Bubbles in prices of stocks, houses, or other assets are usually defined to mean sizable and somewhat prolonged deviations in these prices from the fundamental determinants of the prices. These price deviations are supposed to get larger and larger until the bubble bursts, and then price rather abruptly go back close to the levels expected from fundamentals. Do bubbles so defined exist? I believe they do, although I applaud economists who work hard to find explanations of such price movements in more subtle changes in fundamentals. But we do not have good explanations for when bubbles arise and when they end.
Bubbles depend on expectations that get out of whack and become self-fulfilling for a while. In recent years, one of the most glaring examples of what appears to be a bubble is the pricing of young Internet and biotech companies during the period 1995-2000. Many companies in these fields that had no earnings or even any sales, and objectively had little prospects of earning anything in the reasonable future, were deluged with money from venture capitalists and others. Their stocks if they went public had enormous market values relative to any likely discounted earnings. After a few years the market realized the folly of what had been happening, the bubble burst, values came back to earth, and most of these companies went out of business.
The boom in housing prices in the United States that started in the late 1990s, and peaked in 2006, is another example of what looks like a bubble. According to data that Karl Case and Robert Shiller compiled, real housing prices in the United States went up on average by about 10% a year for six or seven years, and then crashed after 2006 to erase much of the previous gain. Neither increases in construction costs nor in overall population levels, two major fundamental determinants of housing prices, appear capable of explaining these price movements. Some of the price rise is surely explained by low interest rates on mortgages and low down payment requirements, but part of the bubble mentality was the willingness of lenders to give ridiculously generous terms to many buyers who had little ability to withstand any even moderate shocks to their economic circumstances.
The most plausible view of asset price bubbles is that the price increases of an asset are supported by expectations of even further price increases that makes it worthwhile to buy and hold the asset at prices that far exceed the prices determined by the fundamentals. A sophisticated and attractive version of this argument is that social interactions produce large and cumulative changes in prices from modest initiating forces. It is well known in social interaction theory (see, for example, the book Social Economics by Gary Becker and Kevin Murphy) that a “social multiplier” can magnify small initial changes in demand for a good or asset into large changes in prices or consumption.
According to this argument, suppose a “few” participants in say the housing market begin to expect significant price appreciation, perhaps due to low interest rates. Their expectations then influence the expectations of others through a “contagion” or social interaction, process. As more and more persons expect housing prices to rise, this leads to expectations of even greater housing price increases, and a bubble in housing prices starts. The bubble would end when expectations about price increases become even a little pessimistic since then price levels would seem much too high, and price decline expectations could spread through the populations. Prices may then fall abruptly to earth.
Although I find a social interaction approach to bubbles appealing, it does run into several difficulties. Why do not enough savvy investors see through what is going on, and build up large short positions. These short holdings would prevent a bubble from getting out of hand because they in effect increases the supply of the asset to help offset much of the unrealistic increase in demand? Some investors like John Paulson did take short positions in the residential housing market and made fortunes, as this theory would predict, although Paulson did it very indirectly through mortgage-backed securities and swaps. However, papers in finance point out that in many asset markets it is difficult to take large short positions on the future prices of these assets. Such difficulties would limit how much short arbitrage occurs (see the classic paper by Andrei Shleifer and Robert Vishny “the Limits of Arbitrage”, Journal of Finance, 1997).
However, if only small initial shocks are required because of the magnification produced by social interactions, why do not bubbles occur even more frequently in markets like housing? The national housing indexes that Case and Shiller compiled show only a few episodes over the past century when major deviations from fundamentals occurred at the national level-the Florida land boom of the 1920s was a local, or at most a regional, phenomena.
Moreover, if the social interactions explanation is right, bubbles should also happen in a downward direction, so that prices could continue to fall below levels justified by fundamentals. National housing prices have basically never been significantly below levels expected from construction costs and other fundamentals. Prices below fundamentals have persisted for years in declining cities, as Edward Glaeser of Harvard has shown, but these are not examples of bubbles. Rather, they reflect the slowness in the rate of depreciation in the excess housing found in declining cities. Perhaps downward bubbles are generally less common because it is easier to take long rather than short positions, so that arbitragers can more easily buy assets in sufficient quantities to keep prices from falling too much below the fundamental determinants.
If only small initiating and terminating forces are needed for bubbles to start and end, then it is easy to understand why bubbles occur, and why the start and end of bubbles are so difficult to predict, either by market participants or government officials. Some economists have suggested recently- discussed in the May 8 issue of The Economist- that governments try to take actions, such as countercyclical taxes on real estate, that prevent bubbles, in particular housing bubbles, from getting out of hand. The papers The Economist cited appear to misuse the “externality” argument for government actions in the housing market, but in addition I am highly skeptical that government officials can succeed where profit-seeking market participants fail. At least in the US, the vast majority of government officials involved encouraged rather than tried to moderate the housing bubble. I believe the best contribution public policy can make to the control of bubbles is to follow steady well-defined rules of behavior, such as Taylor-type rules, or capital requirement rules, that at least prevent political pressures from exacerbating any bubbles that do develop in housing and other markets.