Financial Bubbles

10 Key excerpts on "Financial Bubbles"

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  eBook - PDF

  Behavioural Finance

  • William Forbes(Author)
  • 2014(Publication Date)
  • Wiley

    (Publisher)

  Chapter 5 Bubbles The volatility of financial markets is both disruptive and costly. Episodes of speculative frenzy followed by market collapse seem the norm of our history. The advent of transformative new technology like the railways, or the Internet, often acts as the trigger to such episodes (see Miller 2003). The crashes of 1929, 1987 1 and most recently the Internet boom collapse of early 2000 are testimony to the ability of financial markets to destroy, as well as create, wealth. Speculative Financial Bubbles may be more than the illusion of paper wealth, which puff up then crush hopes of huge riches amongst the populace. De Bondt (2005) states: Asset market bubbles are worrisome because they misallocate scarce resources and because they lead to economic stagnation. Even if a bubble at first remains confined to one sector, contagion and spill-over effects can cause further damage. Bubbles also redistribute wealth. Sometimes good people get hurt. Financial earthquakes undermine the public’s trust in the integrity of the financial system. This erosion of trust is most probably well placed given the range of dubious dealings associated with sharp rises in the stock market. This creates possible grounds for public policy intervention to prevent the worst excesses of bubbles. Robert Shiller in his commentary of the most recent bubble argues, It is a serious mistake for public figures to acquiesce in the ups and downs of market valuations, to remain silent about the implications of valuations and leave all commentary to market analysts who specialize in the nearly impossible task of forecasting the market over the short term and who may share interests with investment banks, broker-dealers, home-builders or realtors. The valuation of our markets is an important national – indeed international – issue (Shiller 2005, p.208). One legitimate ground for government intervention is public fear (Sunstein 2005).

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  Handbook of the Economics of Finance SET:Volumes 2A & 2B

  Corporate Finance and Asset Pricing

  • George M. Constantinides, Milton Harris, Rene M. Stulz(Authors)
  • 2013(Publication Date)
  • North Holland

    (Publisher)

  The term bubble refers to large, sustained mispricings of financial or real assets. While definitions of what exactly constitutes a bubble vary, it is clear that not every temporary mispricing can be called a bubble. Rather, bubbles are often associated with mispricings that have certain features. For example, asset valuation in bubble periods is often explosive. Or, the term bubble may refer to periods in which the price of an asset exceeds fundamentals because investors believe that they can sell the asset at an even higher price to some other investor in the future. In fact, John Maynard Keynes, in his General Theory, distinguishes investors, who buy an asset for its dividend stream (fundamental value), from speculators, who buy an asset for its resale value.

  Ultimately, bubbles are of interest to economists because prices affect the real allocation in the economy. For example, the presence of bubbles may distort agents’ investment incentives, leading to over-investment in the asset that is overpriced. Real estate bubbles may thus lead to inefficient construction of new homes. Moreover, bubbles can have real effects because the bursting of a bubble may leave the balance sheets of firms, financial institutions, and households in the economy impaired, slowing down real activity. Because of these repercussions on the real economy, it is important for economists to understand the circumstances under which bubbles can arise and why prices can deviate systematically from their fundamental value.

  Hyman Minsky provided an early, informal characterization of bubbles and the associated busts. In his characterization, Minsky distinguishes between five phases (see, for example, the description of Minsky’s model in Kindleberger (1978) ). An initial displacement —for example, a new technology or financial innovation—leads to expectations of increased profits and economic growth. This leads to a boom phase that is usually characterized by low volatility, credit expansion, and increases in investment.1 Asset prices rise, first at a slower pace but then with growing momentum. During the boom phase, the increases in prices may be such that prices start exceeding the actual fundamental improvements from the innovation. This is followed by a phase of euphoria during which investors trade the overvalued asset in a frenzy. Prices increase in an explosive fashion. At this point investors may be aware, or at least suspicious, that there may be a bubble, but they are confident that they can sell the asset to a greater fool in the future. Usually, this phase will be associated with high trading volume. The resulting trading frenzy may also lead to price volatility as observed, for example, during the internet bubble of the late 1990s. At some point, sophisticated investors start reducing their positions and take their profits. During this phase of profit taking there may, for a while, be enough demand from less sophisticated investors who may be new to that particular market. However, at some point prices start to fall rapidly, leading to a panic phase

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  Available until 27 Jan |Learn more

  Speculation, Trading, and Bubbles

  • José A. Scheinkman, Kenneth J. Arrow, Patrick Bolton, Joseph E. Stiglitz, Sanford J. Grossman(Authors)
  • 2014(Publication Date)
  • Columbia University Press

    (Publisher)

  SPECULATION, TRADING, AND BUBBLES

  JOSÉ A. SCHEINKMAN*

  T he history of financial markets is strewn with periods in which asset prices seem to vastly exceed fundamentals—events commonly called bubbles. Nonetheless, there is very little agreement among economists on the economic forces that generate such occurrences. Numerous academic papers and books have been written explaining why the prices attained in a particular episode can be justified by economic actors rationally discounting future streams of payoffs. Some proponents of the efficient-markets theory even deny that one can attach any meaning to bubbles.1

  Part of the difficulty stems from the fact that economists’ discussions of bubbles often concentrate solely on the behavior of asset prices. The most common definition of a bubble is “a period in which prices exceed fundamental valuation.” Valuation, however, depends on a view of fundamentals, and efficient-market advocates correctly point out that valuations are almost always, ex post, wrong. In addition, bubbles are frequently associated with periods of technological or financial innovations that are of uncertain value at the time of the bubble, making it possible, although often unreasonable, to argue that buyers were paying a price that corresponded to a fair valuation of future dividends, given the information at their disposal.

  In this lecture I adopt an alternative approach. I start with a more precise model of asset prices that allows for divergence between asset prices and fundamental valuation and that has additional implications that are easier to evaluate empirically. The model is based on the presence of fluctuating heterogeneous beliefs among investors and the existence of an asymmetry between the cost of acquiring an asset and the cost of shorting that same asset. The two basic assumptions of the model—differences in beliefs and higher costs of going short—are far from being standard in the literature on asset pricing. For many types of assets, including stocks, there are good economic reasons why investors should have more difficulty going short than going long, but most economic models assume no asymmetry. The existence of differences in beliefs is thought to be obvious for the vast majority of market practitioners, but economists have produced a myriad of results showing that investors cannot agree to disagree. One implication of “cannot agree to disagree” results is that differences in private information per se do not generate security transactions, since agents learn from observing security prices that adjust to reflect the information of all parties. Arrow (1986) appropriately calls this implication “[a conclusion] flatly contrary to observation.”2

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  Bubbles and Contagion in Financial Markets, Volume 1

  An Integrative View

  • E. Porras(Author)
  • 2016(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  201 7 Bubbles 7.1. Introduction Every major financial market crash has provoked an avalanche of studies trying to prove or disprove the existence of a bubble that might help explain the crisis. The discussion that ensues typically reflects on whether, as prices increased, investors realized the assets were overvalued. As it is often made clear that this should have been the case, explanations for the participation of agents in the formation of the bubble also begin to mount. During these inflationary events, speculators may trade because they think they will get out in time or because the expected high returns rewards them sufficiently even in the event of a crash. 1, 2, 3, 4 However, regardless of the motives for trading, when a bubble bursts, there is great discontinuity in market-clearing prices, and high price volatility follows as a result of excess supply. Even though much has been written about bubbles, there is still no exact definition for this word. In general, and in this text, a bubble is formed when asset prices are no longer justified by their fundamentals. More formally, the role of the bubble is clear in the following pricing model built according to the EMT. Here, the price is determined by a competitive market and reflects all relevant information. 5 x aE x z t t t = ( ) + +1 ⏐ I t (7.1) where x t is the price of the asset today a is a parameter between 0 and 1 E(·) is the mathematical conditional expectation I t is the relevant information set z t are the fundamentals 202 Bubbles and Contagion in Financial Markets, Volume 1 If the transversality condition preventing departures from the fundamentals holds, its forward solution defines the fundamental value, z t , as F a E z I t t t = ( ) + = ∑ τ τ τ ⏐ ∞ 0 (7.2) where E z I t t t ( | ) is the mean of the expected fundamentals conditional on the rel- evant information set, and I t is a stochastic process since the realization of this information set depends on the variables not included in it.

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  Economics for Financial Markets

  • Brian Kettell(Author)
  • 2001(Publication Date)
  • Butterworth-Heinemann

    (Publisher)

  And there are some, I believe, who practice the fourth, fifth and higher degrees.’ (Keynes, 1936) Bubbleology and financial markets 297 The stock market Keynes (1936) wrote, ‘is a game of musical chairs, of Snap, where the winner is the one who makes his move fractionally ahead of everyone else’. So the equity market, in Keynes’s view, is an environment in which speculators anticipate ‘what average opinion expects average opinion to be’, rather than focusing on factors fundamental to the market itself, including expected future dividends etc. The implication here is that if bubbles exist in asset markets prices will differ from their long-term fundamental values. It is only recently that serious research has taken place on the existence of bubbles. Economic theory, until recently, placed essentially no restrictions on how agents formed expectations of future prices. Thus a folklore of bubbles grew up. These would include the tulip bubbles in seventeenth century Holland, the South Sea bubble in eighteenth century England, and the increase in equity prices during the 1920s in the United States. All these events, when followed by subsequent collapses in asset values have been labelled as bubbles. However, the widespread adoption of rational expectations, discussed below, provides a model amenable to the empirical study of bubbles. But first of all we need to describe the terminology used by ‘bubbleologists’. The bubble terminology Following the technical language of economics, a ‘bubble’ is any deviation from ‘fundamental values’ whether up or down. Fundamental values are a concept easier to define in theory than in practice. This refers to the prices stocks ought to sell for based on business’s real economic value, speculation apart. The assumption is that stock prices will ultimately (whenever that is) return to their fundamental values, however much extraneous factors may be influencing them at any one moment.

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  A History of Financial Crises

  Dreams and Follies of Expectations

  • Cihan Bilginsoy(Author)
  • 2014(Publication Date)
  • Routledge

    (Publisher)

  6 Explaining asset-price bubbles and banking crises DOI: 10.4324/9781315780870-6

  In his Memoirs of Extraordinary Popular Delusions and the Madness of Crowds Scottish journalist Charles Mackay (2009 [1852]) describes tulip mania, the Mississippi Bubble, and the South Sea Bubble as collective delusions spread across all ranks of society. The same state of mind and herd mentality that tempted people to participate in witch hunts and apocalyptic fantasies, which are among the vignettes that Mackay portrays, was evident in the rush to buy assets with dreams of getting rich(er) overnight. Popular songs, allegorical prints, and sarcastic poems that proliferated at the peak and during the aftermath of these episodes also painted pictures of out-of-control greed and a populace devoid of common sense. While these descriptions are amusing and commonplace, they fall short of explaining why bubbles emerge. Their frequent embellishments also provide an easy foil for commentators who dispute the verisimilitude of the historical accounts. Between the two perceptions of the human condition, i.e. individual optimization under competitive conditions that rules out bubbles, and the collective frenzy that makes them ubiquitous, there is a diverse set of theories that acknowledge the existence of bubbles. These theories attempt either to reconcile bubbles with the canons of the standard economic theory or search for explanations based on alternative behavioral foundations or evolutionary capitalist market dynamics.

  This chapter is an introduction to the theories of financial crises. It will focus mainly on asset-price bubbles and, to a lesser extent, on banking crises. I classify the competing hypotheses into five categories. First, the orthodox, fundamentals-based approach is characterized by optimizing agents who operate in perfectly competitive markets. Each economic agent is an independent decision maker, guided by the available information on the fundamentals. Consequently, the fundamental and market prices are identical, and the bubble is just an economic myth. The second category accepts the primacy of the fundamentals but recognizes the possibility of asset-price bubbles. Its explanation for bubbles is that government-policy interventions in the economy distort relative prices and create deviations from the fundamentals. The third category tweaks the orthodoxy. It retains the optimization postulate but recognizes bubbles and banking crises as possible outcomes of pervasive imperfections and frictions in the market. The fourth category replaces the optimization postulate with behavioral foundations of decision-making. Bubbles are outcomes of the interaction of non-optimizing decision-making with social and psychological dynamics. The fifth category focuses on institutional characteristics of capitalist economies and concludes that financial crises that feature manias and panics are endemic to the evolution of competition and the credit cycle in a loosely regulated financial sector. This chapter presents each approach and illustrates it in the context of the classical bubble episodes.

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  Law, Bubbles, and Financial Regulation

  • Erik F. Gerding(Author)
  • 2013(Publication Date)
  • Taylor & Francis

    (Publisher)

  140 Rigor and pragmatism in identifying bubbles

  Despite the advances made by behavioral finance, there is still no consensus among economists about how asset price bubbles form or whether particular historical episodes constituted bubbles.141 Some economists doubt the possibility of asset price bubbles. Yet this lack of absolute consensus does not mean that policymakers should ignore the possibility of future bubbles forming. True, if bubbles are hard to identify after the fact, they are even harder to detect prospectively or in media res.

  Even so, economic research does point to a list of warning signs that booming prices in asset markets may be unsustainable. These early warning alarms include more than skyrocketing asset prices and ratios of prices to earnings. They also include the following:

  •  historically cheap credit (measured by, among other things, low interest rates and a growing money supply);142

  •  higher leverage of households, financial institutions, and governments;143

  •  a surge of external capital flowing into a country (measured by trade or current account balances);144 and

  •  an influx of inexperienced investors into a market.145

  Prices in futures markets may also provide warning signs that bubble prices are unsustainable.146

  In considering these warning signs, policymakers must factor the potential both for false positives and false negatives and the inherent messiness in interpreting data from complex markets. In fashioning policy responses to potential bubbles, policymakers must balance the expected costs of a given intervention (including dampening capital formation) against the very real costs of bubbles and crashes. Again, debt-fueled bubbles pose particularly dire risks.

  Opponents of interventions against bubbles (and those who want boom times to continue) enjoy several advantages. They can offer “hard” data of the costs of restricting investment or credit. By contrast, the benefits of fighting bubbles are squishier given the inevitable uncertainty of whether a bubble exists. Opponents of bubble interventions can proffer “this time is different” explanations for booming prices. They can play off behavioral biases that cause investors and regulators to give excessive weight to recent booming prices.

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  Valuation of Internet and Technology Stocks

  Implications for Investment Analysis

  • Brian Kettell(Author)
  • 2002(Publication Date)
  • Butterworth-Heinemann

    (Publisher)

  But before we proceed further, we first of all need to describe the terminology used by ‘bubbleologists’. Bubble terminology Following the technical language of economics, a ‘bubble’ is any deviation from ‘fundamental values’, whether up or down. Fundamental values are a concept easier to define in theory than in practice. This concept refers to the prices stocks ought to sell for based on business’s real economic value, apart from speculation. The assumption is that stock prices will ultimately (whenever that is) return to their fundamental values, however much extraneous factors may be influencing them at any one moment. A bubble is an upward price movement over an extended range which then implodes. An extended negative bubble is a crash. ‘Noise’ refers to small price variations about fundamental values. So a bubble is a situation in which the price of an asset differs from its fundamental market value. With a rational bubble, as discussed below, investors can have rational expec-tations that a bubble is occurring because the asset price is above its fundamental value but they continue to hold the asset anyway. They might do this because they believe that someone else will buy the asset for a higher price in the future. In a Bubbleology, stock markets and the Internet and technology stock price collapse 111 rational bubble, asset prices can therefore deviate from their fundamental value for a long time because the bursting of the bubble cannot be predicted and so there are no unexploited profit opportunities. When a stock is experiencing a rational bubble, the rate of return on an asset is higher than normal in order to com-pensate the holder for the possibility that the asset’s price might suddenly collapse to its fundamental value. With what is known as a rational bubble, the asset holder is willing to accept a lower rate of return since the asset’s price might suddenly jump up to its fundamental value.

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  Doing Capitalism in the Innovation Economy

  Markets, Speculation and the State

  • William H. Janeway(Author)
  • 2012(Publication Date)
  • Cambridge University Press

    (Publisher)

  The seemingly perverse opportunity to make money by speculating in risky financial assets regardless of the fate of the real investments so funded is – precisely – the vehicle of economic progress. All of this work, theoretical and empirical, has been motivated by the great bubble of the late 1990s. But its significance transcends ad hoc explanation and rationalization of that singular event. These scholars are reconstructing the reciprocal interdependence of invest- ment in financial and real assets, of financiers and entrepreneurs, of the financial system and the real economy. In their rediscovery of Keynes’s economics at this fundamental level, whether acknowledged or not, they have demonstrated as much insight as those who have rediscov- ered the relevance of Keynes’s macroeconomic policy response to the failure of private sector demand, and they will, I expect, have at least as much impact in the long run. Financing new networks A decade ago, at the turn of the millennium, I was living and work- ing in the middle of the dotcom/telecom bubble, which was com- posed of two overlapping but quite distinct ingredients. First, like the nineteenth-century railroad booms and the electrification boom of the 1920s, the bubble funded the build-out of physical infrastruc- ture to support the global deployment of the internet and the World Wide Web riding on top of it. Second, it funded an accelerated explor- ation – a quasi-Darwinian exercise in trial and error – to discover what to do with this new economic environment that, for the first time 14 J. Eatwell, “Useful Bubbles,” in J. Eatwell and M. Milgate (eds.), The Fall and Rise of Keynesian Economics (Oxford University Press, 2011), p. 88. Financing new networks 187 ever, integrated reciprocal flows of information and transactions over arbitrarily long distances and complex networks.

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  Behavioural Economics and Experiments

  • Ananish Chaudhuri(Author)
  • 2021(Publication Date)
  • Routledge

    (Publisher)

  15  Asset bubbles in markets In this chapter I:

  • Discuss what is meant by an asset market bubble, where prices of financial assets rise far in excess of what the asset is really worth;
  • Explore some historical asset bubbles to set the scene;
  • Show how we can study such asset bubbles in the lab and what we know about factors that contribute to such bubbles;
  • Highlight the role of cognitive biases in the generation of such bubbles, which, in turn, also provides clues as to how we can avoid creating such bubbles in the first place.

  Introduction

  I wrote much of this book in 2020, while the world was grappling with the COVID-19 pandemic and the fallout from it. At that point, it was pretty clear that we were looking at a global recession with shrinking gross domestic products (GDP) and rising unemployment. It was not yet clear whether this recession would equal the Great Depression of the 1930s but it was clear that this was going to be worse than the global financial crisis (GFC) of 2008–2009. For many of us, the GFC was the most serious recession that we had encountered until we came face to face with the COVID-19 pandemic.

  In many ways, the GFC started as a financial crisis with a bursting of the housing bubble in the US. Figure 15.1 shows what happened to inflation adjusted average house prices during the latter part of the 1990s and the first decade of the 2000s. As can be seen from this figure, starting from around 1998, house prices increased sharply till around 2006. At that point, the recession hit. House prices fell and a large number of homeowners were saddled with negative equity. This meant that the loans they had taken out to buy the house (the mortgage) was now larger than the value of the house. So, they could no longer afford to repay their mortgages by simply selling their house. How did this come about, and how did this in turn set off a massive global recession?1

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