Follies of the Market

13713A market bubble is – “trade in high volumes at prices that are considerably at variance from intrinsic values.” This phenomenon is not accepted by the entire scientific world, some theoreticians denying it. Scientists also argue about the reasons for the appearance of a bubble – speculation, bounded rationality, processes of price coordination etc. The impact is generally considered to be negative because it allocates resources into non-optimal uses. The crash that follows an economic bubble can affect the whole economy. An example is the Great Depression of 1929. Bubbles change the propensity to consume – when the bubble is created, people spend more because they feel richer, thus expanding it even more. When the bubble bursts people tend to spend less thus aggravating the recession.

The cause of bubbles is still debated. They appear not only in real markets where speculation and psychology play a great role, but also in highly predictable computer generated simulations. A previous theory which states that they are caused by a lack of information, is now considered obsolete because they appear even when people are capable of pricing assets correctly and when speculation is impossible.


An empiricially unsupported theory, the “greater fool theory” states that bubbles are created by the behaviour of over optimistic market participants who buy an overvalued asset with the hope of selling it to another “fool” at a higher price. A second reason described is that bubbles are directed by the greed of overly bullish investors who overbid risky assets.


Extrapolation and peculiarities in regards to human behaviour are also listed, but the most important reason for market bubbles is excessive monetary liquidity. When the monetary policy is expansionary, there is more money and the interest rates are going low, investors tend to avoid putting money in their saving accounts and borrow capital from banks investing in real estate and financial assets. The bubble burst when the Central Bank ceases its policy of increasing the money supply. Interest rates are going high and investors find it difficult to meet their credit requirements.


One of the first known bubbles was the tulip mania in the Netherlands in the beginning of the XVII century. In this case the contract prices for the newly introduced tulip bulbs rose tremendously and then suddenly plummeted. At its height, a couple of bulbs could buy a house.


The next bubble was the South Sea Company Bubble. The South Sea Company was a British company that was granted a monopoly to trade in Spanish South America. Speculation in the company’s stock led to a great bubble that caused financial loss to many. The Mississippi Company is said to have been another big bubble. The Railway Mania was a speculative frenzy in Britain in the 1840s. The price of the railway shares increased and more and more money was poured in by speculators. It reached its zenith in 1846. More and more projects for future routes and for setting up of new railway companies were made. However one third of these projects remained only on paper. Many companies did not do much financial planning, and were bought out by other businesses or appeared to be a downright fraud.


In 1920 Florida saw a big land boom. Miami was viewed as a paradise city and attracted investors form all over the US. Property prices rose due to speculation. Plans for building entire cities in the Everglades were made. However, the prices were based only on the expectation of finding a customer, not on the real land value, so the investors of these huge properties soon found it difficult to resale their land to other buyers profitably. The bubble burst. Problems with the transportation of building materials and infrastructure appeared when the Danish warship Prinz Valdemar sank and blocked the Miami harbour – the main gate of Florida to the world, thus staining the image of a tropical paradise.The railroad companies placed embargoes on all other goods except for food in order to relieve the overburdened railway system. Then natural disasters such as the 1926 Miami Hurricane contributed to the burst of the bubble.


The Florida bubble was a part of the larger American economic boom of the 1920s that eventually led to the Great Depression. The root of the American Roaring Twenties was the First World War. After the war, Europe needed vast rebuilding work. The American economy was closely intertwined with the European economy. American investors put in large amounts of money into European companies and European debt, thus expanding the American economy. Post war Europe was a large market for mass produced American consumer goods. However the speculation that goes hand in hand with every economic expansion had it’s say in the end.


Another bubble was the one from the 70s. It involved the Nifty Fifty – the fifty most popular companies listed on the NY Stock Exchange in the 60s and the 70s, whose stocks were considered solid and secure. This propelled a bullish speculative market in the early 70s.


The price of Australian mining shares soared in late 1969 and then sank in early 1970. It began with the discovery of a promising mining site for nickel by Poseidon NL Company. In this time there was a high demand for nickel and a shortage of supply thus raising the nickel price to very high levels. Poseidon shares peaked initially, but when they started producing the nickel, the nickel price had fallen. The fact that the nickel ore was of a lower quality than expected contributed to the effect. Poseidon shares plummeted and the company was bought out.


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Another type of bubble evolved from the collection of various items such as sport cards and comic books. Valued by collectors at prices sufficiently higher than their intrinsic value, they were sold and resold, reaching very high prices. These bubbles usually burst when the collection lost popularity.


The dot-com bubble is an example of a more contemporary one. From 1995 till 2001 stock markets in Western nations saw their value increase rapidly from growth in the new Internet sector. Japan also experienced such a phenomena, called in Japanese, ‘bavuru keiki’ – a bubble economy. From 1986 to 1990 real estate and stock prices inflated greatly.


In the Asian crisis from 1997 the Thai currency collapsed. The crisis spread to all Southeastern Asia. Foreign debt of the affected countries rose dramatically in comparison to their GDP. Their currencies were saved only by the intervention of the International Monetary Fund.


The most famous example of the consequences of a bubble is the Great Depression. It started in 1929 and lasted throughout the 30s. It was the greatest recession in the 20th century. The stock market crashed on October 29th, on Black Tuesday. International trade dropped by half. Personal income, tax revenues, prices and profits fell dramatically. Heavy industry became nearly totally bankrupted. Crop prices fell by 60 percent. Consumers cut back on their expenditures. In addition a severe drought ravaged the USA. The decline in the USA economy pulled down many countries at first, with internal conditions making things better or worse. The increase in tariffs exacerbated the collapse in global trade.


great-depressionHistorians emphasise structural factors such as massive bank failures due to extensive credit and the stock market crash as main reasons. Another reason may be the British return to the prewar gold standard parities. Though recession cycles are thought to be a normal part of the development of an economy, what turns a mild recession into a severe depression is unclear. The question is, is this is a failure of the free market economy, or a failure due to government intrusion into the economy?


Current theories are classified in three main points of view. The Austrian Economic School holds that central banking decisions lead to over-investment (economic bubble) and depression.


The Keynesian theories blames the recessions to under consumption/overproduction and malfeasance by bankers and incompetence by government officials.


The Marxist theory claims that capitalism tends to create unbalanced accumulations of wealth, leading to over-accumulation of capital and a repeating cycle of devaluation through economic crisis.


Simon Vhlahov writing for the Apollo Institute of Reason AIR Review©


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