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

2.  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

3.  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?

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

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

7.  Take several forms  To promote awareness  Threatening  Lottery/investment opportunity  You receive a letter or email 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

8.  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

9. 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

10.  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

11.  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

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

13. 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

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

15.  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

16.  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

17.  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

19.  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

20.  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

21.  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

23.  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

24.  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

25.  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

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

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

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

29.  Galbraith, John Kenneth. A Short History of Financial Euphoria. New York, NY: Whittle in Association with Viking, 1993. Print.  Kindleberger, Charles Poor, and Robert Z. Aliber. Manias, Panics, and Crashes: A History of Financial Crises. Hoboken, NJ: John Wiley & Sons, 2005. Print.  Thompson, Earl (2007), "The tulipmania: Fact or artifact?" (PDF), Public Choice 130 (1–2): 99–114, doi:10.1007/s11127-006-9074-4, retrieved 2008-08-15 Bibliogrpahy