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CHAPTER 2

A Brief History of Bubbles

Abstract What is a bubble? Most people agree that there was a bubble on the price of an asset after its price has collapsed. In this chapter, we start with a formal defnition of bubble and discuss why it is so diffcult to assess the existence of bubbles in real time. Then, we briefy review three of the most famous bubble episodes in history (the Dutch Tulipmania, the South Sea Bubble and the Dot-Com Bubble). Finally, we develop a housing bubble indicator to track past episodes.

Keywords Asset price bubble · Fundamental · Expectations · Housing bubble

2.1 definition of BuBBles

Was there a bubble in the price of tulips in 1636 in the Netherlands? Was there a bubble in the price of Dot-Com stocks in 2000? Was there a bubble in house prices in the United States in 2006? Is there a bubble in the price of cryptocurrencies? Before answering these questions, it is necessary to agree on a defnition of asset price bubble. Economists have shown that the price of any asset (with an infnite maturity) is the sum of two components: (i) fundamental and (ii) bubble.1

1 See Brunnermeier (2009) for a short discussion on the specifc assumptions behind this decomposition between fundamental and value component.

© The Author(s) 2018 S. Basco, Housing Bubbles, https://doi.org/10.1007/978-3-030-00587-0_2 5

Pt = Ft + Bt .

(2.1) The left-hand size of Eq. (2.1), Pt, is the actual price of the asset. This variable is very easy to fnd out. For example, if one wants to know the current price of a stock, one just needs to type the name of the company or index in Google Chrome. Historical data for stock prices and indices are also publicly available. Finding the price of other types of assets may be more cumbersome but it is also feasible. Therefore, to know whether there is (or there was) a bubble in the price of any asset, one just needs to compute the fundamental value of the asset, Ft. Once we know the fundamental price of the asset and the actual price, we just need to apply Eq. (2.1). If the fundamental value of the asset, Ft, is below the actual price of the asset, Pt, Eq. (2.1) implies that Bt >0. You have found an asset price bubble!

The reader may wonder why there are discussions on the existence of asset price bubbles if the Eq. (2.1) is so conclusive. The answer is that the computation of the fundamental value of an asset is more an art than a science. To understand the concept of fundamental value is useful to think that investors live forever and that once they purchase the asset, they keep it forever. In the case of stocks, after acquiring a particular stock, the investor is entitled to receive dividends from the company in the future. Thus, the fundamental value of a stock is the sum of future dividends.

There are two main problems to compute the fundamental value of an asset. First, no one knows, for certain, the future stream of dividends. Each market participant may have her own forecast of how a given company will evolve in the future. Imagine that an individual investor computes these future dividends, given all her information, and she fnds that the fundamental value of the stock is below its actual price. Does this imply that there is a bubble? The answer is…we do not know. As the reader may have noticed, the computation of these future dividends hinges on the beliefs of each market participant. The price of an asset may be higher than what you think is the fundamental value. However, it is not guaranteed that there exists a bubble in the price of this stock. It could be that you are too pessimistic about the future of this company and the other investors are right about the economic prospects of the company. The second problem to compute the fundamental value of an asset is that investors have (potentially) different time preferences. That is, a dividend of 100 euros tomorrow may be valued for you different

than the same 100 euros in a more distant future (e.g., in 10 years from now). Investors tend to be impatient and put lower weight to more distant dividends (intertemporal discounting). Moreover, this discount may be different across investors. For example, the discount may depend on the age of the investor. Old investors discount more the future than young agents because, for example, their life expectancy is lower. This second problem is usually disregarded and economists use the market interest rate as the common discount factor.

To sum up, we have learnt that the price of any asset can be decomposed into two components: (i) fundamental value and (ii) bubble. The fundamental component is the expected discounted sum of future dividends of the asset. There exists a bubble in the price of an asset when the fundamental value of the asset is above its price.

2.2 A review of fAmous BuBBles

As the reader has noticed, it is not easy to assess in real time whether the price of an asset is above its fundamental value. This is one reason why economists prefer to wait until the bubble burst to call the boombust episode a bubble. There have been several asset price bubble episodes throughout history. A list of famous historical bubbles includes the Tulipmania in the Netherlands (1636), the South Sea Bubble in England (1720) and the Dot-Com Bubble in the United States (2001). In this chapter, we briefy summarize them and highlight the common features in these episodes.

The Tulipmania (1636) is the frst known asset price bubble episode. Tulips were not original from Europe but they were introduced in the middle of the sixteenth century. They became increasingly popular up to the point in which, around 1634, “it was deemed a proof of bad taste in any man of fortune to be without a collection of them” (Mackay 1841). During these early stages, people purchased tulips not as an investment but to admire their beauty in their conservatory. One signal of this popularity is that some buyers committed to pay for the tulip even before it blossomed (Kindleberger and Aliber 2005). Different species (e.g., Admiral Liefken, Admiral Van der Eyck, Childer, Viceroy and Semper Augustus) were priced differently and, as it would be expected, the rarer species were priced higher. Barter was commonly used to purchase tulips. To have a sense of the Tulipmania, Mackay (1841) documents that at some point in early 1636 there were only two roots of Semper