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Just What is a Speculative Bubble?

Good piece here by Robert Shiller discussing the persistence of bubbles in today’s economic environment.  Within the piece he asks an important question – just what is a speculative bubble:

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 c. 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.

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.”

Hard to improve on the definition by the man who has to be one of the greatest bubble callers of our time.  But I don’t know if that’s complete.  I’d define a speculative bubble as follows:

“A speculative bubble occurs when market forces combine to generate a highly unstable and unsustainable position.”

A bubble has an element of disequilibrium that makes it an unsustainable trend.  This is generally driven by irrational perspectives, but I think it’s crucial that bubbles be identified as an unsustainable state of disequilibrium.  Why?  Well, if it’s not highly unstable then it doesn’t burst.  And if it doesn’t burst then how can it be a bubble?  After all, one of the key characteristics of bubbles is that they burst.   Understanding this concept of sustainability played a big role in me calling the silver bubble and saying that government bonds were not a bubble.  These trends were largely about understanding the sustainability of underlying fundamental trends.

Anyhow, that’s my view.  There can be many causes of bubbles (usually psychological as Dr. Shiller notes, but I do think he’s failing to focus on the key ingredient of any bubble – its inherent instability.

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