Greed, self-delusion and group-think are the proximate causes of the massive investments at wildly unrealistic prices in certain assets (tangible or intangible) that capitalism experiences from time to time. It would, of course, be of little interest to most how people can delude themselves into losing large sums of money (particularly people who have immensely large sums of money to begin with), but the inevitable bust generally results in collateral consequences to many others, who neither encouraged the investment nor benefitted from it. As we are once again learning now.
Some day we will awaken, I hope, from the worship of unrestrained capitalism that our ruling class has engaged in for the past 40 years. My hope is not strong, given that we should have awakened during this latest collapse of the capital markets which crippled the world economy and was used to justify enormous wealth transfers from the working and middle classes to the wealthy creators, marketers and manipulators of the new and useless financial “products” which were the objects of the latest burst “bubble.” But we didn’t, because the class of financial overlords have co-opted both political parties (one has become a wholly-owned subsidiary; the other is just rented), because the outlets of mass information are owned by these same plutocrats or those closely allied with them, and because in general the right-wing of this country is better organized to benefit from working class fear and anger (they are actually able to mobilize the very working classes that they have plundered into their cause) than the left is organized to help.
In the hope that some day a more rational political climate might prevail (although how we get there I have no idea), I recommend a study by Georges Harras and Didier Sornette of the Department of Management, Technology and Economics of ETH Zürich. It’s published in arXiv.org and entitled “How to grow a bubble: A model of myopic adapting agents” (v2: November 11, 2010; here for abstract and for access to pdf file and other formats).
The analysis is something of a breath of fresh air because it is not constrained by the neo-orthodoxy of Magical, Self-Regulating Markets. Those clinging to that belief (which includes almost all federal legislators and every policy maker in the Executive) have to look for something unusual or peculiar to the asset overvalued. The popping of the bubble is also seen as some sort of unforeseeable, random event.
The paper of Harras and Sornette makes different assumptions. They show how a bubble is grown over a long period of time. It’s inevitable given what they call a “global cooperative herding mechanism.” They show how at a certain point investment decisions influence the decision of others to invest and create a feedback loop. It doesn’t depend on any kind of program-trading models or other kind of collusion (for lack of a better word). “Paradoxically,” they conclude, “it is the attempt for investors to adapt to the current market regime which leads to a dramatic amplification of the price volatility. A positive feedback loop is created by the two dominating mechanisms (adaptation and imitation) which, by reinforcing each other, result in bubbles and crashes.”
You should read the paper itself for details. It’s a somewhat elegant proof of the proposition. Once the bubble reaches a certain unstable point, the bursting can be caused by the slightest event:
“A crash occurs because the market has entered an unstable phase toward the culmination of a bubble and any small disturbance or process may reveal the existence of the instability. Think of a ruler held up vertically on your ﬁnger: this very unstable position will lead eventually to its collapse, as a result of a small (or an absence of adequate) motion of your hand or due to any tiny whiﬀ of air. This is the proximal cause of the collapse. But the fundamental cause should be attributed to the intrinsically unstable position.”
The elegance of the analysis, of course, will be used against it by our policy-makers. To them the obvious, especially when supported by proof, cannot be true. Wisdom only comes from those who make obscene amounts of money. The fact that they make obscene amounts of money shows the truth of that argument. Q.E.D. That’s why when they are wrong, we, who have neither their money nor their wisdom, are required to bail them out.