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The Lifecycle Of a Speculative Bubble | Shreshtha Mishra

Shreshtha Mishra

“Anyone taken as an individual is tolerably sensible and reasonable- as a member of the crowd, he at once becomes a blockhead” – Friedrich Von Schiller

The Tulip mania began in the 1630’s when people started buying tulips using promissory notes even while the saplings were in the ground. This was primarily because Tulips were very rare in Holland and were a fixture in the Dutch gardens. Since the Tulips were to be delivered at a later date, the promissory notes were sold and resold for higher prices leading to the building up of speculation. According to Mike Dash, a well-known researcher and writer, it was “normal for florists to sell tulips they could not deliver, to buyers who did not have the cash to pay for them and who had no desire to plant them.” This led to building up of speculation. This speculation reached fever pitch when a house was exchanged for three rare tulips and people sold off their carts, houses for a few tulips which were still in the ground. Strange, isn’t it? People were willing to bet everything they had on an outcome over which they had absolutely no control over.

The Tulip Bubble

Almost 400 years after the Tulip mania during the Dutch Golden period, we seem to be living in an age when speculative episodes seem somewhat avoidable. With people warning about the burst of the ‘Startup Bubble’ in India and youngsters losing interest in the startup revolution rapidly (about as many – 20.8% men and 21.2% women — say it is a bubble that is going to burst.), it is worth taking a closer look at what essentially is a speculative bubble.

Speculative episodes are like a speeding train that is hitting a brick wall, it picks up speed in the beginning with much energy, only to crash and burn in a spectacular manner. While they have been scattered across countries and time periods, the surprising fact is that they seem to follow a pattern. This pattern, if identified and analysed can save the world from the disasters.

The various identifiable and general stages of a speculative episode (in simple terms) include:

  1. The advent of an object/change that attracts the attention of investors/buyers

  2. The ensuing mass frenzy and euphoria

  3. Condescending attitude of the mass investors towards people who are not involved in the process

  4. A sudden event that weakens investor sentiments

  5. Mass sellout of the object of speculation, leading to plummeting prices

  6. Bankruptcy, Unemployment and layoffs and the inevitable, financial disaster

Formation and nurturing of the bubble:

As a certain object catches the attention of major investors, they begin investing money in it hoping for large return. As the price of the object of speculation rises, more people start investing in it, fearing that they might be losing out. As prices rise further, people speculate that prices will go up further, perhaps indefinitely. As these investors begin earning profits, they start believing in their “superior understanding of financial matters” versus someone not investing in the object. With increasing prices, this self-confidence goes up further, leading to increased investments as speculation continues.

The inevitable fall:

However, attached to each speculative bubble is the inevitable fall. No matter how astute the agent, predicting the beginning of a financial crisis is an extremely difficult job and even if someone does predict it, people tend to not take it seriously. This includes notable economists, bankers and investors, as they don’t like to accept that the increase in their profits might not last forever.

The fall usually begins with a sudden change in investor sentiments and a mass sellout and a drastic fall in the price of the object. This is akin to a stampede which ends up leaving many injured and trampled upon. The bursting of the bubble is not a gradual process, and even before people can realize what is happening, they lose a lot of money.

Why do Rational expectations not set in?

One might naturally ask that is all speculative episodes follow a pattern, how is it that people don’t learn from it? The answer lies in the observation that the role of history in the financial world happens to be very limited. People like to believe that their predecessors were not smart enough to avoid a financial crisis.  They think that the new developments leading up to speculation are different and the present generation is smarter.

Thus, instead of carefully analysing and learning from financial disasters, people downplay its causes until another disaster strikes. It is admitted here that Galbraith summarised this discussion in a very poignant line.  “Speculation buys up, in a very practical way, the intelligence of those involved.

(This article was first published in the Indian Economist).

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