Another person to join the Federal Reserve discussions was Robert May, who had previously supervised Sugihara’s PhD. An ecologist by training, May had worked extensively on analysis of infectious diseases. Although May was drawn into financial research largely by accident, he would go on to publish several studies looking at contagion in financial markets. In a 2013 piece for The Lancet medical journal, he noted the apparent similarity between disease outbreaks and financial bubbles. ‘The recent rise in financial assets and the subsequent crash have rather precisely the same shape as the typical rise and fall of cases in an outbreak of measles or other infection,’ he wrote. May pointed out that when an infectious disease epidemic rises it’s bad news, and when it falls, it’s good news. In contrast, it’s generally seen as positive when financial prices rise and bad when they fall. But he argued that this is a false distinction: rising prices are not always a good sign. ‘When something is going up without a convincing explanation about why it’s going up, that really is an illustration of the foolishness of the people,’ as he put it.[14]
One of the best-known historical bubbles is ‘tulip mania’, which gripped the Netherlands in the 1630s. In popular culture, it’s a classic story of financial madness. Rich and poor alike poured more and more money into the flowers, to the point where tulip bulbs were going for the price of houses. One sailor who mistook a bulb for a tasty onion ended up in jail. Legend has it that when the market crashed in 1637, the economy suffered and some people drowned themselves in canals.[15] Yet according to Anne Goldgar at Kings College London, there wasn’t really that much of a bulb bubble. She couldn’t find a record of anybody who was ruined by the crash. Only a handful of wealthy people splashed out for the most expensive tulips. The economy was unharmed. Nobody drowned.[16]
Other bubbles have had a much larger impact. The first time that people used the word ‘bubble’ to describe overinflated investments was during the South Sea Bubble.[17] Founded in 1711, the British South Sea Company controlled several trading and slavery contracts in the Americas. In 1719, they secured a lucrative financial deal with the British government. The following year, the company’s share price surged, rising four-fold in a matter of weeks, before falling just as sharply a couple of months later.[19]
Price of South Sea Company shares, 1720
Data from Frehen et al., 2013[18]
Isaac Newton had sold most of his shares during the spring of 1720, only to invest again during the summer peak. According to mathematician Andrew Odlyzko, ‘Newton did not just taste of the Bubble’s madness, but drank deeply of it.’ Some people timed their investments better. Bookseller Thomas Guy, an early investor, got out before the peak and used the profits to establish Guy’s Hospital in London.[20]
There have been many other bubbles since, from Britain’s Railway Mania in the 1840s to the US dot-com bubble in the late 1990s. Bubbles generally involve a situation where investors pile in, leading to a rapid rise in price, followed by a crash when the bubble bursts. Odlyzko calls them ‘beautiful illusions’, luring investors away from reality. During a bubble, prices can climb far above values that can be logically justified. Sometimes people invest simply on the assumption that more will join afterwards, driving up the value of their investment.[21] This can lead to what is known as the ‘greater fool theory’: people may know it’s foolish to buy something expensive, but believe there is a greater fool out there, who will later buy it off them at a higher price.[22]
One of the most extreme examples of the greater fool theory is a pyramid scheme. Such schemes come in a variety of forms, but all have the same basic premise. Recruiters encourage people to invest in the scheme, with the promise that they’ll get a share of the total pot if they can recruit enough other people. Because pyramid schemes follow a rigid format, they are relatively easy to analyse. Suppose a scheme starts with ten people paying in, and each of these people has to recruit ten others to get their payout. If they all manage to pull in another ten, it will mean 100 new people. Each of the new recruits will need to persuade another ten, which would grow the scheme by another 1,000 people. Expanding another step would require 10,000 extra people, then 100,000, then a million. It doesn’t take long to spot that in the later stages of the scheme, there simply aren’t enough people out there to persuade: the bubble will probably burst after a few rounds of recruitment. If we know how many people are susceptible to the idea, and might plausibly sign up, we can therefore predict how quickly the scheme will fail.
Given their unsustainable nature, pyramid schemes are generally illegal. But the potential for rapid growth, and the money it brings for the people at the top, means that they remain a popular option for scammers, particularly if there is a large pool of potential participants. In China, some pyramid schemes – or ‘business cults’ as the authorities call them – have reached a huge scale. Since 2010, several schemes have managed to recruit over a million investors each.[23]
The four phases of a bubble
Adapted from original graphic by Jean-Paul Rodrigue
Unlike pyramid schemes, which follow a rigid structure, financial bubbles can be harder to analyse. However, economist Jean-Paul Rodrigue suggests we can still divide a bubble into four main stages. First, there is a stealth phase, where specialist investors put money into a new idea. Next comes the awareness phase, with a wider range of investors getting involved. There may be an initial sell-off during this period as early investors cash
