Sat, Jul 28, 2012 - Page 9 News List

Bubbles without markets

While serious bubbles occur in a free-market system, the system contains checks and balances that mitigate the occurrence of the far more severe bubbles that have plagued non-market societies

By Robert Shiller

Illustration: Tania Chou

A speculative bubble is a social epidemic whose contagion is mediated by price movements. News of price increases enriches the early investors, creating word-of-mouth stories about their successes, which stir envy and interest. The excitement then lures an increasing number of people into the market, which causes prices to increase further, attracting yet more people and fueling “new era” stories, and so on, in successive feedback loops as the bubble grows. After the bubble bursts, the same contagion fuels a precipitous collapse, as falling prices cause more and more people to exit the market, and to magnify negative stories about the economy.

However, before we conclude that we should now, after the crisis, pursue policies to rein in the markets, we need to consider the alternative. Speculative bubbles are just one example of social epidemics, which can be even worse in the absence of financial markets. In a speculative bubble, the contagion is amplified by people’s reaction to price movements, but social epidemics do not need markets or prices to get public attention and spread quickly.

Some examples of social epidemics unsupported by any speculative markets can be found in Charles MacKay’s 1841 best seller Memoirs of Extraordinary Popular Delusions and the Madness of Crowds. The book made some historical bubbles famous: the Mississippi bubble 1719-1720, the South Sea Company Bubble 1711-1720 and the tulip mania of the 1630s. However, the book contained other, non-market, examples as well.

MacKay gave examples, over the centuries, of social epidemics involving belief in alchemists, prophets of Judgement Day, fortune tellers, astrologers, physicians employing magnets, witch hunters and crusaders. Some of these epidemics had profound economic consequences. The Crusades from the 11th to the 13th century, for example, brought forth what MacKay described as “epidemic frenzy” among would-be crusaders in Europe, accompanied by delusions that God would send armies of saints to fight alongside them. Between 1 million and 3 million people died in the Crusades.

There was no way, of course, for anyone either to invest in or to bet against the success of any of the activities promoted by the social epidemics — no professional opinion or outlet for analysts’ reports on these activities. So there was nothing to stop these social epidemics from attaining ridiculous proportions.

MacKay’s examples may seem a bit remote to us now. Some examples that we might relate to better can be found in the communist centrally planned economies of much of the 20th century, which also had no speculative markets. To be sure, events in these economies might seem attributable simply to their leaders’ commands. However, social contagions took hold in these countries even more powerfully than they have in our “bubble” economies.

China’s Great Leap Forward in 1958-1961 was a marketless investment bubble. The plan involved both agricultural collectivization and aggressive promotion of industry. There were no market prices, no published profit-and-loss statements, and no independent analyses. At first, there was a lot of uninformed enthusiasm for the new plan. Steel production was promoted by primitive backyard furnaces that industry analysts would consider laughable, but people who understood that had no influence in China then. Of course, there was no way to short the Great Leap Forward. The result was that agricultural labor and resources were rapidly diverted to industry, resulting in a famine that killed tens of millions.

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