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How the theory of economic bubbles rose, popped, and rose again

The boom-and-bust economic model has emerged stronger than ever after the Great Recession, and is supported by a new study showing it's not as simplistic as economists thought in recent decades.

How a theory about selfishness rose to academic prominence

The phrase "bubble" came into use in the 1700s as a reference to the fallout of the South Sea Company's financial ruin, caused by inflated stock prices. Bubble cards like this one were used to share the story:

A bubble card. Printed for Carington Bowles, 1721.

Baker Library, Harvard College

Bubble cards helped people spread information about personal financial crises and, sometimes, salvation; the poem on the card above describes a wealthy landowner who shared the profits of South Sea stock with a few lucky servants, before the price crashed:

A Certain Good Old Worthy Rich in Land,

Keeping His Servants Wages in his Hands,

Bought South Sea Stock, when they knew nothing of [it?]

Sold it when High, and gave to them the Profit.

Bubbles, but for economic models

In the modern age, the boom-and-bust theory (of which bubbles are a part) was used to explain why markets collapse when they seem to reach their highest peaks: what goes up must come down. Markets have cycles because human behavior is somewhat predictable. Then the rise of a volatile, globalized economy after World War II led economists to doubt whether a model based on predictable behavior made sense in a postmodern age. An alternative approach gained popularity because it didn't assume the reliability of macroeconomic behavior, as Bloomberg View's Noah Smith explains:

...macroeconomists turned to the "trend-plus-shocks" model that they still mostly use today. But since the grand debacle of 2008 and 2009, there has been a lot of pressure on macroeconomic theorists, from both within academia and without (but mostly from without), to discard old ideas and try new ones.

How the bubble came back

The dot-com bubble returned the concept of reliably depressing business cycles to our national conversation, since it was an event in which thousands of Americans lost or won life savings based on speculation, inflated prices, and greed. Google Trends shows the bubble returned again to the national conversation right around the Great Recession, as well, and has not really gone away since then:

A new study by Paul Beaudry, Dana Galizia, and Franck Portier argues that, in fact, business cycles do exist. They're a little more difficult to see in the wake of unexpected events that shake markets. The business cycle is like the gravity of the moon forming tides every day; but an earthquake — or shocks — can trigger a random event, like a tsunami: may well be that economic forces naturally produce cyclical phenomena; that is, in the absence of any shocks (including shocks to agents’ beliefs) economic forces by themselves may favor recurrent periods of high economic activity followed by periods of low economic activity. This sort of outcome will arise, for example, if the underlying economic system generates a limit cycle. In such a framework, irregular business cycles can emerge from these underlying regular forces when combined with shocks that move the system away from an attracting orbit.

Researchers considered a two-person household trying to buy a good (say, food) and simultaneously look for employment. At the moment of initial purchase, the state of employment is unknown. As time goes on, the longer the household is without income, the more conservative their purchase choices become:

In particular, a fall in the employment rate causes buyers to reduce their purchases, since they fear ending up in the unemployment state with debt that is costly to serve. This mechanism is central to the strategic complementarity that emerges in the model, which in turn is necessary to generate local instability and limit-cycle dynamics.

Planning for the future while random events happen — outside of one's control — is an age-old reality far from retirement.