thai Baht pegged to the US dollar because of which the government was forced to float the baht. As a result, the baht devalued by 20%. The devaluation of Thai baht led to bankruptcy of many Thai banks and foreign debt because of speculative scare (Casey Research 2013). Many foreign investors pulled out capital from several other Asian countries such as Indonesia, South Korea, Malaysia and Philippines assuming that their currencies will also devaluate. However, Corsetti asserts that the causes of Asian Financial Crisis were not based on speculative behavior; instead they were based on high GDP growth, crony capitalism, current account deficits and high US interest rates. Of the several factors, he mentioned that the main factors that led to the Asian Financial crisis was high current account deficits, high GDP growth and questionable policies.

The first argument Corsetti lays out was the fact that these Asian Countries had high current account deficits as a share of GDP. The countries had accumulated large current account deficits by attracting capital flows to finance the deficit. However, then confidence fell, these capital flows dried up leading to a rapid devaluation and fall of economies (Corsetti 1998). The second point that Corsetti makes is that high GDP growth made Asian economies more vulnerable to the crisis (Corsetti 1998). All Asian countries had remarkably high GDP growth rates in early 1990s.  The high output rates boosted consumer confidence; consumers were overly optimistic about the future. This led to investment boom and large capital inflows. Because of changes in investor confidence, there was a rapid reversal of capital flows, which made the economies vulnerable and triggered the currency crash (Corsetti 1998). The last justification Corsetti explains is the policy framework of the affected Asian countries, namely fiscal policy. Despite the fact that fiscal policies had been relatively strong, fiscal expansion in Thailand stimulated crisis (Corsetti 1998). Because of expansionary fiscal policy, several institutions and investors expected growth to continue. Some fiscal adjustment was needed in order to bear the reversal of external capital flows. Many Asian countries had a really constrained budget and could not cover the costs of recapitalizing banks. In this way, Corsetti supports his argument that market fundamentals can explain the Asian Crisis and that the crisis was not just based on speculative scare.

In summary, there are contrasting views regarding the existence of economic bubbles. Researchers who support the notion of economic bubbles explain that economic bubbles occur when asset prices rise far above their true economic value, causing assets to appreciate excessively (beyond their fundamental level). Once the bubble bursts, the fall in prices causes collapse of unsustainable investment schemes, which results in speculative panic, which often results in a financial crisis. Researchers reasoned that the price changes were irrational and were a consequence of behavioral biases. However, few economists such as Garber and Corsetti contested the existence of financial bubbles using the famous historical crisis such as the Tulip Mania, South Sea Company and the Asian Financial Crisis. They argued that one has to eliminate all reasonable economic explanations in order to label a crisis as a bubble. As illustrated in this essay, there are several market fundamentals that explain why the prices of Tulip bulbs decreased, the shares of South Sea and Mississippi Company crashed and the Asian economies crashed as their banks went into insolvency, therefore, they are in fact not bubbles. While the debate continues, economists actually now focus more on how central bank should respond to bubbles especially since bubbles now often lead to economic recessions.

Miha Alam

Byrn Mawr College

USA

Work Cited

Corsetti, Giancarlo, Paolo Pesenti, and Nouriel Roubini. "What Caused the Asian Currency and Financial Crisis? Part I: A Macroeconomic Overview." (1998): n. pag. Web.

Doug French Contributing Editor. "Nobel Prize Winner: Bubbles Don’t Exist."Casey Research. N.p., 28 Oct. 2013. Web. 26 Oct. 2016.

Garber, Peter. "Famous First Bubbles." Journal of Economic Perspectives, 1990. Web. 26 Oct. 2016.

Investopedia. "Can the Efficient Market Hypothesis Explain Economic Bubbles?" Investopedia. N.p., 20 Apr. 2015. Web. 26 Oct. 2016.

"Problems of a Current Account Deficit." Economics Help. Economics.Help, n.d. Web. 26 Oct. 2016.

Wquinn05, ~., and ~. Ehs1926. "The Long Run." The Long Run. Economic History Society, 2016. Web. 26 Oct. 2016.