Evidence about Bubble Mechanisms: Precipitating Event, Feedback Trading, and Social Contagion

Shiller’s feedback loop theory of bubbles involves three elements: a precipitating event that causes an increase in prices, positive feedback trading, and social contagion that draws in new investors. We use brokerage account records from a large Chinese stock brokerage firm to show that all three components of the Shiller feedback loop are found during the Chinese put warrants bubble. An increase in the stock transaction tax made warrants relatively more attractive for speculative trading and was the precipitating event for the extreme phase of the bubble, causing immediate sharp increases in trading by new and existing investors and a jump in warrant prices.  Hazard rate regressions show that there was positive feedback trading, and the period of heavy feedback trading coincided with the extreme phase of the bubble following the increase in the transaction tax.  Proxies for social contagion explain the entry of new investors, and estimates of the trading volume due to feedback trading and the numbers of new investors drawn in by social contagion explain the size of the bubble.