Asset price bubble

An asset price bubble is characterised by a surge in prices that raises expectations of further increases that generate a succession increases until confidence falters, the bubble "bursts", and prices rapidly revert to an objectively-based level. Asset price bubbles can cause extensive economic damage and can even threaten the integrity of the financial system.

The nature of bubbles

A steep and sustained price rise and then its precipitous collapse, both unrelated to the asset's properties - that is the pattern of events which has characterised hundreds of episodes from the "South Sea Bubble" of the 17th century to the housing bubbles of the early 21st century. There is no objective way of assessing the truth of any of the various explanations that have been advanced for them. Their "information cascade" component has been observed in other contexts , and the "herding" behaviour that they exhibit has characterised the conduct of the subjects of many experimental studies of human behaviour. One surge in share prices has been termed "irrational exuberance", and that term has since been applied to other episodes, but whether the word "irrational" is really justified turns on the choice of interpretation. Such behaviour has been attributed to ill-informed noise traders, but John Maynard Keynes, himself a successful investor, has attributed it also to professional investors:

"professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view."

Keynes' insight was supported by an NBER paper by David Scharfstein and others, which demonstrates by means of a model that herding can occur even if all the investors act rationally , and by another model created by Andrei Shleifer, showing the effect s of introducing noise traders .

The routine use of stop-loss orders (that probably contributes strongly to the speed of decline when a stock exchange bubble bursts, and is itself a form of herding behaviour), is widely practised by professional investors .

Examples from history

An account of bubbles in the 18th century, including "The Mississippi Scheme", "The South-Sea Bubble", and "Tulipomania" was published in 1852

Typical consequences

Frederic Mishkin has identified two categories of asset-price bubble:-

• "credit boom bubbles", in which expectations of increases in the price of some assets, lead investors to borrow against the security of those assets, increasing their demand, and enabling them to use the assets to obtain more credit and increase their leverage, in a positive feedback loop which continues until the bubble bursts. The losses then suffered lead to de-leveraging, a credit crunch, reductions in business investment and consumer expenditure, and a fall in economic activity.
• "pure irrational exuberance bubbles", not involving leveraging and de-leveraging, which do not result in a credit crunch or cause any substantial reduction in economic activity.

The house price bubble that led to the crash of 2009 was an example of the former category, and the relatively benign "dot.com" bubble was an example of the second category.

Leading indicators

Asset price bubbles are easy to identify after they have burst, but difficult to distinguish before that happens.