On a recent edition of FS Insider, Cris Sheridan spoke the authors of Boom and Bust: A Global History of Financial Bubbles, out August 2020. Authors William Quinn and John Turner discussed what a bubble actually is, some of history's largest bubbles and the role government policy and debt can play in fostering them. See below for excerpts from their interview.
For audio, see The Bubble Triangle.
What are some of the problems when it comes to defining what exactly a bubble is?
William Quinn: Bubble is a word that gets thrown around very loosely in the financial media and into the general conversation. Investors talk about it a lot, but there's no real solid definition of what it means. It used to mean an unjustified rise in price followed by a crash.
But I theorize, does that have to be? It's not really defined. And is it justified? That's always disputed at the time. Obviously, there are people who believe that the price rise is justified at the time. In theory, you may be able to determine that with hindsight. But what we see when we go through the academic literature is that even with hindsight, that becomes heavily disputed, no one can agree on whether it was actually a bubble or not, which is very tricky.
What you don't want, is to get bogged down in these long conversations about whether a particular housing bubble was actually a bubble or not? That's before we even start to talk about the interesting stuff. Like what caused the bubble? What were the consequences? What could the government have done about it? All of the interesting stuff is shadowed by this focus on having to define a bubble very closely.
So what we do in the book is just say, look, if there was a very large rise in price and a subsequent crash, we'll call it a bubble. In terms of choosing what bubbles we want to cover, we just decided to go with a very large rise in prices and a very large crash afterwards.
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John Turner: One of the things that is very obvious to us, but maybe not obvious to a lot of people who participate in financial markets, is that there's a group of academic economists who believe there's no such thing as bubbles, that it's a vacuous word. It's a meaningless word.
So, Nobel Prize winners, like Eugene Fama, for example, have said that drives him nuts. The word bubble drives him nuts. However, in the everyday use of the word, financial market participants and ambassadors understand better than academic economists, what a bubble actually is.
I'm interested in where this word, bubble, originates from. One of the first uses of bubble in English language is actually in Shakespeare. And he uses the word bubble to mean something that's fraudulent, empty, worthless. Then when you get to 1720 you've got people like Jonathan Swift and really famous authors using the word bubble to describe the new companies being set up in 1720. They're suggesting that these are a worthless and deceptive.
The word bubble has a very pejorative meaning. When we use the word bubble today, we don't mean that something's necessarily worthless.
Can you explain the role government policy and government debt play in fostering bubbles?
WQ: The 1720 Mississippi bubble was caused by John Law, this very colorful character. He was exiled from Scotland after killing someone in a jail and he was supposed to be hung but he escaped from jail and moved to Europe. He went on to become one of the greatest financial theorists of all time.
But what he's most remembered for, is essentially taking over the entire French economy through a series of very intelligent schemes designed to set up an early central bank, which hadn’t existed in France before. And then he used this ability to create money in order to engineer economic growth and engineer a bubble with the ultimate goal of lowering interest rates and therefore lowering the interest that the government needed to pay on its debt.
The way that he did that was to set up the Mississippi Company and purchase government debt on the condition that he will pay the government a lower rate of interest on that debt than had been paid before. Obviously getting people to swap the government debt for a share in this company with very few assets, apart from the promise of a lower rate of interest on the debt itself, is going to be very difficult. So, the way that he did that was by setting up a market that led investors to believe that the shares of his company would experience capital gains.
In the book, we say he invented the bubble because we think this was the first recorded financial bubble in history. And he very deliberately created it as part of this elaborate scheme to reduce the government debt.
To talk more generally about the role of politics and bubbles, it's a little bit different in each case. So, we just say politics. It's not the case that every political bubble is caused by an attempt to reduce the government’s debt. That was really only the case for the for the bubbles of 1720. The bubbles since have been engineered for various reasons, and I think the most common one is to redistribute wealth toward a coalition of voters or a coalition of power brokers that the government needs to keep poor.
Housing bubbles very often come from an attempt to redistribute wealth from people who don't own houses, to people who do houses, which is one of the main effects of a rise in house prices. People who do own houses are very likely to vote. So, they're the people that you really want to keep on board if you want to retain power. And this type of manipulation of asset prices in order to enrich politically important groups is a recurring factor in a lot of the political bubbles.
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