A speculative bubble is a social epidemic whose contagionis mediated by price movements. News ofprice increase enriches the early investors, creating word-of-mouthstories about their successes, which stirenvy and interest. The excitement then luresmore and more people into the market, which causes prices to increase further,attracting yet more people and fueling “new era” stories, and so on, in successive feedbackloops as the bubble grows. After the bubble bursts,the same contagion fuels a precipitouscollapse, as falling prices cause more and more people to exit the market, andto magnify negative stories about the economy.

But, before we conclude that we should now, after the crisis, pursuepolicies to rein in the markets, we need to consider the alternative. In fact,speculative bubbles are just one example of social epidemics, which can be evenworse in the absence of financial markets. In a speculative bubble, thecontagion is amplified by people’s reaction to price movements, but social epidemics do not need markets or prices toget public attention and spread quickly.

Some examples of social epidemics unsupportedby any speculative markets can be found in Charles MacKay’s 1841 best seller Memoirs of Extraordinary Popular Delusions and theMadness of Crowds.The book made some historical bubbles famous: the Mississippi bubble1719-20, the South Sea Company Bubble 1711-20, and the tulipmania of the 1630’s. But the book contained other, non-market,examples as well.

MacKay gave examples, over the centuries, of social epidemics involvingbelief in alchemists, prophets of Judgment Day,fortune tellers, astrologers,physicians employing magnets, witch hunters,and crusaders. Some of these epidemics hadprofound economic consequences. The Crusades from the eleventh to thethirteenth century, for example, brought forth what MacKay described as“epidemic frenzy” among would-be crusadersin Europe, accompanied by delusions that God would send armies of saints tofight alongside them. Between one and three million people died in theCrusades.

There was no way, of course, for anyone either to invest in or to betagainst the success of any of the activities promoted by the social epidemics –no professional opinion or outlet for analysts’ reports on these activities. Sothere was nothing to stop these social epidemics from attaining ridiculousproportions.

MacKay’s examples may seem a bit remote to us now. Some examples that wemight relate to better can be found in the communist, centrally plannedeconomies of much of the twentieth century, which also had no speculativemarkets. To be sure, events in these economies might seem attributable simplyto their leaders’ commands. But social contagionstook hold in these countries even more powerfully than they have in our“bubble” economies.

China’s Great Leap Forwardin 1958-61 was a market-less investment bubble. The plan involved bothagricultural collectivization and aggressivepromotion of industry. There were no market prices, no publishedprofit-and-loss statements, and no independent analyses. At first, there was alot of uninformed enthusiasm for the newplan. Steel production was promoted by primitivebackyard furnaces that industry analystswould consider laughable, but people whounderstood that had no influence in China then. Of course, there was noway to short the Great Leap Forward. The result was that agricultural labor andresources were rapidly diverted to industry,resulting in a famine that killed tens of millions.

The Great Leap Forward had aspects of a Ponzischeme, an investment fraud which attempts to draw in successive rounds ofinvestors through word-of-mouth tales of outsizereturns. Ponzi schemes have managed to produce great profits for theirpromoters, at least for a while, by encouraging a social contagion ofenthusiasm. Mao Zedong, on visiting and talking to experts at a modern steelplant in Manchuria, is reported to have lostconfidence that the backyard furnaces were a good idea after all, but fearedthe effects of a loss of momentum. He appears to have been worried, like themanager of a Ponzi scheme, that any hint of doubt could cause the wholemovement to crash. The Great Leap Forward, and the Cultural Revolution thatfollowed it, was a calculated effort to create a social contagion of ideas.

Some might object that these events were not really social epidemics likespeculative bubbles, because a totalitariangovernment ordered them, and the resulting deaths reflect governmentmismanagement more than investment error. Still, they do have aspects ofbubbles: collectivization was indeed a planfor prosperity with a contagion of popular excitement, however misguided itlooks in retrospect.

The recent and ongoing world financial crisis palesin comparison with these events. And it is important to appreciate why. Moderneconomies have free markets, along with business analysts with theirrecommendations, ratings agencies with their classifications of securities, andaccountants with their balance sheets and income statements. And then, too,there are auditors, lawyers and regulators.

CommentsAllof these groups have their respective professional associations, which holdregular meetings and establish certificationstandards that keep the information up-to-date and the practitioners ethical intheir work. The full development of these institutions renders really seriouseconomic catastrophes – the kind that dwarf the 2008 crisis – virtuallyimpossible.