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Yes, There Is Such a Thing as a Rational Bubble -- We're in One Now


Double, double, toil and trouble, fire burn and caldron bubble. Why financial bubbles are not as crazy as they seem.

MINYANVILLE ORIGINAL When I got interested in finance in the late 1970s, the economy was in the midst of a real asset bubble. Financial assets-stocks and bonds-were hammered during that decade while real assets-real estate and commodities-soared. From 1976 to early 1980, the price of gold rose from $100 to $850 per ounce. Two years later, gold was under $300.

Jonathan Swift in 1721 was the first writer to use "bubble" to mean a public delusion that inflates the price of something without economic justification. But calling something a "delusion" or "the madness of crowds" is not helpful for prediction or explanation. While bubble investors as a group seem to be irrational, individually they can hope to sell at an even more inflated price than they buy, and in fact many people do make money investing in bubbles. The trick is to take out more money than you put in before the bubble pops.
This notion is the germ of the idea that bubbles might be explained without positing irrational actions. If so, not only would that deepen our understanding of bubbles, but it might point to ways to predict them, or perhaps to prevent them, or best of all, to modify them in ways that preserved their benefits while avoiding their costs.

There was a lot of work on rational bubbles from 1978 to 1987, but the stock market crash on October 19, 1987 pretty much ended it. The crash refocused most academic interest to behavioral explanations. There are several well-documented psychological mechanisms that can support irrational bubbles: Overconfidence, recency bias, confirmation bias, information cascades, reputational herding, and envy, among others.

Of course, all these mechanisms are real, and illuminate some aspects of bubbles. But despite years of efforts, behavioral work failed to generate non-obvious insights about historical bubbles. Individuals have biases, but that doesn't explain why other individuals don't figure this out and offset those biases, or why institutions do not develop to control the effect of individual biases.

The same behavioral theories that explain bubbles are also used to explain fashions, but fashion seems to revolve steadily rather than generating booms and busts. Behavioral theorists had no trouble explaining why interest in a financial idea might expand rapidly and then decline even more rapidly, just as clothing or music fads rise and fall. But going from this to a plausible and useful explanation of the economic effects of bubbles proved more difficult. In particular, behavioral models produced nothing but Monday morning quarterbacking regarding the Internet bubble that popped in 2000 and the housing bubble that popped in 2007.
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No positions in stocks mentioned.
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