It’s been three years since the collapse of the last economic bubble, so it’s probably time to start worrying about the next one. Sure enough, commentators are increasingly concerned about gold bubbles, “tech 2.0″ bubbles and venture capital bubbles. To be clear, I know nothing about any of these bubbles; this post isn’t about the virtues of a Groupon IPO or the true value of precious metals. Instead, I’m interested in the persistence of all bubbles. Why are they so inevitable? Why don’t we ever learn? And can they be prevented?
But first, a little history: One of the first financial bubbles was about flowers. In the late 16th century, tulips were introduced to the Netherlands from the Ottoman empire. The flowers were an instant sensation, and were soon cultivated by connoisseurs all across the country, who bred increasingly ornate color varieties.
The speculation began in the early 1630s, when gardeners started selling the spring flowers — tulips only blossom for a few fleeting weeks in April and May — in the winter months. This led to the creation of a futures markets, as buyers bought and sold the promise of spring buds. By the winter of 1636, prices for the flowers began a steep ascent, so that a single tulip bulb was worth approximately 10 times the salary of a skilled craftsman. Acres of land, gold jewelry and prized oil paintings were traded away on the promise of multicolored petals.
And then, in February 1637, the bubble burst. Tulip prices entered a steep decline, with the value of some rare bulbs declining more than 99 percent. In many instances, the speculators ended up with expensive futures contracts they couldn’t resell. All they got was a flower.
While tulipmania might strike modern investors as a ridiculous frenzy, it’s hard to argue that our financial bubbles are less absurd. In recent years, we’ve lived through the aftermath of the dot-com boom, in which startups without business models were suddenly worth billions of dollars, and the real estate bubble, in which Las Vegas tract homes tripled in value before they were even finished. Each bubble has its own macroeconomic explanation – loose money policy, Fannie/Freddie, shady Wall Street “innovations” — but those stories still beg the question: Why don’t we know better? Because here’s the paradox of bubbles: In retrospect the speculation always seem foolish. How can a tulip be worth more than a house? Is Cisco really the most valuable company in the world? But in the frenzied moment, the trading proves hard to resist, so that even amateur investors begin betting on bulbs, dabbling in Nasdaq shares and flipping condos.
In recent years, scientists have begun deciphering the irrational underpinnings of bubbles. Consider an economics experiment led by Colin Camerer, a neuroeconomist at Caltech. He set up a stock exchange in his lab, consisting of shares in a single pretend company, and invited Caltech undergrads to participate. (The simulation was inspired by similar research first done by Vernon Smith, the Nobel Prize-winning economist.) At the start of the market, every “investor” was given two shares and a small amount of money to buy more shares. In order to accurately simulate the real stock market, Camerer made the shares pay a small dividend of 24 cents per period, with the market lasting for fifteen periods. If a student owned one share for the entire game, they earned a total of $3.60, or $.24 x 15.
Camerer designed the experiment so that the value of the shares was transparent. For example, one share at the start of the game was worth $3.60, since that’s how much a student could expect to earn in dividends. By round two, that same share was only worth $3.36. In the next round, it would be worth $3.12, and so on. If the students were rational traders, the shares would steadily decrease in value, until they ended up being worth only 24 cents in the last round.
But that isn’t what happened. As soon as trading began, the students bid the price of each share above $3.60, as they engaged in a typical bout of irrational exuberance. What was strange, however, was the persistence of this speculative bubble. Even when the shares were worth less than $1, students were still bidding more than $2.50. The lesson is that even in a transparent marketplace — the value of the investment was perfectly obvious — bubbles inevitably develop. We can’t help but speculate.
Of course, this still begs the question: Why are we so dumb? To better understand the source of our compulsive speculation, Read Montague, a neuroscientist now at Virginia Tech, has begun investigating the formation of bubbles from the perspective of the brain. He argues that the urge to speculate is rooted in our mental software. In particular, bubbles seem to depend on a unique human talent called “fictive learning,” which is the ability to learn from hypothetical scenarios and counterfactual questions. In other words, people don’t just learn from mistakes they’ve actually made, they’re able to learn from mistakes they might have made, if only they’d done something different.
