Attention and the Economics of Bubbles
1636, Holland. The most dangerous financial instrument was not a stock, bond or currency but a flower. The demand for tulips had boomed and was so high that they were traded on Amsterdam’s stock exchange. A single bulb could be worth large sums of money or a few acres of land. These flowers had become objects of obsessive desire when they became popular with the wealthy and became a symbol of status. Prices climbed constantly because people thought the passion for tulips would last forever. Yet, the appeal soon diminished, and people realized that the folly could not continue. Selling became frantic, confidence plummeted and prices of tulips collapsed by more than 99%.
1995, worldwide. The internet was coming and everyone knew it. What nobody knew was how much it was worth. Investors assumed the world was about to be changed forever and investing in e-commerce seemed like a once-in-a-lifetime opportunity. However, this investment was driven by speculation rather than changes in real value. New companies had no trading history, very low sales and virtually no profits. Greed overcame fear and people rushed to invest. Then the questions started. Where are the profits? When does this make money? Confidence dropped, selling became frantic and more than 7 trillion dollars was wiped off the market value of dot-com shares.
Both stories follow the same pattern. An asset captures the attention of a crowd and sparks imagination. Prices detach from rational basis as expectations rise. And then, it all collapses. As people realise the economic unsustainability of their actions, everybody pulls out at once. Everybody stops believing at once.
Economists call this phenomenon a bubble. Representing something that is hollow inside and something that grows more fragile as it grows. However, this word understates what is happening. A bubble isn’t just a pricing error, but a collective psychological event: a moment where the market is shaped predominantly by a crowd’s belief and not other economic aspects. The burst that follows isn’t just a price correction, but the moment when people lose confidence.
This is where most analysis stop. Greed, irrationality, herd behavior are the most common explanation. Yet, these terms describe what happens, not why it happens at a given time or what causes it to occur for only a few types of assets.
This essay will propose that attention is the missing variable.
Attention guides capital
Here is a rather basic statement: you cannot invest in something you've never heard of. Before an individual consumes or invests in a product, their attention is caught by something positive in it. In supermarkets, products on eye-level shelves sell the most. Trillions are invested in cryptocurrency even though it has no intrinsic value, no backing. Attention guides capital. A bubble is formed when decisions are driven mot by judgment but by attention, and the assumption that the attention of consumers will be fixated on the object for a period of time. When this object loses attention or gains negative attention, a subsequent loss in investments causes the bubble to burst. Many economic theories and concepts can be applied to further this point.
The Keynesian Beauty Contest- This is an example commonly used in game theory. It originates from John Menyard Keynes’ description of a stock market, based on a newspaper contest. The contest went as follows: a newspaper published rows of photographed faces. Contestants were to choose a face they found the most beautiful from each row. However, the prize was given to the contestant whose answer was closest to the average of all other answers. Hence, to increase winning chances, participants would have to predict the option others would choose. Keynes used this concept to describe investing. A skilled investor would not look at just a company’s worth but also how other investors would act and try to stay ahead of the crowd. Keynes never used the word ‘attention’, but his entire argument stems from it. Strip away the specifics of his contest, and what's left is the same mechanism already at work above: capital moves towards what receives the most attention.
Rational Inattention-Introduced by Christopher Sims, the concept of rational inattention states individuals and firms cannot process all given information at all times but choose selectively which information to attend to. It challenges traditional economics which assumes that agents act with complete information. Selection occurs based on maximising utility. This is a secondary cause to why bubbles form and grow, in addition to herd behaviour. If an investor believes that the cost of investing, or not pulling out, is more than that the cost of processing or disconfirming information, it leads to behaviour that seems irrational from the surface.
Information Cascades- Bikhchandani, Hirshleifer, and Welch’s (1992) theory on information cascades: under bounded information, it becomes rational for an individual to follow the actions of others despite their own judgement. Similarly, bounded attention leads to an identical result. Individuals act on the actions of the crowd as an aggregate, because watching every other individual’s action is too costly in terms of attention. This mechanism also explains the subsequent crash. Therefore, cascades caused by herd behaviour multiplies on itself, creating a fragile economy.
Negative asymmetry- Why the crash is faster than the boomA well-documented result of many psychological studies is that negative, threat related stimuli captures and retains attention more effectively than positive stimuli. The origins of this effect can be traced to evolutionary threat-detection and reaction.This explains why it takes years for bubbles to form, and why the collapse occurs in a shorter period. When attention allocates asymmetrically, threats attract attention faster than opportunity. Due to this, the cascade mechanism falls more rapidly than they were formed.
Tulip bulbs and dot-com shares had only one thing in common: for a while, both held everyone's attention. Guessing the crowd, ignoring the fundamentals, copying the person next to you: every concept in this essay is just a different name for that one behaviour. It builds a bubble because attention feeds on itself, and it breaks one for the same reason, only faster, since fear moves through a crowd quicker than hope ever did. A bubble is just a market watching itself instead of pricing the thing it was supposed to.
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