Academic journal article Chicago Fed Letter

Asset Price Bubbles: What Are the Causes, Consequences, and Public Policy Options?

Academic journal article Chicago Fed Letter

Asset Price Bubbles: What Are the Causes, Consequences, and Public Policy Options?

Article excerpt

This article discusses how the global financial crisis has forced researchers and policymakers to reconsider their understanding of both the economics of asset price bubbles and alternative policy options to address them.

Asset price bubbles have generated significant interest, since there have been instances when their bursting has led to turmoil in financial markets and the wider economy. The October 1929 stock market crash is perhaps the most dramatic instance. That said, until recently, the successful performance of the U.S. economy in the post-World War II era, particularly during the "Great Moderation" of 1984-2006, appeared to provide both economists and policymakers with confidence that there was little need for public policy to manage such bubbles. For example, the October 1987 stock market crash had little impact on the real economy, and the bursting of the Internet bubble in 2000 resulted only in a short and mild recession by historical standards. However, the global financial crisis of 2007-09, induced in large part by a crashing of the housing market, had a significant adverse impact on both the U.S. and global economies. As a result, economists and policymakers have begun to reevaluate what they really know about asset bubbles and whether they can (or should) be managed in the public interest.1

To advance our knowledge of asset bubbles, Loyola University Chicago hosted a conference in April 2011. Papers were commissioned from experts to reexamine a number of seminal articles on asset bubbles written before the crisis. The ultimate objective was to challenge orthodox thinking on bubbles in light of recent events.

Subsequently, five seminal papers on asset bubbles, five papers commissioned to evaluate and update these influential works, and additional related research were published in a book titled New Perspectives on Asset Price Bubbles.2 The remainder of this article provides a summary of the analyses of bubbles in that volume.

What are asset bubbles?

In general, according to current economic theory, a bubble exists when the market price of an asset exceeds its price determined by fundamental factors by a significant amount for a prolonged period. The efficient market hypothesis asserts that extraordinary movements in asset prices are a consequence of significant changes in information about fundamentals. Thus, actual and fundamental prices are always the same, and bubbles cannot exist unless they are driven by irrational behavior or market rigidities, such as constraints on the short selling of assets. In a seminal article (first published in 1993), Franklin Allen and Gary Gorton examine this critical question: Are stock prices determined by economic fundamentals, or can bubbles exist?

They carefully develop a detailed theoretical model and show mat the existence of bubbles can be consistent with rational behavior. This result was not fully appreciated at the time by either economists or central bankers, who often were skeptical about the existence of bubbles. In a review of Allen and Gorton's paper, Gadi Barlevy discusses the current state of theoretical models of asset bubbles. He expresses disappointment with the gap between the theoretical work on asset bubbles and the post-crisis change in views about the appropriate policy response among some policymakers (i.e., to intervene). Little in the theoretical literature supports the contention mat intervention is appropriate. Yet empirical evidence suggests mat the potential costs of bubbles may be significant. Barlevy concludes mat theoretical models of bubbles have not adequately addressed welfare considerations and mus are unable to offer convincing analytical guidance to central banks as to whether an economy will be better off from attempts to manage asset bubbles.

Causes and consequences

Among the various types of asset bubbles, stock market and housing bubbles are historically of most interest to central banks, since such bubbles have been associated with the greatest adverse effects. …

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