Today’s episode of ‘Ask the Nobel Laureate’: What is a ‘bubble’?

Is Silicon Valley in a “bubble”?

When you start asking that question of people, the first reply you inevitably get is: Well, what do you mean by ‘bubble’?

To which I reply: Well, um, er...

After fumbling around for an answer, I decided to call up someone who might actually know what he was talking about. And that led me to Robert Shiller, the Yale University economist who won a Nobel Prize last year for his work on economic bubbles.

In a phone conversation, I asked Shiller to define a “bubble,” and he responded by citing the definition of a “speculative bubble” from his book “Irrational Exuberance”:

“A situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increase. This attracts a larger and larger class of investors, who, despite doubts about the real value of the investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.”

In other words, the price of a stock or a house goes on a tear. And someone looks at that and decides that they are going to bet on another stock or house, which sends that asset price soaring. And so on and so on, even though there’s nothing about the stock or the house on their own that would justify the price increases.

Put another way, Shiller says: “I think of it as a social epidemic that distorts thinking.”

Which is a nice way of saying, people lose their minds and start making emotional rather than rational decisions on investments.

But then how do we know if we’re in the middle of a bubble? Back in 1999 and 2000, some people declared a tech bubble while other people countered that it was just a new economy. We didn’t know with 100% certainty that it was a bubble until it popped.

Shiller said it is in fact hard to know for sure in the middle of such moments.

For instance, consider Facebook paying $19 billion for WhatsApp.

For many people, paying that much for a mobile messaging service with few employees and not much revenue seems crazy. But with 500 million users, and the world of tech being transformed by mobile, Shiller said it’s hard to say for sure that the deal doesn’t make perfect sense.

But on a broader scale, one warning sign to look for is what seems to be driving investment decisions. In particular, Shiller said, a real bubble is often indicated when people are investing based on the stories companies are telling rather than their actual performance.

Back in 1999 and 2000, it was all about the story and not actual revenue and profit.

“The people back then were right,” Shiller said. “The economy in the 1990s was going through revolutionary changes. So, how high should the market be then? There’s not a clear connection between the quality of those stories and how high the markets should be.”

And because there’s not a clear connection, that’s where exuberance can get irrational.

Shiller noted that this time around, much of the frenzy in Silicon Valley seems to be driven by large companies making acquisitions, rather than a runaway IPO market.

That means the most influential investment and valuation decisions are being made by a few executives with a lot of money, rather than a broad swath of investors who may have little sense of the performance and potential of new companies.

“A lot of the big stories are about big companies buying smaller companies at high prices,” he said. “It seems to be more of a story about professional investors. It would seem it’s less likely to be a bubble if it’s Google making the purchase.”

But that’s not to say the wizards at Google and Facebook can’t go off the rails. Just because they have a strong vision of the future, doesn’t mean they can’t make awful bets.

“This is the irony about human genius,” Shiller said. “They can be brilliant and foolish at the same time.”