When people discuss bubbles in certain markets (currently housing), what is the dynamic that leads to them growing and then bursting? If it’s what people are willing to pay, how is it a “bubble”? Just from the stanpoint of inflation and the sudden deflation in one market?
At some point, rational behavior is replaced by speculation, a reliance on the “greater fool” theory. The actual value of the commodity becomes irrelevant, whether it’s houses or tulip bulbs. Like any scheme dependent on a continuous supply of new participants and money, it is doomed to collapse.
An academic economist has a precise definition of a bubble though like many other things, the popular press will use the word in a more casual fashion. To an academic, a bubble is a price process that is self-supporting, but not supported by the fundamentals. For example…
Suppose you had a bond contract that paid one dollar per year in interest forever. Suppose further that the interest rate were r also forever. The fundamental value of this bond is 1/(1+r) + 1/(1+r)^2+ … A little algebra shows this series convereges to 1/r. So the fundamental value of the bond is 1/r.
Suppose however that people believed the price at time t should be P_t = 1/r + A(1+r)^t where A is any positive number. Since people believe this, they’d calculate
so the belief is supported by the fact that the bond will earh (in interest payment and capital appreciation) the interest rate. The belief is self-fulfilling: If people believe it, the price will behave in just that way, and any buyer will earn the interest rate.
Is this price belief wrong? Well yes it’s not supported by the fundamentals, but no if I buy at time t and sell later at time T, I earn just what I should – the interest rate.
When people stop believing the price should behave like this, and believe instead that the price should be P_t = 1/r, the bubble collapses with prices falling drastically.
It’s the allure of big money and the psychology of mobs. When more and more
people get into something they would not normally be involved in, the prices
rise. Eventually no more additiional people are available so there’s no new
suckers to sell to and the whole thing collapses.
You know you’re in a bubble if your cab driver starts giving you stock tips or
there are a lot of folks buying homes not to live in or rent, but to flip for a profit
within a few months of purchase.
There is an interesting discussion of this in The Wisdom of Crowds. From that author’s perspective, individual judgements lose their independence and the collective guess as to a stock’s value goes way off. I’m not aware of any particular theory that fully explains what’s going on.
In that same book the author discusses an experiment where a class was given “stocks” that would pay, let’s say, 10¢ per game period. Over ten periods, the stock would pay out $1, so in the first period it would be worth $1; in the second, it would be worth 90¢; and so on. (I’m making the numbers up because I don’t remember what they were.) What happened was that even though everybody fully understood how much each stock was worth, they traded them at prices well above the stocks’ true value. Even near the end of the game they were trading at prices way, way out of line with what was reasonable.
When asked why they paid so much, they all reported that everybody else was trading at such high prices so they figured they’d be able to unload the stocks to somebody else. Pretty big endorsement of the Greater Fool theory.
I think a lot of times people just believe the hype, and because the hype is all one-sided during a bubble, that’s where everybody errs. I knew people—professionals—who thought that fundamentally unprofitable companies would be worth enough in the future to justify their outrageous prices during the internet bubble.
Another fund discussion of Word Com is in A Mathematician Plays the Stock Market (I think that’s the name) by John Paulos. That’s another good book, IMO.
From what little I know, when bubbles crash the dynamic is essentially the opposite. What causes them to crash is often something pretty minor.
Caveal Lector: This post probably belongs in IMHO rather than GQ.