Sun, Jul 21, 2013 - Page 9 News List

Bubbles reappear forever

People are wary of bubbles in finance and industry that see money and jobs lost, but perhaps the word bubble does not accurately describe the situations it is applied to

By Robert Shiller

Illustration: Tania Chou

You might think that we have been living in a post-bubble world since the collapse in 2006 of the biggest-ever worldwide real-estate bubble and the end of a major worldwide stock-market bubble the following year. However, talk of bubbles keeps reappearing — new or continuing housing bubbles in many countries, a new global stock-market bubble, a long-term bond-market bubble in the US and other countries, an oil-price bubble, a gold bubble and so on.

Nevertheless, I was not expecting a bubble story when I visited Colombia last month. However, once again, people there told me about an ongoing real-estate bubble and my driver showed me around the seaside resort town of Cartagena pointing out, with a tone of amazement, several homes that had recently sold for millions of dollars.

The Banco de la Republica, Colombia’s central bank, maintains a home price index for three main cities — Bogota, Medellin and Cali. The index has risen 69 percent in real (inflation-adjusted) terms since 2004, with most of the increase coming after 2007. That rate of price growth recalls the US experience, with the S&P/Case-Shiller Ten-City Home Price Index for the US rising 131 percent in real terms from its bottom in 1997 to its peak in 2006.

This raises the question: Just what is a speculative bubble? The Oxford English Dictionary defines a bubble as “anything fragile, unsubstantial, empty or worthless; a deceptive show. From 17th century onwards often applied to delusive commercial or financial schemes.”

The problem is that words like “show” and “scheme” suggest a deliberate creation, rather than a widespread social phenomenon that is not directed by any impresario.

Maybe the word bubble is used too carelessly.

Eugene Fama certainly thinks so. Fama, the most important proponent of the “efficient markets hypothesis,” denies that bubbles exist.

As he put it in a 2010 interview with John Cassidy for the New Yorker: “I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.”

In the second edition of my book Irrational Exuberance, I tried to give a better definition of a bubble.

A “speculative bubble,” I wrote then, is “a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increase.”

This attracts “a larger and larger class of investors, who, despite doubts about the real value of the investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.”

That seems to be the core of the meaning of the word as it is most consistently used. Implicit in this definition is a suggestion about why it is so difficult for “smart money” to profit by betting against bubbles: The psychological contagion promotes a mindset that justifies the price increases, so that participation in the bubble might be called almost rational. However, it is not rational.

The story in every country is different, reflecting its own news, which does not always jibe with news in other countries.

For example, the current story in Colombia appears to be that the country’s government, now under the well-regarded management of Colombian President Juan Manuel Santos, has brought down inflation and interest rates to developed-country levels, while all but eliminating the threat posed by the Revolutionary Armed Forces of Colombia rebels, thereby injecting new vitality into the Colombian economy. That is a good enough story to drive a housing bubble.

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