Boom and bust: a global history of financial bubbles

Book Preface

What is the difference between the great composer George Frideric Handel and Shane Filan, the lead singer of Irish boyband Westlife? To those of a musical bent, the answer is obvious: Handel is one of the most respected classical musicians of all time, having composed several famous operas. Filan, on the other hand, largely spe-cialised in saccharine cover versions of 1970’s pop songs. The difference that interests us, however, is that while one lost all of their wealth in a bubble, the other got out before a bubble burst, making a handsome profit as a result.

By the time he was 30 years old, Handel’s musical compositions had already made him a very wealthy man, and his patron, Queen Anne, provided him with a considerable annual income. In 1715 he invested some of his wealth in five shares of the South Sea Company, which would have cost about £440. Handel sold his shares before the end of June 1719 for a profit of about £145 – just before the huge bubble in the company’sshares.3 By the time Shane Filan was 30, Westlife was one of the most successful pop groups of all time and the net worth of the group’s four members was over £32 million. Along with his brother, Filan decided to become a property developer in the midst of the Irish housing bubble. In order to purchase as much housing as possible, he supplemented his own funds by borrowing large sums of money from banks. In 2012 he was declared bankrupt, owing his creditors £18 million.

Shane Filan was not the only loser when the housing bubble col-lapsed. In Northern Ireland, where we both live, house prices more than trebled between 2002 and 2007; by 2012, they had collapsed to less than half their peak.4 We thus observed at close quarters the economic destruction that a bubble can wreak. Bubbles can encourage overinvestment, overemployment and overbuilding, which ends up being inefficient for both businesses and society.5 In other words, bubbles waste resources, as clearly illustrated by the half-built houses and ghost housing estates that stood across Ireland when the housing bubble burst. Other inefficiencies are in the realm of labour markets, as people train or retrain for a bubble industry. When the bubble bursts, they become unemployed and part of their investment in education has been wasted. After the collapse of the housing bubble, many of our friends, neighbours and students who had trained as architects, property developers, builders, plumbers and lawyers were either unemployed, in a new industry, or travelling overseas to find work.
The most severe economic effects usually occur when the bursting of a bubble reduces the value of collateral backing bank loans. This, coupled with the inability of bubble investors to repay loans, can result in a banking crisis. The collapse in house prices after 2007 was followed by the global financial crisis and we witnessed the downfall of American, British, Irish and other European banks. This resulted in major long-lasting damage to the economy. Financial crises are astonishingly economically destructive: estimates of the losses in economic output for post-1970 banking crises range from 15 to 25 per cent of annual GDP.6 These estimates, however, conceal the large costs that financial crises have on psychological and human well-being.7 They also ignore the human costs associated with the imposition of austerity measures once the crisis is over. We both experienced and witnessed cuts in real pay, decreased levels of public service provision and cuts in welfare payments to family members.

Not all bubbles, however, are as economically destructive as the housing bubble of the 2000s, and some may even have positive social consequences.8 There are at least three ways in which bubbles can be useful. First, the bubble may facilitate innovation and encourage more people to become entrepreneurs, which ultimately feeds into future economic growth.9 Second, the new technology developed by bubble companies may help stimulate future innovations, and bubble companies may themselves use the technology developed during the bubble to move into a different industry. Third, bubbles may provide capital for technological projects that would not be financed to the same extent in a fully efficient financial market. Many historical bubbles have been associated with transformative technologies, such as railways, bicycles, automobiles, fibreopticsand theInternet. William Janeway, who was a highly successful venture capitalist dur-ing the Dot-Com Bubble, argues that several economically beneficial technologies would not have been developed without the assistance of bubbles.10
Why do we refer to a boom and bust in asset prices as a bubble? The word ‘bubble’, in its present spelling, appears to have originated with William Shakespeare at the beginning of the seventeenth century. In the famous ‘All the world’s a stage’ speech from his comedy As You Like It,he uses the word bubble as an adjective meaning fragile, empty or worthless, just like a soap bubble. Over the following century, ‘bubble’ was widely used as a verb, meaning ‘to deceive’.The applicationofthetermto financial markets began in 1719 with writers such as Daniel Defoe and Jonathan Swift, who viewed many of the new companies being incorpo-rated as not only worthless and empty, but deceptive.11 The bubble meta-phor stuck, but over time its use has become somewhat less pejorative.

Nowadays the word ‘bubble’ is used by commentators and news media to describe any instance in which the price of an asset appears to be slightly too high. Among academic economists, however, using the word at all can be deeply controversial. One school of thought sees a bubble as a non-explanation of a financial phenomenon, a label applied only to episodes for which we have no better explanation.12 Eugene Fama, the father of modern empirical finance, goes further than this, calling the term ‘treacherous’ and complaining that ‘the word “bubble” drives me nuts’.13 In Fama’s view the word ‘bubble’ is devoid of meaning, having never been formally defined.14
In this book, we borrow the definition of Charles Kindleberger, the MIT economic historian and bubble scholar, who describes a bubble as an ‘upward price movement over an extended range that then implodes’. In other words, a bubble is a steep increase in the price of an asset such as a share over a period of time, followed by a steep decrease in its price.15 Others have suggested that, for an episode to constitute a bubble, prices must have become disconnected from the ‘fundamental value’ of the asset.16 However, this definition makes bubbles much more difficult to identify with any certainty, which can lead to lengthy discussions about whether a particular episode was a ‘real’ bubble or not. It is also divorced from the historical usage of the term. The beauty of Kindleberger’s definition for us is that, because the definition makes no claims about the underlying causes of bubbles, we can investigate these causes for ourselves. One implication of this definition is that a bubble can only be identified with 100 per cent certainty after the event. However, this does not mean that bubbles are wholly unpredictable and random events. In this book, we propose a new metaphor and analytical frame-work which describes their causes, explains what determines their con-sequences, and – we hope – will help predict them in the future.