Thought Bubble

I’m halfway reading a book by Roger Bootle called “Money for Nothing”.  It’s a very interesting read for those interested in Economics, it’s practically a book about inflation.  It starts of with an anecdote about Isaac Newton, who sold his stock in a company called South Sea and sold it when it gained in value by a considerable amount.  He famously said “I can calculate the motions of the heavenly bodies but not the madness of the people.”  So what did he do? He saw the market value go even higher so he bought back in, only to find out that the market had crashed.  He lost the equivalent of roughly $2 million because of that adventure. 

Asset price bubbles are normally considered as a scourge upon financial markets and the real economy.  Whether its housing bubbles, stock bubbles, dot com bubbles, tulip bubbles, history has seen it’s fair share of pricing bubbles.

But are they necessarily a bad thing?

I was reading an article (I’ll see if I can find the link) that had a good argument that not all bubbles are bad.  One argument was for the fast rate of investment in large infrastructure projects such as: railroads, telegraph lines and fibre optical cables.  Sometimes heated investment will lead to cheaper factors of production and therefore cheaper goods.  One positive of the effects of the sub prime crisis in the U.S. is that there are relatively some real cheap houses out there, if you can afford it.

The point of deflation in a bubble occurs when an underlying fundamental in the asset changes or when people just freak.  But what if none of these happen?  Lets imagine for a moment that we had a good that was initially priced at $1, there is only one good of its kind in the world and one person has it in his possession.  Now say that person sells it to the person at a $1 dollar mark-up, who in turn will sell it to another at another dollar mark-up and so on.  Let’s assume that you can only mark-up the price by $1.  Assuming no transport or trading costs theoretically that goods price will increase until its price is the amount of people in the world plus $1 mark-up (assuming that everybody in the world is an adult and can finance the trade).  Then the good can either go to someone that already had it once it its possession or there will be the greatest price crash of a single good ever known to man.  This constant trading of the good will only work if people had faith in the value (or the value it was last traded) of the good and had a good amount of certainty that they can gain a profit from it before it busts. 

Sorry if that whole thought experiment sounds muddled, it made sense in my head :p

The thing that intrigues me about price bubbles is the psychology about it.  It’s herd behaviour, its implicit trust in people yet you want to profit from them.  If you have the discipline you can ride the wave of hysteria, but just as the story of Newton pointed out, even the most logical of people get sucked in.