[Re-Post] What About Bubbles?

In a previous post, I outlined what financial market efficiency means (and does not mean). The most common criticism that I received was something to the effect of “what about bubbles?” History is replete with examples of asset price bubbles and speculative manias, or so we are told. People are purportedly driven by emotion and irrationality to bid up price of an asset beyond what it is truly worth, only to see the price come crashing down. People lose wealth from these bubbles, as Hemingway might say, “gradually, then suddenly.”

We are told that these episodes alone are enough to demonstrate that financial markets are inefficient. To understand this madness, we must understand psychology. We must get inside people’s minds and figure out what drives them to participate in this sort of phenomenon. Only then can we understand the waves of emotions that drive asset prices as the moon influences the tide.

This is an incredible and provocative narrative. It draws people in. It provides the perfect backdrop to write beautiful prose about excitement and loss. Who would not want to read about things like “manias” and “irrational exuberance”?

It also doesn’t hurt that it feeds our egos. We, the newly enlightened, can avoid the pitfalls of the past by conquering our emotions. We can be taught rationality by those who have discovered irrationality. These scholars can be our guides by illuminating our innate cognitive biases. These hero scholars can be given prizes and start hedge funds that purportedly (but don’t actually) employ strategies that profit from these biases.

Yet, despite all the good things that this narrative provides, it misses something that is critically important: a knowledge of history broader than the seemingly inexplicable path of the asset price. In short, the archetypal historical bubbles that are frequently referenced are actually stories of political economy. That isn’t as exciting as raw emotion, but it is nevertheless important to set the record straight. In this post, I will do something different when it comes to Economic Forces. I will attempt to provide some historical context by discussing three famous bubbles: The South Sea Bubble, the Mississippi Bubble, and Tulipmania. In other words, this week I am going to focus on evidence rather than theory. We can then ask ourselves if these bubbles have anything to do with irrationality or market inefficiency.

The South Sea Bubble and the Mississippi