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Three Australian Asset-Price Bubbles

Three Australian Asset-Price Bubbles

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Published by: Primo KUSHFUTURES™ M©QUEEN on Sep 05, 2011
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8John Simon
Three Australian Asset-price Bubbles
John Simon
1
 According to modern economic theory—which holds that markets are ef 
 fi
cient,i.e., that share prices re
 fl 
ect intrinsic values, and that speculators are simply rational economic agents intent on optimising their wealth—the history of speculation is adull affair. In the world of ef 
 fi
cient markets there are no animal spirits, no crowd instincts, no emotions of greed or fear, no trend-following speculators, and no‘irrational’ speculative bubbles. Yet the activities of speculators down the agesappear to me to be richer, more diverse in motivation and extraordinary in result,than anything described by economists.
Chancellor (1999, p xiii)
1. Introduction
Stories of speculative bubbles and the ensuing crashes are fascinating. Whenreading through, for example,
 Extraordinary popular delusions and the madnessof crowds
by Charles Mackay (1980) one is left with the overwhelming thought,‘how could rational people behave so?’ Cautionary tales based on the Dutch tulipmania are well known, yet bubbles continue to occur. Each generation seems tobelieve that ‘this time it will be different’. Railways, electricity and the Internet areall great technological advances that spawned great speculative excess.The recurrence of speculative excess in widely differing environments suggeststhat it is, at base, a product of human nature. As such, Australia has had its fair shareof speculative excess. This paper will examine three occasions when Australia hasexperienced asset-price bubbles: the land bubble in Melbourne in the 1880s; thePoseidon nickel bubble of 1969–1970; and the stock and property market bubblesof the late 1980s. These episodes cover property markets, mining stocks and stocksmore generally; as such they provide a diversity of experience that a study of episodesin the stock market alone would miss. Mining stocks, for example, behave verydifferently to those of stocks more generally because of the inherent riskiness of the activity. The property market is different again.Nonetheless, the choice of these episodes anticipates an important discussion:What exactly is a bubble and why do these episodes qualify? While we can all pointto episodes that look like a bubble, actually tying down a de
nition, or categorisinga given episode is much harder. I turn to that question now to provide a justi
cationfor why the particular episodes listed above have been chosen.
1. I would like to thank Simon Guttmann for valuable research assistance. I would also like toacknowledge Michael Cannon and Trevor Sykes, whose books on the Melbourne land boom andPoseidon bubble proved invaluable resources. Tony Richards, Luci Ellis and seminar participantsat the RBA provided useful comments.
 
9Three Australian Asset-price Bubbles
2. What is a Bubble?
One of the more common things said of bubbles is that ‘you know one whenyou see one’. Unfortunately this means different things to different people. Someeconomists do not believe that there have been any asset market bubbles – merelyexamples of unrealised expectations.
2
Others even suggest that periods of ‘irrationaldespondency’ are more common than periods of ‘irrational exuberance’.
3
Thereare numerous academic papers discussing whether certain episodes are, or are not,bubbles and there is no consensus in the literature.
4
To answer the question posed I begin with a brief presentation of four famousbubbles; this serves to outline the data underlying this discussion. Section 2.2 thendiscusses previous academic writing on bubbles and their classi
cation of variousbubble episodes. I argue that most of these papers do not provide a satisfactoryde
nition of bubbles. Instead, I propose a slightly different approach to identifyingbubbles and provide a de
nition of bubbles based on that approach in Section 2.3. Thisde
nition forms the basis for calling the episodes selected in this paper ‘bubbles’.
2.1 Four famous bubbles
I start my de
nition using the following events: the South Sea bubble, railwayspeculation in the 19
th
century, the US stock market in 1929, and the Internet bubbleon the NASDAQ. There have been many more speculative bubbles throughout history.Kindleberger (2000), Mackay (1980) and Chancellor (1999) provide informativereading for those interested in more details and examples. The examples presentedhere are intended to provide a representative rather than exhaustive sample.
2.1.1 The South Sea bubble
5
The South Sea bubble primarily involved trading in the shares of the South SeaCompany in 1720. This company was formed in 1711 by a group of merchants andgiven a monopoly on British trade with the South Seas – Spain’s South Americancolonies – in exchange for taking over some British government debt. A problemwas that Spain was unwilling to allow much British trade.
6
Thus, the actual tradeinvolved in the company’s activities was relatively limited. Rumours of tradeagreements with the King of Spain helped fuel some speculation. The bubble was,however, based around a purely
nancial transaction.
2. See Garber (1990).3. See Siegel (2003).4. Section 2.2 provides more details about the relevant literature.5. See Mackay (1980, pp 46–88) and Chancellor (1999, pp 58–95) for further details.6. The only trade allowed was to provide slaves to the Spanish colonies and one general trade shipper year of a restricted tonnage and cargo value from which the King of Spain, in any case, tooka substantial cut of the pro
ts.
 
10John Simon
In 1719 it was proposed that the entire British government debt would be privatised – holders of government debt would be offered shares in the South Sea Companyin exchange for their debt. This arrangement offered a number of potential bene
ts:the South Sea Company was offering to re
nance the debt at a lower interest rate,so the government would lower its interest costs; debt holders were being offeredtradable equity securities in exchange for their non-tradable debt; and the SouthSea Company was hoping to pro
t as the middleman. However, the South SeaCompany also sought to improve its pro
t through other means. The South SeaCompany in
ated the price of its shares in the market and then offered debt holdersshares whose market value was higher than the value of their debt holdings butwhose nominal value was much lower. The company made easy credit availableto shareholders: shares were offered for sale on 20 per cent deposit, effectivelylending the remaining 80 per cent, the money gained through this offer was usedto offer loans to existing stockholders (secured against their stock) who wished tobuy more stock. This served both to increase demand and reduce supply as sharesused to collateralise loans were held by the company. These activities look muchlike a pyramid scheme where money from early investors is used to attract furtherinvestors. In addition to offering loans, demand was further stimulated by announcingan increase in the dividend payable.
7
The South Sea bubble occurred over about 7 months in 1720. Company sharesare reported to have risen from £130 on February 1 to around £1 000 on August 1.The rise in South Sea Company shares helped to fuel a more general speculativefever in England. Across the Channel, John Law’s Mississippi scheme, whosegeneral principles were copied in the South Sea scheme, had caught the Frenchimagination. Companies were
oated in Exchange Alley with dubious businessplans. The accounts in Mackay (1980) and Chancellor (1999) suggest that manycompanies were started merely to raise capital from speculators and then abscondwith the cash. The most famous of these is the, possibly apocryphal, ‘company forcarrying on an undertaking of great advantage, but nobody to know what it is’.
8
 The FT Actuaries All-Share Index provides a picture of the price movements atthis time (Figure 1).The index shows that overall stock prices rose almost four-fold in as manymonths. Nonetheless, like all bubbles, the collapse was just as rapid; from a peakof over £1 000 at the beginning of August, shares in the South Sea Company fellto £580 on September 12 and £150 on September 30. The general index mirrorsthese movements.The simplest reason for the crash is that the pyramid scheme collapsed when newinvestors slowed and the principals started selling up. The fraudulent activities of many of the fringe companies also soured investors on stocks in general. Subsequently,parliamentary enquiries were established and many of the directors of the companyconvicted of various fraudulent activities.
7. The source of the money to fund the higher dividend was not made clear.8. See Mackay (1980, p 55) and Chancellor (1999, p 72) on this particular South Sea bubblecompany.

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