Market bubbles have existed for as long as there have been markets. Examples of major bubbles can be seen throughout history. Holland in the 1630s experienced a bubble centred on the tulip market. Following their adoption by the European ruling classes as objects of desirability and good taste, tulips began to be seen as targets for speculation and profit. At the tulip market’s height, there were accounts of investors parting with significant portions of their personal fortunes for tulip bulbs and roots; with one tulip bulb being sold over 5000 gilders (nearly £40,000 today).
Various commentators have sought to place a definition over this market phenomenon. Charles Kindleberger, in his book Manias, Crashes and Panics defines a bubble as ‘an upward price movement over an extended range that then explodes’; Brunnermeister follows a similar tone in describing bubbles as being ‘typically associated with dramatic asset price increases, followed by a collapse.’ What both these definitions have in common is an affirmation of the characteristics of one of the most recognisable metaphoric terms in economics; namely the upward surge in asset prices causing a collapse at its zenith.
Economists have historically had difficulty in providing a satisfactory explanation for market bubbles. Standard neoclassical economics and the efficient market hypothesis both struggle to explain the existence of markets based on the assumption that efficient market participants are perfectly rational. However, it has been acknowledged that bubbles can exist in rational markets, as rationality does not rule out mistakes in market readings or the practice of momentum trading, where investors chase high returns as market bubbles grow. These human behaviours were famously termed ‘animal spirits’ by J. M. Keynes. Investors, faced with a multitude of different factors that influence price fluctuation can be rational, yet the fact of divergences of opinion in a vast network of traders and investors remains. An example of a rational bubble can be seen when examining the relationship between gold prices and the rate of inflation in the late 70s, where investors wrongly assumed that inflation was long-term. Other examples of rational bubbles can occur with the mispricing of fundamentals (such as equities) and adverse effects caused by exogenous variables in times of uncertainty.
Some take the position that bubbles are the result of irrational behaviour, driven by flawed or misinformed investors. Here, a market participant’s moves are unconnected to the fundamentals and may follow market trends, the mass following has been variously termed ‘herd behaviour’ or ‘mimetic contagion’. Rational investors may understand that a market, driven by irrational investing, will eventually collapse but choose to play the market whilst it is rising to generate potentially high returns. The Dutch case of ‘Tulipomania’ is a good example of a mainly irrational market, where the price of tulips vastly exceeded that of a neutral market due to the superficiality of trends and desirability that attribute value in a market place.
In this case, the difference between value and market price become clear cut. Whilst willingness to pay and willingness to sell would be rationally dictated by market price and the potential rate of returns to the rational investor; the irrational investor may pay half of his fortune for the root of a tulip with the intent of showing it off, rather than planting it and growing more or selling it on as the bubble grew.