Rational Bubbles

What is it about?

As no rational agent would be willing to take part in the last round in a finite economy, it is difficult to design Ponzi schemes that are certain to explode. This paper argues that if agents correctly believe in the possibility of a partial bailout when a gigantic Ponzi scheme collapses, and they recognize that a bailout is tantamount to a redistribution of wealth from non-participants to participants, it may be rational for agents to participate, even if they know that it is the last round. We model a political economy where an unscrupulous profit-maximizing promoter can design gigantic Ponzi schemes to cynically exploit this “too big to fail” doctrine. We point to the fact that some of the spectacular Ponzi schemes in history occurred at times where and when such political economies existed—France (1719), Britain (1720), Russia (1994), and Albania (1997).

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Why is it important?

Explaining a bubble where everyone is rational is difficult. It is possible to explain a bubble when there is no last round because the number of investors can keep increasing forever. It is impossible to explain a bubble when there is a last round because no investor will take part in this last round as the bubble is sure to collapse. This paper is the first to show that it is possible to have a bubble when there is a last round if we make some assumptions from political economy. These assumptions are unrealistic most of the time. In some rare instances in history these assumptions line up; this is when we have spectacular bubbles. Based on the ideas in this paper, I wrote a satire about fraudster Bernie Madoff in the New York Times on December 18, 2008.

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