Bubbles

Virginia Postrel has an article in the Atlantic on experimental results concerning bubbles. Even though the participants in the experiments can easily determine the fundamental value of the assets they are trading bubbles and crashes still appear. What seems to happen is that traders are not sure if others realize that there is a bubble and try to profit before the crash.

Although she does not mention it, these results are not surprising given the work by Abreu and Brunnermaier on bubbles and crashes. In their work

The resilience of the bubble stems from the inability of arbitrageurs to temporarily coordinate their selling strategies. This synchronization problem together with the individual incentive to time the market results in the persistence of bubbles over a substantial period.

The key point is then is that even if I know a stock is overvalued I may still participate in the bubble if I do not realize that you are similarly aware of it. After all, if I short the stock and am by myself I may lose big time, while if I ride for a while I may profit till enough short sellers are ready to attack. So the sequence of learning is essential.

It is just this phenomenon that the experimenters seem to be pointing at. But Brunnermaier has already shown that similar phenomena were at play in previous bubbles, looking at the trading strategies of informed traders.

But there is another problem regarding bubbles that is worth discussing. That is the bias in the benefits. Think of the housing bubble. While it is taking place who is losing? Certainly those priced out of the markets, but who else? Everybody else is gaining, whether they are construction workers, bankers, financiers, governments dependent on tax payments...Now what happens if the bubble bursts? Everybody who was riding the bubble now suffers.

Suppose that the bubble was burst by the actions of a concerned policymaker. Would this policymaker be applauded? Seems unlikely. Everyone who suffers would blame the messenger. Certainly, everybody hates short sellers -- the only difference being the latter try to profit from their information. But still, if a bubble collapses it is hard to believe that the policymaker would be anything but blamed.

If this is correct, then there is a bias in favor of bubbles. Cheering on the asset price increases the politicians can say how we have a new economy. The old rules do not apply, and look at the prosperity we have brought. The gloomy official who tries to prick the bubble will be pilloried.