Why Economic Bubbles are formed

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By

Siddhartha Rastogi

Why do we humans have such a short memory that we forget the hard learnt lessons so fast?

Why, despite warnings and availability of past data, does more and more money get gutted in each successive bubble?

Is greed more powerful than fear?

There are multiple questions, which economists globally have yet to figure out.

This year-end note of mine is an attempt to answer or perhaps throw some light on the causes of this effect from the human, emotional and psychological perspective. Economically, we understand that bubbles are formed as too much money chases an asset which doesn’t have the same intrinsic value.

Also, we all know and agree that markets are larger than any individual or any institution, even a cartel of humans or organisations cannot successfully defeat the rest of the players consecutively and consistently. The law of average always catches up. As you keep winning in each successive round, the possibility of failure chases you at a disproportionately higher speed. Then why during the great bull run does more money get drawn towards the same asset which during recessionary time is available at throw-away prices with no takers, despite ample liquidity with potential buyers.

History has shown, time after time, that irrational market frenzy has always been succeeded by bouts of lean recessionary period. Between Nov 1936 and Feb 1937, Tulip prices in Holland soared 20 times, before plunging 99% in May 1937, leaving several participants bankrupt.

Many argue that bubbles are formed on account of market participants’ belief, that success of one firm in a particular space can be replicated much faster and hence catching those premature can yield significantly higher returns. This happened in South Sea Company Investments in the 1720s. East India Company captured the entire South East Asia in the early 17th century, reaping benefits to its investors. On similar lines, South Sea Company was formed in 1711 to plunder and rule the South American nations, which were then under the Spanish control. In 1720, the stock of South Sea Company moved up 8x in a year before it fell by 90% in the very next year.

Few economists believe that aggressive monetary policies by central banks under political compulsions lead to bubble in a few cases. Japanese real estate and the stock market bubble relives those memories. In 1986, Japan went into recession on account of a strong yen for the past few years. The Japanese government shepherded the economy by fiscal and economic stimulus leading to asset and stock bubble in 1990, which pushed the Japanese economy to a severe downturn for over 20 years.

The introduction of the Internet and online companies and their frenzy led to the 2000 Dotcom bubble and finally greed and soaring prices in US real estate and perceived irreversibility of it led to the 2008 crisis.

Reasons can be many, but the outcome is similar. Every financial expert and investor knows about it but what happens when asset prices start to soar or move rapidly?

For this we need to delve a little deeper into the human history. Perhaps 30-40 thousand years ago.

During the days of hunter–gatherers, every day was a fresh start, humans had to go out and fend for themselves and for their families. There were days when weather or luck was not so conducive and hence for such phases, it was good practice to share food and keep some surplus. During the Neolithic era, survival was easy if one stayed in a group and followed the one perceived to be of superior knowledge or acumen or insight or health or strength and who had already discovered newer pastures of food, water, basic clothing and safety. Following the herd or the alpha human meant insurance of life with basic necessities. It was unwise to oppose the man who has figured it all out and was almost ritualistic to walk behind till the bounty or lavishness lasts. Back then uncertainty arose from every aspect, including terrain, nature, climate, ecology, non-humans and humans, as well. Thus, the simplest and easiest way was to tread on the heels and stay put, till someone raises an alarm of uncertainty.

Going along with the crowd or confirming with condescending patriarch saved energy

What does that mean?

An average human is hit with ~65,000 thoughts each day. The funny part is that 95% of these thoughts are repeated every single day. This means that humans keep thinking of the same thing again and again. As you get comfortable with few thoughts, the subconscious mind keeps looking for more of the same things.

Let me enumerate with a small example. Suppose you have invested in a particular stock of a company which has been surging and you wish to increase the exposure in the same stock to make a quick buck and get richer fast. The first thing you’ll do is research on that stock or check with your advisors or experts or read about that stock. While surfing through the internet, you find an article from an expert, mentioning 8 other stocks beyond your stock which are expected to do well and the rationale thereof. Now you will go ahead and buy that particular investment alone overlooking other ideas from the expert as it confirms your thesis and bias, while saving your time and energy.

As it is now and was in the past and will remain in future, time and energy have their limits and are scarce. Thus, it is a good idea for survival and for prosperity to go via the trailed path. Humans are creatures of repetition. People tend to stick with their beliefs, as forming a new one is exhausting. It involves a lot of exploratory work as well in some cases the changing of habits or embedded behaviour, which in itself is cumbersome and draws internal resistance.

In some cases, people tend to believe that this is their ticket to success and hence get drawn to the bubble so vigorously that the bubble seems to be reality. The mind tricks you use to pursue the confirmation bias which essentially is just status quo bias.

We all want more, we all wish to have more and when we seek more we know, we need to change as more can’t come in the same state, we need to expand and yet we wish to have our old stuff with us as it gives us comfort and makes us believe that we are on the right path and things which have yielded us so far will continue to take us forward as well, without realising that if Change is the constant thing then You are entering a bubble which is surely going to burst.

Siddhartha Rastogi

Siddhartha was born to a learned middle class educated family in Semi Urban India. His father was an extremely honest man who because of his honesty had to pay the price in corporate world. Mother is a determined woman who ensured that children are being well taken care off. After a few years of birth, doctors called Siddhartha, a slow child having flat foot. He would fall more than he could walk. Determined mother ensured all therapies for her son to come out strong to fight the world. Siddhartha joined swimming when he was in 6th standard. Seeing other children of his class, he jumped in 10 feet deep pool and learnt swimming on his own, the very same day.

From that day there was no looking back. He topped his city in 12th and went to score highest in his B school exams. During his profession as banker, he became youngest branch manager of a MNC bank managing their biggest wealth branch in the country. There he found love of his life and got married. His love of his life emerged in the form of his daughter who completely changed him for good.

Siddhartha Rastogi is Director for a boutique Investment bank in India.

Siddhartha is a forward looking thinker & writer who has written a book on decision making. 8 Simple steps to effective decision making.

He writes on various social and current issues via his blog and can also be found on twitter.