Bubbles Burst

During the last two years of my undergraduate degree I worked for a stock brokerage. One of the requirements for young potential traders then was to read a "classic" called Extraordinary Popular Delusions on the Madness of Crowds. One of the delusions in the book was about tulipmania when the 17th Century Dutch supposedly went gaga over tulip bulbs and destroyed or at least maimed their economy in this wild speculation.

In today's Financial Times a book is reviewed ,Tulipmania, which debunks at least part of the story. It turns out that the speculative bubble was nowhere as pervasive as the Delusions book had argued and thus the eventual crash had only a minor effect on the Dutch economy.

There are two questions here. First, what should we say about speculative bubbles from learning that one of the most prominent is inaccurate? The story of how the bubble developed, regardless of its total impact, seems to be about right. So the cautions offered by Delusions are a good guide for anyone interested in investments. Benjamin Graham in his legendary book on security analysis suggested that any investment should be viewed with careful analytical eyes.

The second question is equally important. How do we protect ourselves against "intellectual bubbles?" In the literature on public goods (how things get put into the public sector) there are a heap of comments about things that cannot be priced. The leading example of that is the constant reference to lighthouses. The argument went like this - it is impossible to stop a ship passing a lighthouse and so this is obviously a good which cannot be priced and therefore a good example of something which needs to be provided by government. The argument went back to John Stuart Mill, if not before. The only problem was it was wrong. Nobel Prize winner Ronald Coase thought about that line of logic at one point and so did the research on the subject. Coase published an article in the Journal of Law and Economics (Journal of Law and Economics, Vol. 17, No. 2 (Oct., 1974), pp. 357-376) actually did the research and found that contrary to simple logic, indeed, there are plenty of examples of pricing the services of lighthouses by following ship records. If a ship in some venues were expected to pass a point, based on its trade route, it could be assessed a fee. That seems like a small point but when you begin to think about pricing goods like lighthouses, it becomes less convincing to move all sorts of other things into the public sector. That is a simple but important point and Mr. Coase was smart enough to help all of us think a bit more clearly.