Economic Theory and Asset Bubbles: Gadi Barlevy. Federal Reserve Bank of Chicago; National Bureau of Economic Research
Posted: 11 Sep 2007 Economic Theory and Asset Bubbles by Gadi Barlevy :: SSRN
Follow link for full. Here's some sections;
(I added in any of these bits)
- In the late 1990s, there was a dramatic run-up in the stock prices of various publicly traded U.S. firms, particularly those specializing in information technology and its applications. A similar run-up occurred in housing prices in the early 2000s.
- These episodes have often been cited by pundits as examples of “asset price bubbles.” Implicit in this description is the notion that the rapid growth in the prices of the assets in question over such a short period suggests these assets were overvalued and thus at risk of a “correction,” or a sharp fall in price.
- The slowdown in the growth of housing prices starting in the summer of 2006 has been offered by some as evidence of the beginning of a similar decline in the housing market.
- Some of those who have identified these respective episodes as asset bubbles have also warned of the dangers in letting asset prices rise so rapidly. For example, an editorial in The Economist magazine argued that “the risk is not just that asset prices can go swiftly into reverse.
- As with traditional inflation, surging asset prices also distort price signals and so can cause a misallocation of resources
- Quite naturally, this has led to calls for policymakers to rein in the prices of assets whose values appear to be inflated before they rise to astounding heights
- Yet a number of studies have argued that policies designed to contain asset bubbles might end up doing more harm than good
- One problem, highlighted in Cogley (1999), is that it is often difficult to assess whether an asset is overvalued
- Bernanke and Gertler (1999) raise a different issue, noting that using monetary policy to rein in asset prices may lead to unwanted deviations of inflation from its optimal path. They argue that monetary policy should focus exclusively on inflation, not asset prices (Hmmmmmmmmm)
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This then goes on to explain a case for not popping the housing bubble in 2007 (Market would manage that itself).
- In this article, I argue that, even absent the practical issues that other researchers have pointed out, policymakers would be wise to proceed with great caution before acting to stem asset bubbles. The reason is that economic theory suggests bubbles can only occur under certain circumstances, and these circumstances may have relevance for whether acting to burst bubbles is desirable.
- ” Even if policymakers could accurately identify an asset bubble and rein in its price without affecting other economic variables such as inflation, there remains the possibility that intervention by policymakers to rein in asset bubbles can exacerbate the very distortions that allowed the bubble to emerge in the first place
What is an asset bubble?
Talks a bit about tulips and Nasdaq. Then gets into the concept of buying things because they go up rather than buying things for literally any reasonable or practical reason as per the fundamentals.
- By contrast, economists do view dramatic increases in the price of assets as a potential cause for concern. This is because the increase in price is sometimes so rapid that it seems unlikely to reflect real changes in the true value of the underlying asset. Instead of signaling a genuine need for more such asset
- In particular, most economists would define a bubble as a situation where an asset’s price exceeds the “fundamental” value of the asset.
Talks a lot about general pricing/fad/speculation stuff. Has a picture of the Nasdaq. Source, Standard and Poor's (Did you know the S&P stood for that? Look it up if you think I am joking).
A bubble is formally explained using hieroglyphics.
When can asset bubbles arise?
(Reminder this was written in late 2007)
- The idea that asset prices can assume arbitrary values rather than reflect their underlying worth is rather disturbing. (Isn't it?)
- Not surprisingly, economists have sought to determine whether this possibility can be ruled out. There are in fact various conditions that can be used to rule out the existence of bubbles on theoretical grounds. This section reviews the results for when bubbles can and cannot occur
- A natural starting point for a discussion of when bubbles can emerge is a paper by Milgrom and Stokey (1982). They consider the distinct but related question of whether it is possible for agents to engage in “speculative trading” in one-shot markets.
An analogy is inserted which basically takes a lot of words to say the above means people betting against each other in zero-sum games. There's a Bob and Alice. It's one of those types of stories. Then it moves on to talking a bit about the Greater Fool thing.
- In particular, investors who purchase an overvalued asset are also speculating that they will be able to sell the asset to another trader in the future. As such, they must believe they will be able to sell the asset for more than the dividends it will pay future owners of the asset (They've over paid so they need someone else to overpay, more greatly)
It then goes on to explain why Milgrom and Stokey say we don't have to worry about this because the fact there are people with opposing opinions in the market will make the other side duly considerate of the possibility they are wrong. Someone knows more than them. They should seek more info and make a more cautious and objective decision.
IDK who Milgrom or Stokey are. It sounds so much like "Milgram and Stonkey" I can't even be sure if they are real people or this was just some subtle joke about compliance in bubbles. If it wasn't, I think we can mark of M&S as probably knowing nothing at fucking all about how participants in a market act during a bubble.
- Milgrom and Stokey argue that in their example, speculative trade will not be possible under certain circumstances. This is because the fact that the other party is willing to engage in trade will convince both Alice and Bob that they may have failed to take into account some information about the asset that the other side has access to.
- This would dissuade both sides from completing the trade, even if they never actually see the information of the other party.
- The formal argument that rules out speculative trade requires several assumptions. (I'd say none of these assumptions would be made by anyone who knew anything about ... anything)
- . First, all traders must share the same initial beliefs about the company before they engage in research
- Second, before trade occurs, the stock is assumed to have been allocated efficiently. That is, there would have been no reason for Alice to buy the stock from Bob back when both of them shared the same initial beliefs about dividends.
A pause at this point. They're talking about dividends. I'm sure most people know, but just to clarify - when talking about the dividends they're basically just talking about how much the stock is actually worth. There was a time this was an important part of buying a stock. How much the thing was actually worth, as in how much you'd make owning it. If two people could work out the stock was too expensive, they'd not buy it. Seriously, that's probably happened before.
- Finally, all traders are assumed to be rational and profit maximizing, and this is commonly known by all traders. That is, not only are Alice and Bob rational, but they know each other to be rational, they know that the other trader considers the counterpart to be rational, and so on. If all of these conditions are satisfied, Alice and Bob will not trade
Puts on Milgrom or Stokey if you ask me.
I'll be honest, I started to skim read after meeting M&S. So I won't quote any more. We'll jump to conclusion:
- In this article, I have argued that in addition to the practical difficulties associated with identifying asset bubbles and using monetary policy to affect asset prices, there are theoretical reasons why policymakers should proceed with caution if they intend to combat asset bubble
- In many ways, economic theory views bubbles as oddities, since under ideal conditions they would never occur. More precisely, if traders are rational and markets operate efficiently, as is typically assumed in various economic models, the existence of bubbles can be ruled out explicitly. ('If' I had more fingers I could point to more irrational traders)
- Some economists, most notably Garber (1990), have argued on this basis that most of the commonly cited historical examples of asset bubbles are not really bubbles as economists define them. (Well what the fuck are they? Was interested in this one. Looked this one up. TLDR; They're an EMH.
- Yet, as the work reviewed in this article suggests, bubbles can occur once we depart from ideal conditions, and so there is some merit to contemplating whether and how policymakers should respond to a bubble (About 12 months after this was written, the head of the Fed would tell President Bush the world economic system could collapse within 24 hours because of the fall-out of the bubble popping)
- . Simply put, the emergence of a bubble may signal that the economy already suffers from certain structural problems, and then one has to be careful to distinguish whether bursting the bubble can mitigate or exacerbate these problems.
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