Bubbles: The Classic Cases Econ 4905 Financial Fragility and the Macroeconomy Michael DellaMedaglia

 Discuss the various names given to bubbles and note some of their distinct features  Present three of the earliest economic bubbles  Similarities and distinguishing factors  Reflect about their timeless features and potentially devastating results Outline

 As defined by Kindleberger, “Non-sustainable patterns of financial behavior, in that asset prices today are not consistent with asset prices at distant future dates.” What are Bubbles?

 Pyramid schemes  Chain letters  Ponzi schemes  (Tend not to disrupt macro-economy)  Manias  (Certainly can disrupt macro-economy) Types of Bubbles

 Unstainable “business” venture  Propagated on the promise of reward for recruiting new members  Nowadays masquerading as “Multi-level Marketing” Pyramid Schemes

 Take several forms  To promote awareness  Threatening  Lottery/investment opportunity  You receive a letter or asking you to  Send money to a particular person  Send the letter to 5 people you know in the next 5 days  The promise is that within 30 days you will receive $64 for every $1 “investment” Chain Letters

 Fraudulent investment operation  Usually claims to offer extraordinary rate of return on investment  Able to deliver that for a period of time by using the proceeds from new investors rather than earned profits from operations  Continue to recruit new investors to support scheme  Fabricating returns Ponzi Schemes Charles Ponzi Bernie Madoff

Ponzi vs Pyramid Schemes  Pyramid schemes  Limited liability  Leader is not directly in contact with successive recruits  Has option to leave discretely and still receive benefit  Grow exponentially  Dissolve more quickly  Ponzi schemes  Leader is a “hub” in contact with all new recruits and builds relationships with them  Dissolve less quickly  Difficult for leader to exit the scheme without it being shocking  Susceptible to a bank run phenomenon because of “investment” illusion  May start out as a legitimate business that falls into distress

 Frenzied pattern of buying  Leads to rising prices and trading volume  People want to buy before the price increases again, and rush to do so  Mania often turns to panic Manias

 Sometimes the reason for this is that the purchaser believes they can sell their asset to someone else at higher price  Or more generally, asset prices are based on other’s perceptions rather than intrinsic value Greater Fool Theory

 Individual rationality and participation vs overarching unsustainable structure Is all of this rational?

Macroeconomic Effects  Pyramid schemes, Chain letters and Ponzi schemes are usually contained  When they fall apart those who have participated in the scheme suffer losses  Losses typically do not spread beyond than those directly involved  Manias and asset price bubbles often have wide ranging effects  When the asset price bubble pops it can bring many other asset prices down with it  Often end in Panic

 Dutch Tulip Mania 1636  The South Sea Bubble 1720  The Mississippi Bubble 1720 Selected Classic Cases 1600s1700s1800s1900s2000s

 Often cited as the first major financial bubble  Widespread speculation on tulip bulb prices  People sold their property to invest in tulip bulbs  Bulb prices were expected to keep rising forever…  Bulbs changed hands very frequently  10 times day  Dealing with a futures market  The bulbs being traded were never seen or delivered Dutch Tulip Mania 1636

 Transition from mania to panic  All of a sudden in February of 1637  People began to become skeptical and started to sell  Prices fell precipitously  People went bankrupt  “Futures” contracts could not be delivered  An economic depression followed Dutch Tulip Mania 1636

 Recent skepticism into whether or not this was actually a bubble  Garber points out that the mania may have been limited to a very small group of individuals  Exotic bulbs started the price increases  These bulbs had a virus  Virus made the bulbs beautiful and hard to cultivate  Maybe the exotic bulbs really deserved this high price  But not all bulbs… Dutch Tulip Mania 1636

 The South Sea Company was founded in Britain in 1711 aimed at consolidating government debt  The company was paid a 6% interest rate and was allowed to issue stock  It was also given a monopoly by the British government to trade in the Americas  This arrangement ignored the fact that Spain was in complete control of the trade region in question The South Sea Bubble 1720

 There was hope that negotiations could allow greater opportunity for Britain and the South Sea Company to trade in the Americas  But Spain only allowed the company one voyage per year  Stock continued to be issued based on false hopes for the company  Legislation was influenced by gifting stock to government officials  Insiders of the company also rewarded themselves with additional shares The South Sea Bubble 1720

 Spawned other similar enterprises in Britain  Britain passed the Bubble Act to ban joint stock companies created without a charter  And to prop up the South Sea Company  By July 1720 the end of the company was in sight  Insider profit taking  Company asked for support from the newly founded bank of England  Prices fell rapidly through the Fall and Winter The South Sea Bubble 1720

 1716 John Law establishes Banque Royale  With initial capital the bank assumed government debt and issued notes  The notes were well received and more were issued  To generate revenue for the bank Law organized the Mississippi Company  Granted monopoly by French government for trade in the Americas The Mississippi Bubble 1720

 Terrific marketing job by Law exaggerates wealth to be had  Shares were offered to the public without evidence of the riches promised by Law and the new business venture  Speculation ensued  Proceeds from the shares were not reinvested in the business toward the discovery of gold  Instead they went to pay government debts The Mississippi Bubble 1720

 Demand for shares grew and prices soared  Shares paid out profits with notes  People began to try and redeem their notes for gold from the bank  Of course the bank could not pay  Values collapsed  Law survived in exile The Mississippi Bubble 1720

Reflection Tulip Mania Exuberance Anger Diffuse responsibility South Sea Bubble Exuberance Anger Swindling Concentrated responsibility? Mississippi Bubble Exuberance Anger Swindling Concentrated responsibility?

 Those who set up the companies in question?  Those who bought into the hype? Whose Fault is it?

 How to deal with bubbles?  They are hard to recognize before hand  Should the Fed pop the bubble?  Is that ethical? Extensions

 Galbraith, John Kenneth. A Short History of Financial Euphoria. New York, NY: Whittle in Association with Viking, Print.  Kindleberger, Charles Poor, and Robert Z. Aliber. Manias, Panics, and Crashes: A History of Financial Crises. Hoboken, NJ: John Wiley & Sons, Print.  Thompson, Earl (2007), "The tulipmania: Fact or artifact?" (PDF), Public Choice 130 (1–2): 99–114, doi: /s , retrieved Bibliogrpahy