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It has become almost mainstream that bubbles are an important cause of economic recessions. The main question posed by experts is how one knows when a bubble is forming.

The common view is that if the central bankers knew the answer to this question then they might be able to prevent bubbles from forming in the first place and thus prevent recessions.

A Nobel Laureate in economics, Robert Shiller, argued that bubbles could be diagnosed using the same methodology that psychologists use to diagnose mental illness.

Shiller is of the view that a bubble is a form of psychological malfunction. Hence, the solution could be to prepare a checklist similar to those used by psychologists in order to determine, for example, if someone is suffering from depression. The key factors that typify a bubble, according to Shiller, are:

Sharp increases in the price of an asset. Great public excitement about these price increases. An accompanying media frenzy. Stories of people earning a lot of money, causing envy among people who aren’t. Growing interest in the asset class among the general public. New era “theories” to justify unprecedented price increases. A decline in bank lending standards.

What Shiller outlines here are various factors that he holds are observed during the formation of bubbles. Such a description, however, does little in providing an understanding as to the key causes underlying the emergence of such bubbles.

In order to understand the causes one needs to establish a proper definition of the object in question. The purpose of a definition is to present the essence, the distinguishing characteristic of the object one is trying to identify. A definition is meant to inform us as to the fundamentals or the origins of a particular entity. On this, the seven points outlined by Shiller tell us nothing about the origins of a typical bubble. Neither do they tell us anything as to why bubbles are bad for economic growth.

Defining Bubbles

If the price of an asset is the amount of money paid for it, then it follows that for a given amount of a given asset, an increase in its price can only come about as a result of an increase in the flow of money to this asset.

The greater the expansion of money, the higher the increase in the price of the asset, all other things being equal. We can re-phrase this by saying that the greater the expansion of the monetary balloon, the higher the prices of assets, all other things being equal.

The emergence of a bubble or a monetary balloon need not be always associated with rising prices — for instance, if the rate of growth of goods corresponds to the rate of growth of the money supply then no change in prices will take place.

We suggest that what matters is not whether the emergence of a bubble is associated with price rises but rather with the fact that the emergence of a bubble gives rise to the emergence of non-productive activities that divert real wealth from wealth generators.

The expansion of the money supply, or the monetary balloon, in similarity to a counterfeiter, enables the diversion of real wealth from wealth generating activities to non-productive activities.

As the monetary pumping strengthens, the pace of this diversion accelerates. We label various non-productive activities that emerge on the back of this expanding monetary balloon as bubble activities — they were formed as a result of the monetary bubble.

Also note that these activities cannot exist without the expansion of the money supply that diverts real wealth to them from wealth generating activities.

Bubbles Aren't Created by Price Increases — They're Created by Misallocation of Resources

From this we can infer that the subject matter of bubbles is the expansion of the money supply. The key outcome of this expansion is the emergence of non-wealth-generating activities.

It follows that a bubble is not about strong asset price increases but about the expansion of the money supply and the resultant misdirection of resources. In fact, as we have argued, bubbles — i.e., the products of an increase in the money supply — can take place without a corresponding increase in prices.

Once we have established that an expansion in the money supply is what bubbles are all about, we can further infer that the key damage that bubbles generate is by stimulating non-productive activities, which we have labeled as bubble activities.

Furthermore, once it is established that formation of bubbles is about the expansion in the money supply it is obviously the central bank and fractional reserve banking that are responsible for the formation of bubbles. As a rule it is the central bank’s monetary pumping that sets in motion an expansion of the monetary balloon.

The Kay Factor in Bubbles: Central Banks

Hence to prevent the emergence of bubbles one needs to arrest the monetary pumping by the central bank and to curtail the commercial banks’ ability to engage in fractional reserve banking, i.e., in lending out of “thin air.”

Once the pace of monetary expansion slows down, in response to a tighter central bank stance or in response to commercial banks reducing their expansion of lending out of “thin air,” the inevitable bursting of these bubbles begins.

Remember that a bubble activity cannot fund itself independently of the monetary expansion that diverts to it real wealth from wealth generating activities. (Again bubble activities are non-wealth generating activities.)

The so-called economic recession associated with the bursting of bubble activities is in fact good news for wealth generators, since now more wealth is left at their disposal. An economic bust, which weakens bubble activities, lays the foundation for genuine economic growth.

Note again that it is the expansion in the monetary balloon that gives rise to bubble activities and not the psychological disposition of individuals in the market place.

Psychology and Economics

Psychology was smuggled into economics on the grounds that economics and psychology are inter-related disciplines. However there is a distinct difference between economics and psychology. Psychology deals with the content of ends.

Economics, however, starts with the premise that people are pursuing purposeful conduct. This is a general behavioral phenomenon — it doesn’t deal with the particular content of various ends.

According to Rothbard,

A man's ends may be "egoistic" or "altruistic," "refined" or "vulg." They may emphasize the enjoyment of "material goods" and comforts, or they may stress the ascetic life. Economics is not concerned with their content, and its laws apply regardless of the nature of these ends.

Whereas,

Psychology and ethics deal with the content of human ends; they ask, why does the man choose such and such ends, or what ends should men value?

Therefore, economics deals with the fact that men have ends and utilize means to attain these ends. Consequently, economics is a separate discipline from psychology.

By introducing psychology into economics one obliterates the generality of the theory, and renders it useless. Therefore the use of psychology is counterproductive as far as economic analyses are concerned.

Contrary to Shiller, in order to establish that a bubble is forming we don’t need to apply the same methodology employed by psychologists. What we require is the establishment of a correct definition of what bubbles are all about.

Once this is done one discovers that, contrary to popular thinking, bubbles have nothing to do with some kind of psychological malfunction of individuals — they are the result of loose monetary policies of the central bank.

Furthermore, once we observe an increase in the rate of growth of the money supply we can confidently say that this sets in place the platform for bubble activities — i.e., for an economic boom.

Conversely, once we observe a decline in the rate of growth of the money supply we can confidently say that this lays the foundations for the bursting of bubble activities — i.e., an economic bust.