Chapter 1--The Greater Fool Theory

The Greater Fool Theory 1

Speculative bubbles have occurred throughout history. These episodes are characterized by a continuous sharp rise in the price of a particular asset or group of related assets, leading to further price increases driven by new speculators seeking profits through even higher prices. These higher prices are driven by the potential profits to be made through trading, rather than the earning capacity or economic value of the asset. These speculative manias then come to abrupt and dramatic endings, as expectations change and buyers quickly become sellers, in mass. The consequences are often disastrous, with the ensuing crash inflicting financial pain on the region or country involved. Euphoria turns to despair as the mandatory readjustment that takes place in the economy creates massive worker dislocation and great numbers of bankruptcies.

Contemporary economists’ views concerning speculative bubbles vary. The Rational Expectations School questions whether speculative bubbles can happen at all, given rational markets. Charles Kindleberger concisely gives the rational expectations viewpoint:

Rational expectations theory holds that prices are formed within the limits of available information by market participants using standard economic models appropriate to the circumstances. As such, it is claimed, market prices cannot diverge from fundamental values unless the information proves to have been widely wrong. The theoretical literature uses the assumption of the market having one mind and one purpose.¹

History tells a different story, of course. Market speculators at various times in history have bid up prices to extraordinary levels, not based upon fundamental values, but with the expectation of selling the asset in question at an even higher price and thus making a profit. This is sometimes referred to as the “greater fool theory.”

John Maynard Keynes spends the whole of chapter 12 of The General Theory of Employment, Interest, and Money discussing speculation and bubbles, pointing to five factors which foster these episodes: (1) neophyte investors owning an increased proportion of capital investment; (2) the day-to-day price fluctuations having an excessive influence over the market; (3) violent changes in the mass psychology of ignorant individuals changing asset valuations; (4) professional investors devoting their skills to “anticipating what average opinion expects the average opinion to be;” and (5) confidence, or lack of, in the credit markets.²

Keynes metaphorically describes speculative markets:

Nor is it necessary that anyone should keep his simple faith in the conventional basis of valuation having any genuine long-term validity. For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs—a pastime in which he is victor who says Snap neither too soon nor too late, who passes the Old Maid to his neighbor before the game is over, who secures a chair for himself when the music stops.³

Keynes also touches upon the consequences of speculative bubbles and manias:

Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.⁴

Ironically, it is due to a Keynesian economic policy and its monetary apparatus, i.e., that of expanding the supply of money to increase economic activity, that speculative price bubbles and manias are engendered. This was exemplified by John Law, whose system (driven by a huge increase in the supply of money) created the Mississippi Bubble in France. Law, who preceded Keynes by two hundred years, held many of the same views as Keynes. As Charles Rist explains:

It is said that history repeats itself. One can say the same thing about economists. At the present time there is a writer whose ideas have been repeated since Keynes, without ever being cited by name. He is called John Law. I would be curious to know how many, among the Anglo-Saxon authors who have found again, all by themselves, his principal arguments, have taken the trouble to read him.⁵

However, there are economists who do not feel the episode in early eighteenth century France was a bubble. As Peter Garber writes:

That Law’s promised expansion never materialized does not imply that a bubble occurred in the modern sense of the word. After all, this was not the last time that a convincing economic idea would fracture in practice. One respectable group of modern economists or another have described Keynesian economics, supply side economics, monetarism, fixed exchange rate regimes, floating exchange rate regimes, and the belief in rational expectations in asset markets as disastrously flawed policy schemes. Indeed, elements of the first three were primary components in Law’s scheme.⁶

Other contemporary economists pursue the explanation of speculative bubbles through mathematical formulas. It is not surprising that this search for empirical evidence has produced nothing that aids in our understanding of these episodes. The tools of econometrics were designed to explain the movement of lifeless particles, not the activities of humans, who act with purpose to improve their condition in life. In an article by Robert Flood and Robert Hodrick, it is pointed out that “academic economists conducted relatively little formal empirical analysis of actual markets until recently, probably because economist’s analytical and statistical tools were inadequate.”⁷ Messrs. Flood and Hodrick go on to pursue the case that “the widespread adoption of the rational expectations hypothesis provided the required underpinning for theoretical and empirical study of the issues.”⁸ But, as was pointed out above, those in the Rational Expectations School, through their belief that all market participants can foretell the future, and thus only act rationally, virtually rule out the potential for speculative bubbles. Unsurprisingly, after surveying the current empirical literature concerning bubbles, they come to the conclusion that “the current empirical tests for bubbles do not successfully establish the case that bubbles exist in asset prices.”⁹

This present volume contends, based upon historical experience, that speculative bubbles do occur and that these bubbles are precipitated by a large increase in the supply of money. This monetary intervention creates situations that manifest themselves in malinvestment, i.e., speculative bubbles. What then follows is the required period of readjustment, i.e., crash and depression. This sequence of events is similar to the Minsky/Kindleberger sequence of events that characterize stock market booms and busts, as outlined by Antoin Murphy:

1. The market rise starts off because of some exogenous shock such as war, the end of a war, a technological or natural resource discovery, or “a debt conversion that precipitously lowers interest rates.” The shock creates new opportunities for profit, and a boom is engendered.
2. The boom is nurtured by an expansion of bank credit which expands the money supply. Alternatively, the velocity of circulation increases.
3. As increased demand pushes up the prices of goods and financial assets, new profit opportunities are found and confidence grows in the economy. Multiplier and accelerator effects interact and the economy enters into a “boom or euphoric state.” At this point overtrading may take place.
4. Overtrading may involve:
   1. Pure speculation, that is over-emphasis on the acquisition of assets for capital gain rather than income return;
   2. Overestimation of prospective returns by companies;
   3. Excessive gearing involving the imposition of low cash requirements on the acquisition of financial assets through buying on margin, by installment purchases, and so on.
5. When the neophytes, attracted by the prospect of large capital gains for a small outlay, become numerous in the market, the activity assumes a separate abnormal momentum of its own. Insiders recognize the danger signals and move out of securities into money.
6. A financial distress period sets in as the neophytes become aware that if there is a rush for liquidity prices will collapse. The race to move out of securities gathers pace.
7. Revulsion against securities develops as banks start calling in loans and selling collateral.
8. Panic sets in as the market collapses and the question arises as to whether the government or Central Bank should come in and act as a lender of last resort in what has been recently described as a “lifeboat operation.”¹⁰

Help in accounting for how speculative bubbles are initiated comes to us from the Austrian School. The Austrian trade cycle theory serves to shed a bright light on how boom-bust business cycles are created, with speculative bubbles many times being an offshoot from these business-cycle booms.

The Austrian view of the trade cycle begins with the view that, in a market economy, entrepreneurs serve as forecasters, predicting what consumers will want in the future. After determining future wants, they set about the task of organizing and implementing the factors of production in the present, so that the product will be available when the consumers demand it, at a price sufficient for the entrepreneur to reap a profit.

What happens in a bust and the subsequent depression is that a preponderance of entrepreneurs have predicted in error and go bankrupt. Why is there this cluster of entrepreneurial errors? The answer lies not in examining the bust, but the boom that leads up to the crisis.

The boom-bust cycle begins with a monetary intervention into the economy. In the modern world, this occurs by way of the banking system’s excessive issue of credit. This increase in what Mises called “fiduciary media,” or unbacked banknotes or deposits, serves to reduce interest rates, and sends the false signal to entrepreneurs that consumers have changed their consumption/investment mix to one of greater investment and less consumption. Businessmen then invest this increased amount of money in capital goods, shifting resources away from consumer goods.

Prices and wages are then bid up in capital goods industries, but as this new money trickles down to consumers, their “time preferences,” or consumption/investment mixes, have not actually changed, thus there is no increase in demand for the now abundant capital goods. The increased supply of unwanted capital goods, or malinvestment, must then be liquidated. This liquidation is then followed by a recession or depression, which is the economy’s healing period, serving to reallocate the factors of production to more productive and efficient ways of satisfying customer wants.¹¹

What also must be considered, when searching for what creates an environment from which speculative bubbles can emerge, is that age old question: What is the right amount of money for any given economy? Is more money beneficial for an economy? Does more money constitute more wealth? If more money is beneficial, then would not all the new money be channeled into production investment? David Hume explains what money is, and is not:

Money is not, properly speaking, one of the subjects of commerce; but only the instrument which men have agreed upon to facilitate the exchange of one commodity for another. It is none of the wheels of trade: It is the oil which renders the motion of the wheels more smooth and easy.¹²

Money is useful only for its exchange-value, thus an increase in the supply of money, as Murray Rothbard indicates, “does not— unlike other goods—confer a social benefit.”¹³ Thus, if there is more money produced in an economy, its price will drop, making all other goods, which money is traded for, more expensive, in money terms.

The supply of money in the free market is determined by the market. So if gold is the money in a particular economy, the market will decide the amount of gold that will be produced for use as money. All of the gold that is mined will not be demanded by the market for use as money. Some of the precious metal would be channeled toward jewelry or industrial uses. But if by government mandate all gold is coined, even though the market does not demand it, the effect of this over-supply of money will lead to the same malinvestments as an increase in fiduciary media.¹⁴

Three different speculative bubbles will be explored in this volume. The first is Tulipmania, which occurred in 1634–37 in Amsterdam. The Tulipmania episode was spurred by the enormous influx of silver, and to a lesser extent, gold specie into Amsterdam. This influx was the result of free coinage laws, the stability of the Bank of Amsterdam, increased trade, and the Dutch Navy’s success on the high seas at confiscating treasure.

Next, is a discussion about the life and theories of perhaps the world’s first inflationist, John Law and the bubble that he directly engineered, the Mississippi Bubble. Law viewed paper money, and in fact stocks, bonds, or any other financial instruments as superior to gold or silver money. Law, like so many after him, also felt that low interest rates and more money were essential for a healthy, thriving economy. Law was to fuel the speculation in Mississippi Company shares with enormous amounts of banknotes before the house of paper finally collapsed. The South Sea Bubble, which occurred almost simultaneously with the Mississippi Bubble, was an attempt to mirror Law’s system, refinancing government debt with the shares of the South Sea Company. This company, whose share price was to rise ten-fold, had no real assets and could only make a profit from a large increase in the price of its stock. The share price increase was aided with increased bank loans and other credit.

In conclusion, these three episodes shall be viewed in the context of the Austrian theory of malinvestment. What will also be considered are the prospects for the continued occurrence of speculative bubbles and the inevitable crashes that follow, given fiat banking and the presence of ubiquitous central banks waiting to prolong any boom and prop up any inevitable bust.