I’m obviously late to the game when it comes to talking about the Bubble (or not), but I wanted to present a different way to make sense of all the discussion going on [1].

A bubble shouldn’t be defined by the amounts of money being spent, the number of people doing startups, the sky-high valuations and so on, (although typically they are all symptoms of being in a bubble), but instead by looking at people’s motivations. This is what typically changes in a bubble. Normally, investors and entrepreneurs are motivated by the fundamentals in a market or in a business. This is great, where there is a problem to be solved or an inefficiency to be eliminated, the opportunity is seized.

However, what soon happens is that this behaviour, when successful, motivates other people to start doing the same, and eventually you end up with people starting companies, writing facebook applications, and making investments not because of the fundamentals, but because everyone else is. When this happens, you know you’re in a bubble.

So, ask yourself, do you know of people starting companies (or writing facebook apps) because everyone else is? Do you see investors making investments to “not miss out” rather than because of a business’ merits? Therein lies a better way to answer the question.

Because people are heavily influenced by what other people are doing, bad decisions become more common (and ‘noise’ is introduced into the market).

I’m expounding a framework that I read in Critical Mass [2], a great book that incidentally is one of the few books not to be panned in The Black Swan.

[1] – In my first meeting with a VC when I went to San Francisco in January, I asked him if he thought there was a bubble, his answer was yes. After the Y Combinator Winter program in March, I asked Paul Graham, and his answer was no. Obviously people use different metrics. And I’ve been thinking about it for far too long.
[2] – In fact, Mr Ball (the author) says talks of bubbles and crashes is also wrong – cycles don’t exist, just continuous fluctuations. He has an excellent blog, and this post is particularly good.

To quote some of it:

“Everyone knows that market statistics, such as commodity values, fluctuate wildly over a wide range of timescales (while, in the long term, showing generally steady growth). There is nothing particularly remarkable or surprising about that: clearly, the economy is a complex system (one of the most complex we know of, in fact), and such systems, whether they be earthquakes or landslides or biological populations or electronic circuits, show pronounced and seemingly random noise. What is unusual about economic noise, however, is that an awful lot of money rides on it.

That is why, rather than regard it indeed as noise, economists and market analysts are desperate to ‘explain’ it. Imagine a physicist looking through a magnifying glass at the wiggles in her data, and deciding to find a causal explanation for each individual spike. But that is precisely the game in market analysis.

The standard approach to this aspect of economic theory is as revealing as it is disturbing. Economic noise is a ‘bad thing’, because it seems to undermine the notion that economists understand the economy. And so it is banished. Noise, they say, has nothing to do with the operation of the market. In the ‘neoclassical’ theory that dominates all of academic economics today, markets are instantaneously in equilibrium, so that they display optimal efficiency and all goods find their way effectively to those who want them. So the marketplace would run as smoothly as the Japanese rail network – if only it did not keep getting disrupted by external ‘shocks’.

These shocks come from factors such as technological change – an idea that stems back to Marx – which force the market constantly to readjust itself. The very language of this process, in which economists talk of ‘corrections’ to the market, betrays their insistence that none of this is the fault of the market itself, which is simply doing its best to accommodate the nasty outside world. “Nothing more useless than listening to a newscaster tell us how the market just made a little ‘correction’”, says Joe McCauley of the University of Houston, who believes that ideas from physics can help explain what is really going on in economics. (I have a forthcoming article in Nature on this topic.)

“The economists incorrectly try to imagine that the system is in equilibrium, and then gets a shock into a new equilibrium state”, says McCauley. “But real economic systems are never in equilibrium. There is, to date, no empirical evidence whatsoever for either statistical or dynamic equilibrium in any real market. In their way of thinking, they have treat one, single point in a time series as ‘equilibrium’, and that is total nonsense. It’s completely unscientific.”