History of Economic Bubbles
From Londonhua WIKI
History of Economic Bubbles
- 1 History of Economic Bubbles
- 2 Abstract
- 3 Introduction
- 4 Background
- 5 Deliverable
- 6 References
Through out financial history there have been many periods were the economy has gone out of control and crashed. As a kid I was always confused about what my parents were talking about when I heard them mention sub-prime loans or the housing bubble and never understood the 2008 financial crisis in depth. My knowledge of it got clearer in high school where I took economics and had covered the 2008 financial crisis to know that it was partially caused by a bubble. In order to try to complete my understanding I decided to research past bubbles such as Britains South Sea Bubble and compare them to modern bubbles such as the Housing Bubble. My biggest take away from this milestone was the lack of concern for the future that occurred by bankers and the government leading up to the 2008 financial crisis.
This milestone goes through the history of major economic bubbles that have occurred and their impact on the world. Though out my research I learned that the economy has suffered through countless bubbles and decided to narrow the scope and focus on The Tulip Craze Bubble, The South Sea Bubble, The Dot-Com, and the Housing Bubble. I decided to write an essay that tries to explain each bubble in a way that is understandable to the average person and end the essay with some of the similarities between them. Because of the confusing nature of the topic I felt that having an essay was the best way to present the information as the reader can easily reread sections to obtain a better understanding.
What is a bubble?
A bubble is the sharp rise and fall of asset prices over a period of time. The rise of the bubble is often caused by speculation of future prices causing the asset to be overvalued. When the asset is overvalued it is being traded or sold at a price above its actual value or intrinsic value. After the people come to the conclusion that the asset is overvalued the price crashes and returns back to its intrinsic value bursting the bubble.
Examples of Bubbles
The first recorded bubble in history was the tulip mania bubble that took place in holland in the mid 1600s. Tulips were a new addition to the garden in Holland and became very popular. Then a virus started to infect the tulips leaving them with fire like patterns. These new tulips became in demand by almost all of holland, driving the price up. Eventually the continual rise in price caused the tulips to be viewed as a good investment because the price should continue to go up. The price escalated to the point of people exchanging land, jewels, and cows for the tulips. By the time the tulips had reached their peak the price had increased 20 fold. With the price so high people some people decided that it would be advantageous to sell the tulips and collect their profits. This lowered the price of the tulips for the first time. Because the tulips had no reason for escalating in price other than speculation the prices crashed with no reason to speculate on the tulips.
South Sea Bubble
The South Sea bubble is a bubble of new company stock caused by the desire for investment opportunities in 18th century England. The East India Company was hugely successful and paid out huge sums of money to its investors. However, only very few people were able to invest in the East India Company leaving many wealthy people without investment opportunity. In France the Mississippi Company had just started up and was bringing lots of money for the French investors. The wealthy Englishmen wanted an investment outlet and the South Sea Company offered that. The South Sea Company was set up to trade with South America and hopefully be as successful as the East India Company. However, South America was under the control of Spain and Portugal leaving little hope for the success rivaling the East India Company as the East India Company had full control over India. The South Sea Company attempted many trade ventures such as slave trading and and wool trading. However, the mortality was too high on the slave boats and they could not sell the wool stuck rotting on docks for many of them to be profitable.
The invention of the internet was one of the single greatest achievements of recent years and changed the way people interacted and obtained information. Many companies were created to use the new technology. These companies were heavily invested in because of how exciting and promising the internet seemed to be. With all these investments the stocks rose quickly over time attracting more and more investors. All that was needed was just and idea to obtain insane amounts of investment capital from investors wanting to get in on the internet boom. With the rising amount of people investing in internet companies, more and more people pitched their ideas in an attempt to grab money.
Companies often changed their name to have “com” in it hoping to cash in on the internet craze. New start-ups were created and raised money from investors with silly or non-existent business plans that were eerily similar to the start-ups during the South Sea Bubble. All that mattered was having a cool sounding name and a registered internet domain name. The rest would be figured out later. And, the money came pouring in.
Growth Stock New Issue Craze
Investors had a huge appetite for space-age stocks in the Soaring Sixties. More new issues were created in the 1959-62 period than in previous period in the history of the stock market. It was labeled the “tronics” boom. Many of the stock offerings had names with some garbled version of the word “electronics” in their name, even if the company had nothing to do with electronics. Investors quickly bought up shares in just about any company with “tronics” in its name.
What investors wanted was growth in earnings per share. By the mid 1960’s businesses found a way to create this with conglomerates touting “synergies”. Synergism is the quality that 2+2 = 5. Thus because of supposed synergies two companies combined would create more earnings per share than the two of the separately. Essentially a firm with higher price/earnings multiples would buy another company which trades at lower price/earnings multiples. The combined company would have higher earnings per share, thus having an increased earnings per share growth. But, all that was happening was the conglomerate (the combined companies) revaluing the earnings of the lower multiple company at the other firms’s higher multiple. It all worked until the conglomerates could not keep buying up cheaper companies and pulling in their earnings into their own at high multiples. When that happened the conglomerate boom collapsed.
Concept Stock Bubble
This fad was in stocks with a good story to tell, or a “concept”. This became known as the “go-go era”. Often these concept stocks had something to do with marketing to youth. It was the youth culture of the 1960’s and one of the concepts was that only youth could market to and sell to youth. Only they understood other youths. One such stock was NSM, National Student Marketing”. Each of its divisions had something to do with the college-age youth market from posters to records sweatshirts.
The Nifty Fifty
After the last couple of bubbles, investors decided they needed safe growth stocks. About 50 stocks were considered safe premier growth stocks. These included familiar names such as IBM, Xerox, Avon, Kodak, McDonalds, Polaroid, and Disney. As more and more investors purchased these supposedly safe growth stocks they pushed their prices to higher and higher levels till many of them were trading at as much as 80 times earnings, compared to a typical stocks 15 times earnings. Ultimately this bubble ended and the Nifty Fifty stocks cam crashing back to earth.
Just like in the early 1960’s, the 1980’s were a new issue market. This time around the craze centered around Biotechnology and Microelectronics stocks. Most Biotech companies were not profitable, and the potential for profits was very far in the future. But, still investors flocked to them, bid their prices up to very high levels. The results were predictable. A lot of stocks with names and business plans in the Biotech or Microelectronics areas were sold, went up, and then ultimately crashed to earth. In the late 1980’s most biotech stocks lost 75% of their value, or more.
Comparing the South Sea Bubble to More Modern Bubbles
A bubble is an economic term describing a cycle of rapid expansion of asset prices followed by a rapid contraction. Often the increase in price is a result of trend-following investors who believe the price will continue to rise in the future. In the theoretical literature of bubbles a bubble occurs when the expected rate of change in the price of an asset is an important factor in determining the current market price of the asset. In other words, the rapid run up in prices is more important to investors and speculators than the asset’s true intrinsic value. During bubbles speculators often purchase the assets using borrowed money or debt. Bubbles are also often accompanied by a belief that “this time is different”. In a bubble investors hope to sell the asset later on at a higher price to future investors. This is known as the greater fool theory because each investor or fool has bought an overvalued financial asset in the hope that a future investor or greater fool will buy it from him. The bursting of bubbles occurs when there are no more fools willing to invest in the overpriced asset and a mass selloff of the asset causes the price to plummet. Although this seems like a simple trap to avoid, because of the difficulty in accurately determining an asset’s intrinsic or true value it is hard to detect bubbles until they have already occurred. Bubbles can occur in a variety of assets and have occurred many times throughout history. Some of the asset bubbles covered here include tulips, stocks, and housing prices.
Tulip Bulb Mania
One of the earliest documented examples of a bubble was the Tulip Mania Bubble in Holland during the mid 1600’s. Tulips were a new flower introduced in the 1600’s and over time the tulip became very popular and expensive. A non-fatal virus known as “mosaic” occurred which resulted in contrasting colored stripes or “flame” like patterns on the tulip petals. These new tulips, which were called “bizarres” were highly sought after and much more expensive than plain tulips. The more bizarre a tulip, the greater its price. Merchants began trying to predict which variegated tulip style would be the most popular for the coming year and buy those in bulk to hold, anticipating an increase in price. This was not much different than merchants stockpiling any other item such as cloth, anticipating that if that color or weave of cloth was in fashion the next year it would command higher prices. Shown below are a plain tulip and a variegated or “bizarre” tulip.
As bizarre variegated tulip prices began to rise wildly, people started to view tulips as a sound investment instead of just a decoration. As the price of tulips continued to climb more and more people bought and traded tulips in the hopes of selling them at a higher prices. People who believed that Tulip prices could not go any higher watched as their relatives and friends made enormous profits. The temptation to join in the tulip speculation and trading was was huge and it took a very disciplined person to resist the siren call to get rich quickly in tulips.
Near the end of the tulip mania in 1634 to early 1637 people were exchanging land jewels and furniture to obtain the bulbs. Thus, this irrational stage at its peak lasted several years. Eventually all bubbles peak. The Tulip bubble appears to have peaked when bulb prices reached astronomical levels. Near the very end of the bubble in January 1637 tulip bulb prices increased twenty-fold in that one month. Eventually prices got so high that some people decided they would sell out of tulips. Then, others followed their lead. Like a snowball rolling down a hill the sell-off gathered momentum as more and more people sold their tulips. This resulted in rapidly decreasing tulip prices. Government ministers stated that there was no reason for tulip prices to fall. Tulip bulb dealers went out of business. Tulip bulb prices declined and declined until finally the prices stabilized at about the price of a common onion! Although this example of a bubble about 400 years ago dealing with tulip bulbs may seem almost farcical, the pattern of the tulip bubble has been repeated many times in many different situations in the ensuing centuries.
The South Sea Bubble
The early 1700’s followed a long period of prosperity. Thus people in Britain had substantial savings and few investment alternatives. In addition there was a corporation, the East India Company, which had the exclusive rights to trade in the Indian subcontinent and China. By the 1700’s the East India Company accounted for roughly half the world’s trade, particularly in silk, cotton, indigo dye, salt, and tea. Given the huge success of the East India Company, and the wealth accumulated by its less than 500 shareholders, there was considerable appetite for a similar company that people might invest in, and hopefully become rich from. In 1711 the South Sea Company was created and granted by the British government the exclusive right to trade with South America. However, Spain and Portugal controlled virtually all the colonies in South America. Thus, the value of the ability to trade with the South American colonies by a British company was somewhat dubious. Nevertheless, the South Sea Company issued stock shares which were eagerly snapped up and purchased by a citizenry eager to reap the rewards of a government granted monopoly which they hoped would be similar to that enjoyed by the East India Company.
None of the directors of the South Sea Company had any experience in trade with South America. They outfitted ships for the slave trade to South America, which turned out to not be profitable due to the mortality rate of the slaves on their ships. Wool that was to be sold in Vera Cruz was instead sent to Cartagena, where it rotted due to lack of buyers. What the directors lacked in business experience they made up with the image they created with the public. They rented a luxurious house in London to entertain in and court prospective investors. Demand for South Sea stock was such that the Directors issued more stock, which was purchased by an eager public. This issuance of stock was repeated several more times, with it being quickly bought up by a public eager to to buy more, and each time driving up the price of the stock. Seeing investors reactions to the South Sea Company stock many people started their own companies to attract investors. With the willingness to invest so high, the company business plan didn't even need to feasible. One company’s business plan was to extract light from cucumbers. Another company intended to build a perpetual motion machine. One company was set up with the promise of bringing investors money, however the investors could not know the business plan as it was completely secret. All of these companies succeeded in attracting investors and driving up their stock prices. However, each one of their stocks crashed after a couple weeks like most of the new companies at the time leaving the investors poorer and the entrepreneurs richer.
None of the failures in the start-up companies with silly business plans caused a change in the desire of the British people to invest in more companies that were being created because of the continued success of the South Sea Company. However, the directors of the South Sea Company recognized that their stock price was inflated and likely to crash just like the smaller companies and the directors sold off their stocks. At this point the stock had risen over seven-fold from around 125 to 950 pounds, as shown in the figure below. Now the South Sea Company lost its only asset, that of appearing to be profitable . The South Sea Company stock price plummeted leaving the investors at a huge loss while enriching the directors. After seeing the failure of the South Sea Company, investors no longer had an appetite for the new start-ups with silly or fraudulent business plans. No longer could promoters create a startup with no real business plan and wait for investors to flock to buy the stock. An era had ended. With so many investors hurt including the famous Isaac Newton, Parliament passed the bubble act ending the ability for companies to issue stock.
The invention of the internet was one of the single greatest achievements of recent years and changed the way people interacted and obtained information. Many companies were created to use the new technology. These companies were heavily invested in because of how exciting and promising the internet seemed to be. With all these investments the stocks rose quickly over time attracting more and more investors. One of the first huge internet companies was TheGlobe.com a messaging service hoping to earn money from website advertising. TheGlobe.com started off at $9 a share and exploded to $97 a share by the end of the first day of trading even without existing revenue. The success of TheGlobe.com became extremely dangerous as it showed that new internet companies did not need to be profitable. All that was needed was just and idea to obtain insane amounts of investment capital from investors wanting to get in on the internet boom. With the rising amount of people investing in internet companies, more and more people pitched their ideas in an attempt to grab money.
Companies often changed their name to have “com” in it hoping to cash in on the internet craze. New start-ups were created and raised money from investors with silly or non-existent business plans that were eerily similar to the start-ups during the South Sea Bubble. For example, instead of a company to extract light from cucumbers, in the dot-com era we had companies such as “bunions.com”, “Zap.com”, “Fogdog”, and more. There was a rush to register what people believed would be the premier names in some business segment such as “DrugStore.com”. All that mattered was having a cool sounding name and a registered internet domain name. The rest would be figured out later. And, the money came pouring in.
There was a belief that “this time is different”. There was a belief that these “new economy” technology and dot-com stocks were different and that old valuations principles did not apply. That coupled with rapidly rising prices, and so many people getting rich, led others to get in because they thought they were getting left behind. New startups prided themselves on their “burn rate” -- the rate that they burned through funding investors had provided. They burned through the money designing cool glamorous offices with no thought to the actual business. This was similar to the fancy house in London the directors of the South Sea Company rented to entertain and impress potential investors. Worrying about a viable product or service, or profitability, were considered passe’ and old fashioned. New cable news networks were started such as CNBC to constantly hype these new internet and technology companies and tell investors that the old principals did not apply any more.
More and more ordinary people were investing in stocks, often with on-line trading accounts, which were a new creation, and also part of the dot-com bubble. Everyone was making money hand over fist, or at least expected to soon be making money hand over fist. Cocktail parties, cookouts, kids sports games, all were places where people would gather and talk about their investments. A survey of individual investors near the peak of the dot-com bubble revealed that most of them expected to earn returns on their investments of 35% to 50% per year in the long run. This despite the fact that the long-run return on stocks had long ago been documented to average about 10% in the long run. Eventually all bubbles burst. And, so it was with the dot-com bubble. The internet was one of the greatest achievements of recent years. However, the dot-com/technology bubble also represented the largest creation, and subsequent destruction of stock market wealth of all time. When the dot-com bubble imploded in the early 2000’s over $8 trillion of stock market value evaporated. Eventually investors began to look at a company’s intrinsic value again, and found that it didn’t exist for many many internet stocks. Stocks such as JDS Uniphase, which had risen over 3,000% lost almost all of their value and were selling at pennies per share. Worldcom, PalmPilot, Nortel, and many many other once high flying household internet stock names crashed and lost almost all of their value. The names were different, the fad this time was different (the internet) but the bubble followed the classic playbook all the way through including the inevitable crash.
In the early 2000’s housing prices seemed to only rise driven by demand for housing spiraling out of control. The demand was driven mainly by the changing of lending practices. Banks had stopped holding on to mortgages and collecting money from people instead sold the mortgage to investment companies who packaged the mortgages into mortgage backed securities to sell as investment opportunities that payed off if the majority of the loans were paid off. Mortgage backed securities became a very popular investment opportunity. However, with a finite amount of mortgages bankers needed to change lending practices in order to obtain more mortgages to keep up with the demand from the investment bankers. The banks lowered the standards of people who were eligible for mortgages to the point where NINJA (no income no job no assets) loans became widely used because after they sold the loan there was no risk for the banks. This accomplished the goal of creating more mortgages to sell. However it also allowed people who did not have the financial assets to buy an expensive house they could not afford and in some cases buy multiple extravagant houses. The mortgage backed securities that the risky loans were put into were rated AAA, the highest rating, by the rating agencies making the mortgage backed securities everyone was investing very dangerous. While the mortgage backed securities were becoming riskier and riskier the housing market kept rising. Eventually like all the bubbles it popped. The demand for housing ended around 2008 when the default rates on mortgages skyrocketed ending the demand for housing and plummeting the value of houses back down to before the 2000’s. This wiped out many American families as their house, their most valuable asset, plummeted in value and many found themselves paying off mortgages worth more than their houses current value. However, the aftermath would not stop there. The mortgage backed securities that were so popular were now failing and brought down many global financial institutions that had invested in them spreading the crisis around the world.
Unfortunately the saying history repeats itself is true with regards to investing in financial bubbles. Time and time again people get caught up in the new way to make money and often times end up worse than before. However, all of the bubbles do have common similarities. The first one is all bubbles occur after a time period that allows for high amounts of investing. This often means that there is a lot of wealth such as in the time before the South Sea Bubble or in the highly successful 90’s before the Dot-Com Bubble but it can also occur in other ways such as the loose lending before the Housing Bubble. The other main reason for bubbles is the attitude that this time it will be different. As shown by the Tulip bubble, economists have known about bubbles for hundreds of years and yet people always follow the current get rich quick plan. In the 1600’s it was tulips and in the 2000’s it was Dot-Com stocks. When the success of some lucky investors spreads it can attract more investors further raising the price and causing the cycle to repeat. Even some who see through the now overpriced assets still invest in the hopes that they can be smart and sell out before it is too late. Although it is impossible to completely prevent bubbles, there is still hope that people can learn from societies mistakes and decrease the frequency bubbles occur and how devastating they are to the economy.
Malkiel, B. G. (2016). A random walk down Wall Street: the time-tested strategy for successful investing. New York: W.W. Norton & Company.
Larry Neal and Eric Schubert, “The First Rational Bubbles” A New Look at the Mississippi and South Sea Schemes, Faculty Working Paper No. 1188, University of Illinois. Sep 1985
Rik Frehen, William Goetzmann, Geert Rouwenhorst, “New Evidence on the First Financial Bubble.Yale working paper No 09-04, July 2012