Just What is a Speculative Bubble?

Good piece here by Robert Shiller discussing the persistence of bubbles in today’s economic environment.  Within the piece he asks an important question – just what is a speculative bubble:

This raises the question: just what is a speculative bubble? The Oxford English Dictionary defines a bubble as “anything fragile, unsubstantial, empty, or worthless; a deceptive show. From 17th c. onwards often applied to delusive commercial or financial schemes.” The problem is that words like “show” and “scheme” suggest a deliberate creation, rather than a widespread social phenomenon that is not directed by any impresario.

In the second edition of my book Irrational Exuberance, I tried to give a better definition of a bubble. A “speculative bubble,” I wrote then, is “a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increase.” This attracts “a larger and larger class of investors, who, despite doubts about the real value of the investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.”

Hard to improve on the definition by the man who has to be one of the greatest bubble callers of our time.  But I don’t know if that’s complete.  I’d define a speculative bubble as follows:

“A speculative bubble occurs when market forces combine to generate a highly unstable and unsustainable position.”

A bubble has an element of disequilibrium that makes it an unsustainable trend.  This is generally driven by irrational perspectives, but I think it’s crucial that bubbles be identified as an unsustainable state of disequilibrium.  Why?  Well, if it’s not highly unstable then it doesn’t burst.  And if it doesn’t burst then how can it be a bubble?  After all, one of the key characteristics of bubbles is that they burst.   Understanding this concept of sustainability played a big role in me calling the silver bubble and saying that government bonds were not a bubble.  These trends were largely about understanding the sustainability of underlying fundamental trends.

Anyhow, that’s my view.  There can be many causes of bubbles (usually psychological as Dr. Shiller notes, but I do think he’s failing to focus on the key ingredient of any bubble – its inherent instability.


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Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services. He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.

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  • FrankH

    It seems as though part of the problem with economics is that no one agrees on oft used terms.

  • Brad S

    Given the definition of Speculative Bubble listed by Mr. Roche, can we use it to judge whether or not there is “inherent instability” in the oil/gas business at this time? Or would we need actual data, such as global consumption of oil, to help us a little better?

  • Widgetmaker

    Gold sure looked to be in a bubble up until the past year or so. But then, who can say what the fair value of an asset is that does not produce a cash flow?

  • TJR

    By Shiller’s definition it’s hard to conclude that we are experiencing any bubbles at the moment–there doesn’t seem to be the kind of wide-spread buying enthusiasm that he describes as a characteristic of a bubble. And yet it seems fair to say that many assets seem quite pricey–houses in some areas; stocks; long-term treasuries.

    So Cullen, I think your criterion of fragility is might be more useful–it can be used to characterize over-priced markets and to characterize bubble markets. If we add price deviation from historical norms, would it be even more useful? Could we further add price deviations due not to fundamental economic factors but to other things such as market interference, for example the extreme monetary policy that the Fed is conducting?

    And of course, we could yet keep Shiller’s characterization as well when trying to evaluate if a market is experiencing a bubble. The kind of enthusiasm he is talking about I remember quite well from the tech bubble of the 1990s. It was distinctive and extreme. I recall near the top of the bubble, on CNBC they literally dragged two New York cops of the street from walking their beat, put them before the camera and asked them to give their stock buying advice!

  • Andrew P

    You can’t talk about “sustainability” unless you specify the time frame. After all, everything eventually goes to zero on a long enough time line.

  • http://orcamgroup.com Cullen Roche

    And you can’t specify time frame without knowing more about what you believe is in a bubble….

  • marius the humble investor

    don’t you think it would be better to not use the word “bubble” at all? catchy yes, but it brings a lot of confusion and it’s wayyyy too easy to get emotional about the whole thing (which is good or bad for investing again?). take Gold for example. Many people bought gold because the dollar & the stock market etc etc were all “bubbles” that HAD to burst in the near future (leaving gold investors the only survivors). What happened to gold recently? now, off course, gold is considered by many a bursted speculative bubble (yadda yadda). Why view the world in these binary terms? beats me.