In the presence of bubbles, asset prices consist of a fundamental and a component, with the bubble component following an explosive dynamic. The general idea for bubble identification is to apply explosive root tests to a proxy of the unobservable bubble. This chapter provides a theoretical framework that incorporates several definitions of bubbles (and fundamentals) and offers guidance for selecting proxies. For explosive root tests, we introduce the recursive evolving test of Phillips, Shi, and Yu (2015a,b) along with its asymptotic properties. This procedure can serve as a real-time monitoring device and has been shown to outperform several other tests. Like all other recursive testing procedures, the PSY algorithm faces the issue of multiplicity in testing. We propose a multiple-testing algorithm to determine appropriate test critical values and show its satisfactory performance in finite samples by simulations. To illustrate, we conduct a pseudo real-time bubble monitoring exercise in the S&P 500 stock market from January 1990 to June 2020. The empirical results reveal the importance of using a good proxy for bubbles and addressing the multiplicity issue.

Chapter 1 introduces the reader to macro-prudential policy and exposes the reader to the problem of persistently instable financial markets, which raise the question of if and how far the macro-prudential regulatory program post-crisis had any effect. In contrast to binary paradigm shift views, which see no to little change, I introduce a multidimensional view of regulatory change that can detect massive change in the economic ideas underlying financial regulation, while pointing to the administrative and political limitations that prevent these ideas from becoming fully performative. Pointing to these contradictions, the chapter introduces the analytical framework and the main contributions of the book, followed by an outline of the different chapters.

The South Sea Bubble of 1720 was Britain’s first modern financial crisis. This chapter uses digital tools to study the development, during the early eighteenth century, of a conceptual framework describing bubbles in the financial market. It traces the emergence of the phrase ‘South Sea Bubble’ in the months and years after the crisis, alongside the more complicated patterns of evolution in what that phrase describes, ultimately arguing that there is little resemblance between the ‘South Sea Bubble’ of the 1720s and that of the present-day historical imagination. The chapter’s final claim is that the conceptual framework underpinning how we understand present-day financial crises has its origins in the latency of the words used, at the time, to describe the emerging and interlinked crises of 1720.

This chapter highlights the strong relationship between dialogue and political moderation by drawing on the ideas of J. S. Mill’s On Liberty (1859). It makes a plea for cultivating the civil art of disagreement that is vital to our free and democratic way of life.

Chapter 4 examines the bubble in railway shares which occurred in the UK in the mid-1840s. Railway share prices more than doubled between 1843 and the autumn of 1845. In addition, there was a promotion boom with hundreds of new railways being authorised by Parliament. By the autumn of 1845, 562 new railway schemes had been submitted to Parliament. Following several major newspaper editorials regarding this folly, the bubble came to an end. The chapter then moves on to discuss the causes of the bubble. The incorporation of hundreds of railway companies by Parliament resulted in an increase in marketability. In terms of money and credit, interest rates were at an historical low and part-paid shares leveraged the buying of shares. The railway bubble witnessed the democratisation of speculation, with many middle-class individuals buying shares for the first time. The spark which set the bubble fire alight was the Railway Act. This Act signalled that railways had the potential to be very remunerative investments. It also created the Railway Board, which was a means of coordinating applications to build railways so that a national rail network was constructed. The chapter concludes by examining the consequences of the bubble, arguing that the bubble was a deeply inefficient way to create a national rail network, and much too wasteful to be considered useful.

Chapter 11 examines the stock market bubbles which occurred in China in 2007 and 2015. Between the end of 2005 and October 2007, the stock market soared by over 400 per cent. One year later, the market had fallen by 70 per cent. Similarly, in the year before June 2015, the stock market had increased by more than 150 per cent. It then collapsed by more than 50 per cent in under three months. The chapter discusses how, in the space of 20 years, China went from having almost no marketability to having heavily controlled marketability, and then near-free marketability. China also went from having virtually no middle class to having the world’s largest middle class, which then became the new speculating class. Thanks to margin lending, they were able to borrow heavily to finance their investments. Both bubbles are very clear examples of how and why governments engineer bubbles in the first instance. In 2007 the Chinese authorities needed to stimulate privatisation and in 2015 they needed to unwind the largest economic stimulus in history.

Chapter 12 is the conclusion of the book. The chapter starts by arguing that the bubble triangle can explain why the cryptocurrency bubble occurred in 2017. It then asks whether the bubble triangle is a good predictive tool. The answer to that question is yes, but bubbles are still difficult to predict because the sparks are difficult to discern. The bubble triangle is also able to predict which bubbles will be destructive (politically sparked bubbles with high bank lending) and which will be useful (technology sparked bubbles with low leverage). The chapter then moves on to look at what governments could do to prevent bubbles. However, since political bubbles are often created because they are in the government’s interest, governments cannot be relied upon to take these measures. The question then arises as to whether the news media can alert investors to the presence of bubbles. The answer to this question very much depends on whether they have the incentive to do so, and this incentive appears to be diminishing over time. The chapter concludes by arguing that investors need to build broad mental models, which include history, if they are to have any chance of predicting bubbles.

Chapter 3 examines the bubble that occurred in the UK in 1824 and 1825. This bubble concerned the promotion of Latin American mining companies and various new companies on the London stock market. The price of mining shares quintupled and those of other new companies more than doubled between August 1824 and February 1825. Over the next year, the prices of these stocks plummeted. This was then followed by one of the most serious banking crises ever to hit the UK. The chapter then moves on to discuss how all three sides of the bubble triangle were in play. Marketability had been revived by the liberalising attitudes of MPs in the UK Parliament. Part-paid shares leveraged the buying of shares and, allied to low denominations and low returns on other assets, stimulated speculation. The spark which set the bubble fire alight was a change in government policy towards Latin America and the corporation. The chapter concludes by examining the consequences of the bubble. The post-bubble banking crisis which started in December 1825 resulted in the collapse of many banks and was followed by a very deep recession.

Chapter 2 examines the first financial bubble, which occurred in 1720. Following the War of the Spanish Succession, the countries of Europe, particularly France and Britain, were heavily indebted. John Law invented the bubble in order to help the French government reduce their debt burden. He did so by creating a scheme whereby the Mississippi Company would refinance the government debt. Following Law’s lead, the directors of the South Sea Company proposed a similar scheme to refinance Britain’s public debt. Subsequently, the shares prices of the both the Mississippi Company and South Sea Company exploded and then dramatically collapsed. In addition, in Britain there were nearly 200 bubble companies floated on the stock market and the shares of existing companies also experienced a bubble. The chapter briefly discusses similar episodes elsewhere, especially in the Netherlands, but none of these were on the same scale as in Britain or France. The chapter then moves on to discuss the causes of the bubble. The debt conversion schemes turned unmarketable government debt into very marketable company shares. Part-paid shares leveraged the buying of shares in both countries and John Law’s bank meant that France’s entire monetary policy was directed towards creating the bubble. The bubble’s creators were also adept at stimulating speculative investment. The chapter concludes by examining the consequences of the bubble, which were severe and long-lasting in the case of France and minor in the case of Britain.