Price Bubble

A price bubble is a situation in which the price of an asset rises far above its fundamental value, driven by expectations of further price increases rather than by the fundamentals. Bubbles are a recurrent feature of financial markets and are a source of concern for policymakers.

Characteristics

A bubble is characterised by a rapid increase in the price of an asset, accompanied by high trading volume and by the entry of new investors. The increase is not justified by the fundamentals, which may change little during the episode.

The bubble is sustained by expectations of further price increases, since investors buy the asset in the belief that they can sell it at a higher price. The expectations are self-fulfilling for a time, as the purchases themselves raise the price.

The bubble eventually bursts, when the expectations change and the price falls. The fall is often rapid and is accompanied by a decline in trading and by losses for the investors who bought at the peak.

Causes

Several factors contribute to the formation of bubbles. The availability of credit is a common factor, since the ability to borrow allows investors to buy the asset with leverage, amplifying the increase in the price.

The behaviour of investors also contributes. Herd behaviour, in which investors follow the actions of others, and the tendency to extrapolate recent price increases into the future, are both associated with bubbles.

Institutional factors, including the regulation of the market and the incentives of the participants, can also contribute. The design of the compensation of managers and the structure of the financial system affect the willingness of the participants to take risks.

Examples

The history of finance includes many examples of bubbles, including the tulip mania of the seventeenth century, the South Sea bubble, and the railway mania. More recent examples include the dot-com bubble of the late 1990s and the housing bubble that preceded the financial crisis.

The examples share common features, including the rapid increase in prices, the entry of new investors, and the eventual collapse. The episodes differ in the assets involved and in the institutional context.

Policy

The policy response to bubbles is debated. Some argue that the authorities should act to prevent bubbles, through the use of interest rates and of macroprudential instruments, since the collapse of a bubble can have severe consequences for the economy. Others argue that bubbles are difficult to identify in advance and that the authorities should instead focus on the resilience of the financial system.

The debate reflects the difficulty of identifying bubbles and of assessing their effects. The design of policy must take account of the uncertainty and of the risk that intervention may itself create distortions.

Bubbles and Financial Stability

The collapse of a price bubble can have severe consequences for the economy, particularly when the bubble is financed by credit. The decline in the asset prices reduces the wealth of the households and the value of the collateral of the firms, which reduces the spending and the lending.

The interaction between the asset prices and the credit is a central feature of the analysis of financial crises. The increase in the asset prices raises the value of the collateral, which allows the borrowers to obtain more credit, which raises the asset prices further. The process reverses when the prices fall.

The analysis of the interaction informs the design of the macroprudential policy, which seeks to contain the build-up of the risk during the expansion of the credit.

Detecting Bubbles

The detection of bubbles in real time is difficult, since the fundamental value of the asset is not observed. The analysts use a range of indicators, including the ratio of the price to the earnings, the ratio of the price to the rent, and the growth of the credit.

The indicators are imperfect, and the episodes of rapid price increases that are not followed by a collapse complicate the analysis. The difficulty of the detection is a central argument against the use of the policy to prevent the bubbles.

The development of the methods for the detection of the bubbles is an active area of research. The methods include the statistical tests for the explosive behaviour of the prices and the analysis of the expectations of the investors.

The Policy Response

The policy response to the bubbles is debated. The advocates of the intervention argue that the authorities should act to prevent the bubbles, since the collapse can have severe consequences. The opponents argue that the bubbles are difficult to identify and that the intervention may create distortions.

The response includes the use of the monetary policy, which affects the asset prices through the interest rates, and the use of the macroprudential policy, which seeks to contain the build-up of the risk. The design of the response must take account of the uncertainty and of the costs of the intervention.

Summary

Price bubbles are a recurrent feature of the financial markets and a source of concern for the policymakers. The analysis of the causes, of the consequences, and of the policy response informs the understanding of the financial stability.

See also

• Financial Economics
• Market Failure Theory
• Behavioural Economics