WaPo | The market gyrations involving GameStop’s 64-fold rise in price since August are certainly eye-opening. How a money-losing company whose stock previously traded less than 10 million shares a day can shoot up to trading 50 million-plus shares in a day — and cause the stock price of a completely unrelated but similarly named Australian company (GME Resources) to rise 50 percent on Thursday — is hard to reconcile with today’s uber-efficient high-frequency markets.
Media coverage routinely refers to GameStop’s price surge as a bubble. But what are financial bubbles — and what causes them? As I noted when writing about bubbles in 2008 in the Review of Financial Studies, the phenomenon had been around for centuries — in the 18th century, Scottish economist Adam Smith called it “overtrading.” But that doesn’t explain what starts a bubble in the first place. Plenty of economists, historians and others have tried.
The Swedish economist Knut Wicksell, in an observation that resonates today, argued in 1898 that bubbles are attributable to interest rates that are too low. In 1929 — we know what happened in the markets then — the Dutch economist historian N.W. Posthumus cited the entrance of nonprofessional buyers fueled by credit. In this view, today’s Federal Reserve and the Reddit crowd would seem natural culprits.
An alternative view in history is that bubbles can emerge if traders are rational but markets are irrational. The economist and historian Charles P. Kindleberger makes this argument in his classic 1978 book, “Manias, Panics, and Crashes: A History of Financial Crises.” What drives market irrationality, Kindleberger says, is the fallacy of composition: Each trader believes he can sell at a higher price, and if he can in fact do so, then it is rational for him to buy. But not everyone in the market can do that, so the market as a whole behaves irrationally.
A variant on this irrationality of the market theme underlies the “beauty contest” analogy offered in 1936 by the English economist John Maynard Keynes. He argued that individuals do not pick stocks based on what they think a firm is worth, but rather on what they think other people will think it is worth. (Has Keynes’s “beauty contest” morphed into today’s “chat room”?) In that description, each individual is acting rationally, but the market overall is not.
Short sellers in GameStop — mostly hedge funds that had been betting massively on the company’s stock to fall — had reportedly lost $23.6 billion as of Wednesday. They may find little consolation in the dictum often attributed to Keynes: “Markets can stay irrational longer than you can stay solvent.”
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