What cause a bubble?

Allen and Gale (Bubbles and Crises, 1998) develop an asset-pricing model to explain how the agency problem results in asset bubbles. Before obtaining fund by issuing debt, borrowers may claim that they will invest the fund in relatively safe projects. However, they may break their promise after getting the money since risky assets are more likely to bring them excess return above debt payment. Thus, they bid the risky asset at the price above the fundamentals and such price departure leads to bubbles. Unfortunately, lenders are unable to observe such moral hazard caused by ex post asymmetric information. Therefore, even if the investors are rational, bubbles also exist.

Although this model is not perfect to explain the Mississippi Bubble, we can also find the agency problem in it. Law prints money in order to stimulate the economy. If we regard the money as lending (because Law can print money if he wants, the money creation can be considered as credit expansion), then we can observe the agency problem. The public spend all the paper money to buy the shares. They believe the share price would keep increasing. Thus, they are willing to buy shares at a high price level, resulting in the sharp rise in stock price and large departure between the market price and fundamental price. For example, the share price increased from 8000 livers to 10000 livers in a single day (the story is shown in the last post).

Second, technological revolutions also contribute to bubbles. Pastor and Veronesi (Technological Revolutions and Stock Prices, 2009) indicate that “academics studying bubbles know that a technological revolution took place, but investors living through the revolution were uncertain as to the eventual impact of the new technologies”.

The “issuing of paper money” can be regarded as a technology revolution in Mississippi Bubble. What is the value of paper money? Why is some money equal 20 pound while others are worth 50 pound? How can we know we are sure to get the same amount of money through this piece of paper? We are willing to hold money since it is guaranteed by governments. Meanwhile, governments will not print money without any restriction in case a hyperinflation occurs. In the Mississippi Bubble, the public also believe that the value of banknotes equals to equivalent metallic currency at first. They trust the government. However, they have not though about why they obtain so much paper money. They fail to realize the money they hold is not worth the number on the paper. Thus, the public think they become rich and the wealth is brought by Law’s company. In fact, it is only a “Money illusion”.