How The Greater Fools Theory Influence Bubbles : The Indicator from Planet Money History is full of financial bubbles. People speculate on real estate, stocks, coins, even flowers. Why do bubbles happen? The answer may lie in a concept known as the greater fools theory.

The Origin of Value: The Greater Fools Theory

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SYLVIE DOUGLIS, BYLINE: NPR.

(SOUNDBITE OF DROP ELECTRIC SONG, "WAKING UP TO THE FIRE")

STACEY VANEK SMITH, HOST:

This is THE INDICATOR FROM PLANET MONEY. I'm Stacey Vanek Smith.

DARIAN WOODS, HOST:

And I'm Darian Woods.

VANEK SMITH: And so, Darian, you know this, but there is this thing I've been kind of obsessing about for the last few months...

WOODS: Yeah.

VANEK SMITH: ...Which is this idea of value - like, where value comes from, why we value things the way we do, like, what gives something value. It's very interesting.

WOODS: I mean, you could write an entire Ph.D. on this.

VANEK SMITH: You could.

WOODS: But in the case of something like bread or water or gas for your car, that value is pretty obvious. But then things get fuzzier.

VANEK SMITH: They get so much fuzzier. And then especially recently, things like cryptocurrency and NFTs - you know, they pose all these questions.

WOODS: Like, you could get a video clip of a poodle jumping through a hoop that could sell for $200,000. But why?

VANEK SMITH: I know, right? I mean, in this case, I think a lot of the value of the - like, the poodle jumping through the hoop NFT, the reason you would pay $200,000 for it is that you think other people think it's valuable, that it's worth $200,000. And that is where something called the greater fools theory comes in, which does sound very judgy, I will admit.

(LAUGHTER)

WOODS: Bill Bernstein has studied the greater fools theory for years. He's the author of "The Delusions Of Crowds." He joins us after the break to talk greater fools, bubbles and how our approach to investments has evolved.

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WOODS: Today we are talking about something called the greater fools theory. And we're joined by William Bernstein, author of "The Delusions Of Crowds."

VANEK SMITH: So William, the greater fools theory - is this, like, the idea - like, if you take some cryptocurrency - like, let's take an extreme case, like Scamcoin - like, well, I kind of know that this isn't really worth anything. But I think that Bill might believe it's worth something, so I'm going to buy it. Is that how it works?

WILLIAM BERNSTEIN: Yeah. That is exactly how it works.

VANEK SMITH: I mean, is this just something humans have always done?

BERNSTEIN: Well, that's an interesting question. And I think the big break point occurred roughly the middle of - the beginning of the middle of the 17th century. You know, you have these traders coming back from the East Indies with fabulous amounts of gold and silver and jewels that they got from trading spices and other luxury goods. They would arrive in London, and London, of course, didn't really have a banking system. You had all this valuable stuff, and you didn't have a place to put it. So who were the people who were best at keeping all this valuable stuff safe? Well, it was jewelers. And so what you would do is you would bring, let's say, you know, 100 pounds of silver, and you would give it to the jeweler, and he would give you a certificate. Well, these certificates very quickly became tradable.

VANEK SMITH: Yeah, it's like paper money.

BERNSTEIN: It was paper money. Well (laughter) the jewelers, who morphed into bankers, very quickly discovered that they could print up excess certificates and they could lend them out at interest to people who needed loans.

VANEK SMITH: Oh, my God. Really? That happens, like, a little Federal Reserve?

BERNSTEIN: Exactly. And of course, you run into the problems that are all very familiar, which is that if you print up too many certificates and all of a sudden people show up at your jeweler shop and want their certificates redeemed for silver or gold...

VANEK SMITH: There's a margin call (laughter).

BERNSTEIN: Yeah. You get - yeah, you know, you get "It's A Wonderful Life." And so bankers were basically able to print money.

VANEK SMITH: OK. So we've got these jewelers who have basically become banks. And they have a certain amount of silver, but they're issuing lots and lots of certificates. And then what happens?

BERNSTEIN: So credit can expand and contract. You don't see bubbles when credit is tight. But you see bubbles at times like this when money is very easy. And then, of course, the second thing that you need to have bubbles is you need some sort of technological advance, like the internet, let's say, or NFTs. So you...

VANEK SMITH: Why do you need a technological advance?

BERNSTEIN: You need something for people to get excited about. You need a narrative. And then you get the story that people buy into, and then they borrow money to take part in the narrative.

VANEK SMITH: Is there, like, a first case of greater fools?

BERNSTEIN: The tulip bubble. And of course, that's what most people - what was the first bubble? I think that's the one they would come up with.

VANEK SMITH: I mean, I have read that, like, there was one tulip, a sort of frilly red and white tulip, I think, that was worth, like, a house.

BERNSTEIN: Yeah, it was the Semper Augustus. And an ordinary tulip is not worth that much money. But when they became infected with this mosaic virus, they would develop these very beautiful patterns. And so they were very rare. You had to find a tulip, you know, that was infected with this virus.

And yes, there's an apocryphal story about the sailor who visits the house of a rich merchant, and the merchant feeds him some herring, and the sailor is rooting around in the kitchen for some onion to have with his herring, and he slices up one of these bulbs, thinking that was an onion. And it was a bulb that was worth, you know, as you say, the price of a house. That's a very famous and almost certainly apocryphal story. But it's one that everyone remembers.

VANEK SMITH: Is there a difference between sort of the greater fools, the way it played out with the tulips, and the greater fools playing out in something like an NFT or Scamcoin? Is it the same exact thing going on? Has it evolved?

BERNSTEIN: No. It's - you know, if you read historical descriptions, all you have to do is change a couple of the names, and you might as well be reading The Wall Street Journal.

VANEK SMITH: Really? We haven't gotten more sophisticated?

BERNSTEIN: You're dealing with the two sort of memes in the book, if you will, is that, yes, we are the ape that tells - listens to your stories. But even more importantly than that, we are the ape that imitates. So when you see people around you getting rich, you want to become rich, too. And the world's most pleasing narrative is the one that - you're going to become effortlessly rich.

VANEK SMITH: Do you have any investments in cryptocurrency or NFTs?

BERNSTEIN: Oh, no. I would completely destroy my reputation. As someone who likes to immerse himself in financial history, I know how the story ends.

VANEK SMITH: Yeah.

BERNSTEIN: I mean, you see four things with a bubble, all right? The very first thing you see is when something becomes the topic of everyday conversation, everyday - so, you know, you can't get into an Uber car these days without your driver talking to you about cryptocurrency. So that's No. 1. No. 2 is when you see people quitting otherwise stable, gainful employment to trade assets, and there's descriptions of that going back to the early 18th century, of people quitting their jobs. The third thing you see is more subtle, and it took me decades to recognize this, which is that when you expressed skepticism, it's not just met with disagreement. It's met with anger.

VANEK SMITH: Oh.

BERNSTEIN: And I saw that back in the late '90s, when I would talk to my Bitcoin friends and say I've seen this movie. I know how it ends. It does not end well. And they would get angry. It always ended with these same five words, which is, you just don't get it. And then the fourth thing you see are extreme predictions.

VANEK SMITH: Although, if you had purchased Bitcoin back in the late '90s, you would be, like, a katrillionaire (ph).

BERNSTEIN: That's correct. Yeah. The trick with bubbles is, they can go on for a long time before they finally burn out. And that's, you know, one of the characteristics of bubbles, is you can feel like a fool for a very long time until the bubble meets its inevitable end.

VANEK SMITH: Oh. Do you ever wish you'd gotten into crypto in the early '90s?

BERNSTEIN: Well, in the same way that I wish, you know, I had purchased the winning lottery ticket. You don't ever want to confuse outcome with strategy. Sometimes you can have very good outcomes from very bad strategies. It is not a good strategy to invest your life savings in lottery tickets. And just the same way, it's not a good long-term strategy to participate in bubbles, although, you know, you can be wrong for short periods of time.

VANEK SMITH: Of course, Darian, sometimes those short periods of time can be, like, decades long.

WOODS: Yeah. I mean, people have made millions of dollars selling Beanie Babies, NFTs, tulips and cryptocurrencies. Does that make them fools?

VANEK SMITH: Right? I mean, they're, like, fools with private islands. I mean, maybe the greater fools are you and me who have, like, our money in government bonds or something while people are making millions of dollars jumping in and out of tulips and NFTs.

WOODS: It certainly feels like that some days.

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VANEK SMITH: This episode of THE INDICATOR was produced by Jamila Huxtable with help from Julia Ritchey. It was fact-checked by Michael He. THE INDICATOR is edited by Kate Concannon and is a production of NPR.

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