How to tell when a financial bubble is about to burst

The fact that investors have made a great deal of money makes them feel bullet-proof

"LIFE," WROTE the Australian poet Adam Lindsay Gordon, "is mostly froth and bubble." For Dryden it was honour that was "but an empty bubble", and for James Grainger it was fame. For the rest of us, though, the most likely place we will encounter a bubble is, more prosaically, in the financial markets. If the bubble has long been a favourite image of the writer, it also has been a recurring visitor to the world of finance.

During the last two or three weeks there have been signs that we may be receiving such a visit shortly. The candidate for bubble-pricking is the surge in Internet and other hi-tech shares, mainly in the US, that has happened over the last 18 months. The sharp falls in the share price of these hi-tech companies - and the string of stories of distress among the "day traders" in these stocks - hold out the possibility that the Internet bubble has popped.

But we don't know yet. What we do know is that financial bubbles occur again and again. A new book, Devil Take The Hindmost, by Edward Chancellor, charts the history of such bubbles, including the starred-alpha examples: the Dutch Tulip Mania of the 1630s, the run-up to the South Sea Bubble of 1720, Wall Street's roaring Twenties before the great crash of 1929 and the Japanese bubble of the late 1980s.

We also know that while, afterwards, the rationale behind each bubble seems absurd, at the time it is all very plausible. The fact that investors have made a great deal of money makes them feel bullet-proof.

I remember being in Tokyo in October 1987, the week after share prices had collapsed on Wall Street. The insurance chief I was talking with was suddenly called out of the meeting for an urgent phone call. When I saw him again a few minutes later he was bursting with pride. The call had come from the Ministry of Finance, which was "suggesting" to Japanese institutions (not actually instructing them, please note) that they should buy US shares en masse. "Japan," the executive told me proudly, "will save America."

At that time, such a thought was not as ridiculous as it appears now. The Japanese stock market did continue to boom, so that at one stage it equalled that of the US. Land prices soared to such an extent that, in theory, the value of the Imperial Palace gardens in the centre of Tokyo would have equalled that of the entire state of California.

In 1989, Nomura Securities, the largest Japanese broker, predicted that the Nikkei share index (then approaching 40,000) would reach 80,000 by 1995. It fell to 14,000, and even after the recent recovery stands at only 17,300.

And America now? The country's economy is riding high. As anyone who visits this summer will notice, the place oozes contentment and prosperity. People are working hard and living well; unemployment is negligible in many regions and businesses are being created (mostly in high-technology industries) faster than anywhere else on the globe.

But the visitor may also notice that certain arrogance that goes with success. It is not as marked as it was in Japan in the late 1980s and even high-tech US businesses meet periodic reverses that make them aware that the rest of the world can be an effective competitor.

For example, here in Britain, Freeserve has toppled AOL (America On Line) as number one Internet service provider. Nokia of Finland has replaced Motorola as the world's largest manufacturer of mobile phones.

Still, for many Americans, arrogance wins. In his new book, much-hyped in the States, The Lexus and the Olive Tree, Thomas Friedman, who writes for The New York Times, praises US-dominated globalism and concludes "If you are not American ... I suggest you learn."

I suppose it would be easier than learning to be Japanese, and Friedman does have a point: US technology is dominant in the high-tech industries and will probably remain so. The problem is one of pricing: how should the markets value American excellence? Get the value right and there is no bubble; get it wrong and there is a bubble, and one which will surely burst.

There are various unscientific tests you can apply. Rather bravely the economics team of the bank HSBC has listed the various symptoms of recent bubbles, including the Japanese one noted above, but also our own house price bubble. Typical symptoms include above-trend economic growth, falling personal savings, etc. On that check-list, both Japan and the UK scored 12, while the US currently scores 10.

That is for the US market as a whole. If you look at the value of Internet stocks, where companies that have never made a profit are valued on multiples of their revenues, the parallels with Japan in the late 1980s seem quite chilling.

When the telephone giant NTT was floated it was at least making some profits - but the valuation of 200 times earnings was pretty extreme for the equivalent of our British Telecom, which was as I recall worth about 12 times earnings.

Britain's only sizeable example of these Internet stocks is Freeserve, a company which when it was floated had revenues of just pounds 2.7m - yet was valued at more than a long-established retailer like W. H. Smith.

No-one doubts that the Internet boom will run and run, for it is a technology that is capturing large chunks of consumer spending. And some companies are using it to great commercial advantage. Ryanair, the successful cut- price airline that reported profits this week almost as big as those of BA, is now selling 30 per cent of its tickets over the Net. But whether it will be the Freeserves or the Ryanairs that make the serious money out of the Net is still far from clear.

The comment I personally found most disturbing came the other day from an American executive to whom I was talking. I queried the values that the US markets were putting on high-tech stocks. "But," he replied, "we are awash with liquidity and there is nowhere else for people to put their money. So I reckon that liquidity will carry on supporting prices."

The idea that shares have to go up because there is nowhere else for the money to go is a beguiling one. But it neglects the fact that just as markets can create wealth, they can also destroy it. Once they start destroying wealth, as they did in Japan or indeed in our housing market here, then the fall in prices feeds on itself.

The bigger the bubble, the louder the bang when it pops.