These go to eleven...

What does a quote from the excellent This is Spinal Tap have to do with bubbles?  In the film, Nigel gives Marty a lesson on amplifiers: that’s what this post is all about.  What if an amplification process leads to asset prices rising rapidly?  Sticking to the musical theme, Shiller (2000) describes this as a “positive feedback loop”. 

These don't go to 11. (photograph permitted under the Creative Commons
Attribution Share - Alike 3.0 Unreported License)

Let’s break this down into an abstract representation.  Suppose person A buys x at a price of 10.  This then increases in value to 11 (these go to eleven…).  Person B sees this (maybe person A has been boasting about how much money they have made), and buys x at 11.  Then x increases to 13.  Seeing this, person C buys x at 13; x increases to 16.  During each stage, people are drawn into buying the asset as the price increases from its previous level.  This in turn leads to further increases in the price of x.

Mackay (1841) notes how this manifests itself in real life.  As people start to make money, confidence in the asset grows, leading more people to invest and make money.  In turn, confidence in the asset increases still further.  Increasing levels of confidence in an asset – based on the past increases in price - lead to these increased price of the asset in question.  Galbraith (1954) noted how this confidence multiplier was present in the Florida real estate bubble of the early twentieth century.  Liebenstein (1950) used the “bandwagon effect” to describe similar activity. 

Initial price increases in gold can lead to increased confidence in the value of the asset, in turn leading to an increased price of the asset, and so on.  A positive feedback loop is born, and the price of gold increases to dizzier new heights.  Has this been happening?  The next post will look at this in more detail (and I have a few of my own home made charts to show off!).