Financial Bubbles
Financial bubbles refer to periods of rapid escalation in the prices of assets, often driven by speculation and investor optimism rather than intrinsic value. These bubbles eventually burst, leading to sharp declines in asset prices and significant economic repercussions. Examples include the dot-com bubble of the late 1990s and the housing market bubble of the mid-2000s.
8 Key excerpts on "Financial Bubbles"
eBook - ePub- Piyush Tiwari, Michael White(Authors)
- 2014(Publication Date)
- Wiley-Blackwell(Publisher)
...A bubble could also be described as a trade in assets with inflated values. Economists have attributed uncertainty (Smith et al., 1988) speculation (Lei et al., 2001), or bounded rationality (Levine et al., 2008), as the causes for bubbles. However, recent evidence suggests that bubbles even happen in the absence of these. It has been suggested that bubbles might ultimately be caused by processes of price coordination or emerging social norms. Since it is often difficult to observe intrinsic values in real-life markets, bubbles are often conclusively identified only in retrospect, when a sudden drop in prices appears. The boom and the bust phases of the bubble are examples of a positive feedback mechanism, in contrast to the negative feedback mechanism that determines the equilibrium price under normal market circumstances. Prices in an economic bubble can fluctuate erratically and become impossible to predict from supply and demand alone. The focus of this chapter is on real estate asset bubbles. A starting point to understand the bubbles is the financial theory on ‘market efficiency’. According to Malkiel (as quoted in Malpezzi, 2004), ‘a capital market is said to be efficient if it fully and correctly reflects all relevant information in determining security prices…Formally, the market is said to be efficient with respect to some information set…implies that it is impossible to make economic profits by trading on the basis of [that information set]’. If the capital markets are efficient, opportunities for excess or abnormal returns do not exist. Since all the information is incorporated into prices, the investor is unable to make profits by trading on the information. The aforementioned definition is a theoretical definition of market efficiency and is seldom satisfied. Based on the information set, three common definitions of market efficiency have been used...
eBook - ePubBehavioural Investing
A Practitioner's Guide to Applying Behavioural Finance
- James Montier(Author)
- 2009(Publication Date)
- Wiley(Publisher)
...When business executives were the traders, a truly awe-inspiring bubble was created. Price started off at 20% of fundamental value. At the peak of the bubble prices represented a breathtaking 570% of value! And remember this was in the simplest, cleanest possible market. Experimentalists have uncovered many traits that make the creation of a bubble more likely. A bubble is more likely to be found when: • The ratio of inexperienced to experienced traders is high. • The greater the uncertainty over fundamental value. • The lottery characteristics of the security are high (effectively a small chance of a big payoff increase the likelihood that people will overpay for an asset - growth stocks?). • Buying on margin is possible. • Short selling is difficult. The last of these strikes us as particularly interesting given the recent debate over short selling in the UK. The experimental evidence shows that far from being an “evil”, short selling helps to move the market towards efficiency. BUBBLES IN THE FIELD However, enough of artificial bubbles; what of bubbles in the real world of financial markets (surely an oxymoron?) We have previously presented a framework for analysing bubbles (see Global Equity Strategy, 18 July, The anatomy of a bubble). In that note we explored bubbles in a very general way, drawing our examples from a wide range of historical events. In this chapter, we will examine the US and Japanese bubbles in order to see what lessons we can derive from them. The framework we use to characterize the bubble process is drawn from the work of Irvine Fisher and Hyman Minsky, popularized by Charles Kindleberger in his tour de force - Manias, Panics and Crashes. Fisher was among the leading economists in the USA at the time of the 1929 crash...
eBook - ePub- Ananish Chaudhuri(Author)
- 2021(Publication Date)
- Routledge(Publisher)
...There were others, such as the so-called “dotcom” bubble, also during the late 1990s and early 2000s, where the prices of internet based “tech” companies went through the roof. This led the then Chairman of the Federal Reserve, Alan Greenspan, to talk about “irrational exuberance” of investors, and a best-seller book of the same name by Robert Shiller of Yale. The effects of some of these bubbles were more localized and when the bubbles burst, the majority of the damage was confined to the investors. But, in some cases, such as the bursting of the US housing bubble, the consequences were far more widespread and devastating, resulting in a global recession. Given this, researchers, policy makers, investors and even ordinary citizens have an obvious interest in how, why and when such bubbles form. I have discussed the path-breaking work undertaken by Vernon Smith and his colleagues, showing that lab experiments can be set up as microcosms of such macroeconomic phenomena. The work done by Smith in this area has subsequently generated a very large literature and added to our knowledge of why and how such bubbles form. We have seen that such bubbles may form in markets for assets with declining fundamental value as well as flat fundamental values. The formation of bubbles depends not only on speculative motives, but may also come about due to decision errors by traders. Well-known behavioural biases, such as lack of self-control and overconfidence, can exacerbate such market bubbles, to an extent by fuelling speculation in the anticipation of capital gains. We have learned that trader expectations play a crucial role in the formation of asset bubbles. Those who make better forecasts benefit at the expense of those who do not. By and large, the major factor behind attenuating asset bubbles is trader experience. With greater experience the trajectory of prices track the fundamental value closely...
eBook - ePubA 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...
eBook - ePubUnderstanding Central Banking
The New Era of Activism
- David Jones(Author)
- 2014(Publication Date)
- Routledge(Publisher)
...7 Asset Price Bubbles While it is true that asset bubbles are not new, it is also certainly the case that over the past quarter century or so, globalization, deregulation, and financial innovation have resulted in a plethora of asset price bubbles. Combine an unprecedented period of highly accommodative monetary policy moves with recurring bouts of collective investor enthusiasm and the conditions could not have been more favorable for global asset price bubbles. This point is underscored in remarks by Fed chair Ben Bernanke in his discussion of the global impact of repeated efforts to increase monetary policy accommodation. Specifically, in remarks on October 14, 2012, the Fed chair admitted that Fed “unconventional” asset purchases, and an accommodative monetary policy more generally, encouraged capital flows to emerging market economies. These capital flows, according to Bernanke, are said to cause undesirable currency appreciation, too much liquidity leading to asset bubbles or inflation, or economic disruption as capital inflows quickly give way to outflows. D EFINITION The definition of an “asset price bubble” (stocks, real estate) is a temporary surge in asset prices caused by the collective enthusiasm of market participants rather than the consistent estimation of the real value of the assets involved. One example of contemporary asset price bubbles is the powerful Japanese asset price bubble in the late 1980s, involving soaring real estate prices accompanied by surging stock prices, from which the Japanese financial system and economy are yet to fully recover. Another example of a striking asset price bubble is the U.S. hightech (dotcom) stock price bubble that formed in the late 1990s...
eBook - ePub- Morris Altman(Author)
- 2012(Publication Date)
- For Dummies(Publisher)
...American economist John Kenneth Galbraith in his analysis of the Great Crash of 1929 emphasized psychological and sociological drives, as well as the spread of misleading and overconfidence-breeding information, as key to the stock market boom and eventual crash. Decisions are not made in isolation, as conventional economics would have it. And fundamental values are less of a concern as investors’ confidence in prices continues to increase in the near future. Many behavioral economists refer to such behavior as irrational because it’s tied to the behavior of others, not to the fundamentals of the economy. Other behavioral economists view much of this behavior as understandable and even rational, given imperfect knowledge and the knowledge at hand. But even rational behavior can cause market inefficiencies. Bubbles and Busts: A Preface to Inefficient Markets Bubbles in asset prices, such as for bonds and shares in the stock market, represent a deviation from their fundamental values. Busts represent an eventual market adjustment to fundamental values, usually after they fall below fundamental values. Documenting bubbles and subsequent busts in asset prices has been critical to the development of behavioral finance. Cycles in assets prices represent movements around the fundamental values of financial assets. So, asset prices typically don’t represent fundamental values. Basically, movements in asset prices tend to differ or deviate from movements in the fundamental values of these assets. The facts challenge the conventional wisdom, opening the door to alternative understandings of the movement and level of asset prices. The Dutch tulip bulb bubble There have been many bubbles and busts over the past centuries, but one referred to often by economists is the “tulip mania” that took place in 17th-century Netherlands. In February 1637, the value of a single tulip bulb was worth many times the wage of a skilled worker...
eBook - ePubReal Estate Economics
A Point-to-Point Handbook
- Nicholas G. Pirounakis(Author)
- 2013(Publication Date)
- Routledge(Publisher)
...This is why conventional or ‘rule-of-thumb’ ways of identifying bubbles – see Section 11.4 – will continue to be used. To those seeking a failsafe way to spot the crest of a bubble, or the trough of a burst, the uncertainty may appear disappointing; it is nevertheless inevitable. Summary of main points 1 Asset-, including housing-, price bubbles happen when buoyant expectations of further price growth overshoot the influence of ‘fundamental’ factors determining demand and supply, and, at the same time, demand is ‘excessively’ enhanced, and speculative expectations begin to have material effects, with the help of ‘outside’ finance, particularly credit. 2 Bursts happen when market ‘actors’ realize, through an accumulation of signs, that the current level of prices is unsustainable. 3 In the housing sphere, the most potent of such signs are (a) a strong increase in the rate of house prices to incomes, relative to the ratio's long-run trend, and (b) an oversupply (or ‘overhang’) of dwellings. 4 The more a bubble has been financed by credit, and the greater and more varied the interconnections among financial institutions, or the complexity of their financial products, the more adverse the effects of the burst will be upon the wider economy. 5 Planning and land-use restrictions, and taxes, do not normally cause bubbles or bursts, but may contribute to them when other factors are also present and begin to work. 6 No single factor sparked the speculative wave that caused the US housing bubble of 2006...
eBook - ePubHousing Bubbles
Origins and Consequences
- Sergi Basco(Author)
- 2018(Publication Date)
- Palgrave Pivot(Publisher)
...© The Author(s) 2018 Sergi Basco Housing Bubbles https://doi.org/10.1007/978-3-030-00587-0_3 Begin Abstract 3. Origin of Asset Price Bubbles Sergi Basco 1 (1) Universitat Autònoma Barcelona, Barcelona, Spain Abstract The recurrence of asset price bubbles throughout history has stimulated the interest of economists in different generations. We divide theories on the origin of bubbles in two: (i) behavioral and (ii) rational. First, we explain how differences in the beliefs of agents may result in bubbles (behavioral explanation). Second, we discuss how asset price bubbles may emerge because the economy has a shortage of assets (rational explanation). Finally, we develop a simple model to explain how rational housing bubbles may appear in financially underdeveloped economies. Keywords Behavioral Rational bubbles Shortage of assets Financial constraint End Abstract Asset price bubbles have triggered the interest of distinguished economists across generations. This list includes several Nobel Prize winners. Starting with the late Paul Samuelson, who was awarded in the second edition (1970) and ending with the most recent Nobel Prize winner, Richard Thaler (2017). In between, Robert Shiller (2013) and Jean Tirole (2014) have also been awarded with the Nobel Prize. This (incomplete) list of economists help us to distinguish between two very different views on the origin of asset price bubble episodes. The first group, which includes Samuelson and Tirole, developed models to explain how asset price bubbles can be the rational market response to a market imperfection. The second group, which includes Shiller and Thaler, resorts to behavioral (or irrational) models to explain how boom-bust asset price episodes occur in equilibrium. 1 It is outside the scope of this book to make a formal literature review of these two big strands of the literature...
