What About Bubbles?

Surely, I cannot seriously believe financial markets are efficient, right?

In my previous post, I outlined what financial market efficiency means (and does not mean). The most common criticism that I received was something to the effect of “what about bubbles?” History is replete with examples of asset price bubbles and speculative manias, or so we are told. People are purportedly driven by emotion and irrationality to bid up price of an asset beyond what it is truly worth, only to see the price come crashing down. People lose wealth from these bubbles, as Hemingway might say, “gradually, then suddenly.”

We are told that these episodes alone are enough to demonstrate that financial markets are inefficient. To understand this madness, we must understand psychology. We must get inside people’s minds and figure out what drives them to participate in this sort of phenomenon. Only then can we understand the waves of emotions that drive asset prices as the moon influences the tide.

This is an incredible and provocative narrative. It draws people in. It provides the perfect backdrop to write beautiful prose about excitement and loss. Who would not want to read about things like “manias” and “irrational exuberance”?

It also doesn’t hurt that it feeds our egos. We, the newly enlightened, can avoid the pitfalls of the past by conquering our emotions. We can be taught rationality by those who have discovered irrationality. These scholars can be our guides by illuminating our innate cognitive biases. These hero scholars can be given prizes and start hedge funds that purportedly (but don’t actually) employ strategies that profit from these biases.

Yet, despite all the good things that this narrative provides, it misses something that is critically important: a knowledge of history broader than the seemingly inexplicable path of the asset price. In short, the archetypal historical bubbles that are frequently referenced are actually stories of political economy. That isn’t as exciting as raw emotion, but it is nevertheless important to set the record straight. In this post, I will do something different when it comes to Economic Forces. I will attempt to provide some historical context by discussing three famous bubbles: The South Sea Bubble, the Mississippi Bubble, and Tulipmania. In other words, this week I am going to focus on evidence rather than theory. We can then ask ourselves if these bubbles have anything to do with irrationality or market inefficiency.

The South Sea Bubble and the Mississippi Bubble

Both the South Sea Bubble and the Mississippi Bubble are stories of attempts to consolidate and lower the interest rates of government debt. In the case of the South Sea Company, this is quite straightforward. In the case of John Law’s experiment that resulted in the Mississippi Bubble, the scheme was an elaborate attempt of a corporate takeover of France.

During the War of the Grand Alliance and the War of Spanish Succession, both England and France had accumulated significant amounts of government debt. Both states had to consider ways to generate revenue. In fact, the Bank of England was chartered in 1694, in the midst of the War of the Grand Alliance, in exchange for its purchase of 1.2 million pounds of government debt.

The South Sea Company has a similar origin story. In the midst of the War of Spanish Succession, the South Sea Company was created to help consolidate the government’s debt and reduce the government’s borrowing costs. The company was granted a monopoly over trade with South America, which at that time really meant the slave trade. While the source of the company’s profitability was ostensibly the trade monopoly, its role in financing government debt plays a much greater role in the story of the bubble.

In 1719, the South Sea Company came up with a plan to further consolidate the debt of the British government. The idea was to issue new shares of the company’s stock in exchange for annuities that had been issued by the government to pay for war. In doing so, they would convert this illiquid debt into liquid equity. At the same time, the approval of this plan was predicated on new terms of the debt that would allow the government to pay lower rates of interest. The interest payments paid to the company could used to pay out a dividends to the firm’s shareholders.

The success of this scheme inspired a subsequent plan to further consolidate the government’s debt and reduce its interest payments. The deal was sealed with a large payment to the treasury and bribes to members of Parliament. This scheme was similar to the previous one in that it would allow investors to trade in their illiquid annuities for a liquid stock. Furthermore, the firm’s dividend could be paid using the income generated from interest payments of the government and income earned from the trade monopoly.

While this created reasonable expectations of growing dividends, it was also followed by public hype, including from members of Parliament, about expected future dividends and the profitability of the trade monopoly. The ability to buy shares in payment installment plans also created greater demand. In addition, the terms of the exchange of annuities for shares was favorable to those trading in their annuities and became even more favorable as the stock price rose. This further drove the price higher. At the peak of the bubble, there was a time in which the price plateaued, in which the exchange books were closed and that allegedly gave insiders a chance to liquidate.

There is still a debate as to what caused the collapse in the price. Many scholars blame a liquidity issue triggered by either the Bubble Act of 1720 or an international liquidity crisis in the aftermath of the collapse of John Law’s scheme. Others argue that the pause in the dividend, combined with the knowledge of insider traders created an exodus from the stock.

Nonetheless, what is somewhat interesting about this event is the surrounding political economy. England was only decades removed from the Glorious Revolution. Some members of the Tories had Jacobite sympathies and wanted to return the Stuarts to throne. These Jacobites were therefore a threat to King George. Jacobite rebellions were a legitimate threat. The South Sea Company was set up by the Tories, whereas the Bank of England had been set up by the Whigs. Whether there is merit to the argument or not, the Tories did not consider the Bank of England reliable and thought the South Sea Company could be an alternative. In the aftermath of the bubble, Robert Walpole, a Whig, assumed the role of the white knight who came in to clean up the mess. As part of this clean up, 5 million pounds of South Sea capital was transferred to the Bank of England as part of the company’s restructuring. Of course, this is not to claim that this was some sort of grand plan or conspiracy, but rather to point out that there are interesting issues of political economy at play here that are much more interesting than the psychology of the traders.

John Law’s experiment immediately preceded the South Sea Bubble and was even more ambitious. What John Law did was effectively attempt a corporate takeover of France. In 1716, Law set up a bank, the Bank Generale, that issued paper money backed by gold and silver. In addition, Law set up the Mississippi Company in 1717. Initially, the Mississippi Company was given a monopoly over trade with Louisiana and in Canadian beaver skins. Law funded this company by issuing stock in exchange for government debt. He then renegotiated the terms of the debt with the French government.

In 1718, Law’s bank was nationalized with the notes guaranteed by the King of France. Law remained in charge of the bank. That same year, the Mississippi Company acquired the monopoly rights to the tobacco trade as well as French trade with Africa. Subsequently, in 1719, Law purchased the East India Company and the China Company. He therefore had acquired monopolies over all of French trade that was not conducted in Europe. The Mississippi Company also acquired the rights to mint French coins. In August and October of 1719, respectively, Law bought the rights to collect all indirect taxes and direct taxes for the French government. Law also continued to issue new stock in exchange for either the notes issued by the bank or government debt.

Law’s purchases of government debt were considered to be mutually beneficial to Law’s company and to the French government. The government benefited from debt consolidation and lower interest payments. The Mississippi Company benefited from a consistent flow of income from owning this debt. His goal was to consolidate all of the government’s debt.

By 1720, John Law was officially put in charge of French government finance. This meant that he controlled the expenditures of France (through his government position), the debt (through his company), tax collection (through his company), and money creation (through his bank and his company’s right to mint). At the same time, his company held a monopoly over all non-European trade with France.

It is not surprising that this sort of business venture would attract investors. After all, who wouldn’t want to profit from the corporate takeover of France? The Mississippi Company largely financed its acquisitions through sales of new shares. Law saw the rising share price as essential to continuing to grow his company. The popularity and apparent success of his corporate takeover of France attracted a lot of investors. Share prices rose from a price of 500 livres tournois to 10,000 livres tournois between April of 1719 and January of 1720.

The problem for John Law is that people wanted to take profits on their gains and they wanted the profit paid out in specie, not bank notes. This led to a significant decline in the stock price. In order to support the stock price, the bank started issuing notes in order to buy the stock and maintain its price. In further attempts to stop the sale of stock for specie, Law restricted payment in gold to no more than 100 livres. Furthermore, the bank notes issued by the bank were made legal tender to encourage people to be more willing to hold paper money rather than specie. Later Law announced that he had pegged the price of the stock at 9,000 livres. Inflation started to rise quite rapidly. Ultimately, John Law was forced to devalue the shares and the stock price collapsed. Law’s enemies were able to conduct a hostile takeover of the company.

From the perspective of a value investor, it is not hard to understand the collapse. In an effort to support the stock price and to avoid the withdrawal of specie, the bank was issuing notes to support the price. The drain of specie and the simultaneous increase in the supply of bank notes caused a significant inflation. Similarly, since the bank was acting in concert with the company, one can think of the two companies as though they were consolidated (the company was managing the bank). What Law was effectively doing was exchanging debt (notes) for equity at an above market valuation, which generates rational fears of insolvency.

Nonetheless, as Adolphe Theirs notes in his book on the Mississippi bubble, the French government actually benefited from the collapse. It was able to retire some of its debt and reacquire the revenue-generating rights that the Mississippi Company had previously taken over.

While we are often told that these events are signs of market inefficiency or of irrationality and evidence of how humans get caught up in their emotions, it is hard not to look carefully at what happened and notice the following. First, these attempts to consolidate the debt and reduce the interest payments of the government were quite successful from the government’s perspective. Second, the confidence in these schemes was driven, at least in part, by explicit government endorsements. Third, as Peter Garber has pointed out, the ex ante expectations were not egregiously out of step with the information that investors knew at the time. Fourth, while the average investor lost money, insiders tended to profit. And fifth, the aftermath of the bubble allowed the governments (each of which was under threat of revolution at the time) to come in as the white knight to clean up the mess while scapegoating their political opponents. Thus, there might be a larger political economy story at play. In fact, the political economy of these events seems substantially more interesting — at least to me — than any attempt to understand the psyche of the investors or claims that such events demonstrate inefficiency within financial markets.

Tulipmania

Tulipmania is perhaps the favorite example of those interested in bubbles and manias. To provide some background, the so-called Tulipmania occurred in the Netherlands during the 17th century. Growers in the Netherlands developed different varieties of tulip bulbs. Typical bulbs were sold at ordinary, low prices. However, some varieties of the bulbs were rare and were sold for much higher prices. These rare bulbs were even subject to speculation. The accounts a Tulipmania describe a process in which prices of these rare tulip bulbs started to increase in November of 1636 and by February of the following year were selling for 20 times what they had sold for in early November. By March, however, the bulb prices were back to their pre-November prices.

Based on this description, it is understandable why one might consider this a bubble or speculative mania. What could be more bizarre and seemingly irrational than bidding up the price of tulip bulbs? Can you believe it? Tulip bulbs. Everywhere people went, everyone was talking about tulip bulbs. They were doing amazing things with tulip bulbs. People had never seen tulip bulbs like these. If you talk to bulb people, they couldn’t believe it.

This whole things sounds somewhat insane to an outsider observer. Clearly, this must be evidence of irrationality and market inefficiency. Not so fast. It turns out that this was not even a bubble. Sad!

As Earl Thompson discovered, the purported rise in the price of the tulip bulbs was an artifact of Dutch legislation rather than evidence of a bubble. The prices quoted for tulips were futures prices. However, the terms of the tulip futures contracts were changed such that those who purchased the contracts after November 30, 1636 had the option, but not the obligation to pay the contract price. What this did was convert these futures contracts to options contracts. The quoted prices therefore reflect the strike prices on options contracts that would have been paid if the spot price had risen above the strike price. As such, the prices quoted as evidence of a bubble were actually the unrealized strike prices on the tulip contracts.

In fact, Thompson uses a model of option pricing to reverse engineer the implied strike price from what we know about transactions costs and finds that the predicted strike price is consistent with the unrealized strike prices typically quoted. In addition, he shows that the pricing of these options contracts is remarkably consistent with option pricing in modern markets. He concludes that the contracts “appear to provide a remarkable illustration of efficient market prices.”

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What all of this teaches us is that the famous, or perhaps infamous, bubbles that are frequently cited as evidence of manias, irrationality, and the victory of emotion over reason are actually much more complicated than all of that. In the case of Tulipmania, the supposed bubble is an artifact of a change in the terms of the contract rather than what Charles Mackay called the “madness of crowds.” In the case of the South Sea Bubble and the Mississippi Bubble, one might understand why investors had such high hopes for the success of these business ventures ex ante. Furthermore, there are broader, political factors that seem at least as important for understanding these events as any sort of appeal to investor psychology or inefficient markets.

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P.S. I quite like my introduction to this post, but nothing quite compares to John Cochrane’s introduction for his review of Garber’s Famous First Bubbles. You can find that here.