What we learn from the biggest bubbles in history

What exactly is a bubble and what can we learn from past experiences that can tell us about today’s mania in the cryptocurrency markets?

First of all, every market bubble is different from the last. In fact usually so much so that ‘this time is different’ is proclaimed loudly enough by the believers they become deaf to the naysayers. 

Patterns vary, as do the causes of bubbles. The South Sea Bubble was little more than a fraud that went to the highest echelons of 18th century British society; the tulip mania in Holland was a classic speculative boom where the greater fool theory played out to perfection. 

And for this reason, that the collective memory has forgotten the last bubble, bubbles are able to keep recurring despite all the warnings from the more cautious among us. 

But all are based on a foolhardy assumption that prices will keep rising, no matter what, for once “a golden bait [is] hung temptingly out before the people”, it is almost impossible to resist.

You don’t know it’s a bubble until after the party is over

When does a bubble start? It’s usually quite hard to tell. Bitcoin has exhibited classic signs in terms of the parabolic shape of the price chart, but is this really the stage of euphoria, or is it just getting started. It’s impossible to tell until after the event. 

Although house prices were skyrocketing, few investors truly realised the US mortgage bond market was in a bubble of its own, largely because the ratings agencies failed to assess risks correctly. 

Investors and markets fail to accurately price securities when they are either new or are influenced directly by something new. 

Likewise, one could argue that US stock market valuations are currently in a bubble that is more dangerous to the financial system than cryptocurrencies are.

According to the cyclically adjusted price-to-earnings ratio devised by professor Robert Shiller, equities have only been this expensive once before – just before the dotcom bubble burst.

The danger with US equity prices is that not only are they excessively valued, but no one seems to think it’s a problem.

However, there is a consistency in the way many bubbles start – disruption in the market. Sometimes called displacement, this is often a technological shift (dotcom bubble), or can be down to a new discovery (tulip bulbs being brought to Europe).

In the case of the US housing bubble, it was an economic policy shift. The Federal Reserve’s benchmark rate fell from 6.5 per cent in May, 2000, to 1 per cent in June, 2003, fuelling the sub-prime market.