Bubbles and Fools;

Bubbles and fools Gadi Barlevy Introduction and summary and a glut of assets created while prices were rising. In the wake of the financial crisis of 2007–08 and the This suggests defining a bubble as an asset whose Great Recession precipitated by it, a growing chorus has price is somehow too high, which is indeed the way argued that policymakers ought to act more aggressively economists typically define the term: A bubble is an to rein in asset bubbles—that is, scenarios in which asset whose price deviates from its “natural” value. asset prices rise rapidly and then crash. Before the But what is the natural value for an asset? When the crisis, conventional wisdom among policymakers cash flows an asset pays out in dividends are drawn cautioned against acting on suspected bubbles. As laid from a known probability distribution, a natural bench- out in an influential paper by Bernanke and Gertler mark value is the expected present discounted value (1999), there are two reasons for this. First, while asset of the dividends it generates—also known as the fun- prices are increasing, it is difficult to gauge whether damental value of the asset. Intuitively, society values these prices are likely to remain high or revert. Second, assets for the dividends they are expected to yield, so many of the available tools for reining in asset prices, such as raising nominal short-term interest rates, tend to be blunt instruments that impact economic Gadi Barlevy is a senior economist and research advisor in the Economic Research Department at the Federal Reserve Bank of activity more broadly. Bernanke and Gertler argued Chicago. The author thanks Lisa Barrow, Bob Barsky, Antonio that rather than responding to rising asset prices, policy- Doblas-Madrid, and François Velde for their helpful comments. makers should stand ready to address the consequences © 2015 Federal Reserve Bank of Chicago of a collapse in asset prices if and when it happens.1 Economic Perspectives is published by the Economic Research Department of the Federal Reserve Bank of Chicago. The views The severity of the Great Recession and the challenge expressed are the authors’ and do not necessarily reflect the views of trying to stimulate economic activity even after of the Federal Reserve Bank of Chicago or the Federal Reserve lowering short-term rates to zero led many to rethink System. Charles L. Evans, President; Daniel G. Sullivan, Executive Vice whether policymakers should wait and see if asset President and Director of Research; David Marshall, Senior Vice prices collapse and then deal with the aftermath. Of President and Associate Director of Research; Spencer Krane, course, just because the stakes are great does not Senior Vice President and Senior Research Advisor; Daniel Aaronson, Vice President, microeconomic policy research; Jonas D. M. mean policymakers can or should do anything if they Fisher, Vice President, macroeconomic policy research; Anna L. are concerned about a possible bubble. To determine Paulson, Vice President, finance team; William A. Testa, Vice President, regional programs; Lisa Barrow, Senior Economist and whether anything can or should be done, we need to Economics Editor; Helen Koshy and Han Y. Choi, Editors; Julia understand when and why bubbles can emerge and what Baker, Production Editor; Sheila A. Mangler, Editorial Assistant. that might mean for policy. This article considers one Economic Perspectives articles may be reproduced in whole or in part, provided the articles are not reproduced or distributed for explanation for bubbles known as the greater-fool commercial gain and provided the source is appropriately credited. theory of bubbles, as well as its implications for policy. Prior written permission must be obtained for any other reproduc- As a first step, let me be clear on what I mean by tion, distribution, republication, or creation of derivative works of Economic Perspectives articles. To request permission, please a bubble. Arguably, the distinguishing feature of the contact Helen Koshy, senior editor, at 312-322-5830 or email various historical episodes that are usually described [email protected]. as bubbles is that asset prices seem to rise too quickly, ISSN 0164-0682 culminating in an eventual collapse of asset prices 54 2Q/2015, Economic Perspectives the fundamental value represents how much an asset than they think it is worth because they anticipate they ought to be worth if it is to be supplied efficiently. In might be able to sell it to someone else for an even practice, though, the distribution of dividends is typically higher price. Such explanations have come to be known unknown; scenarios that matter for dividends may have as greater-fool theories because they all invariably in- few or no historical precedents that can be used to volve speculative trading in the sense in which I defined gauge their likelihood. If agents held different beliefs it earlier—that is, traders trade assets because they as to the likelihood of these states, it isn’t clear what expect to profit at the expense of others (who would the benchmark value of an asset should be: Whose be the greater fools) rather than because they expect beliefs should we use to compute the expected present mutual gains from trading.5 This feature distinguishes discounted value of cash flows? In what follows, I discuss this explanation of bubbles from some of the explana- some ways of extending the definition of a bubble to tions based on asset scarcity that feature finitely lived the case where agents have different beliefs.2 Indeed, agents who buy infinitely lived assets. In the latter one of the themes of this article is that some models case, agents also buy an asset intending to eventually that purport to capture bubbles rely on a particular way sell it to someone else for a higher price. But in such of defining the fundamental value of an asset when a case, they do not expect to profit at the expense of traders hold different beliefs, though using alternative those they trade with and would have been willing to definitions would imply the asset is in fact properly hold on to the asset if they could. priced. It is thus unclear whether these models should Theories of bubbles based on asset shortages or be viewed as capturing bubbles in the sense that the risk shifting are straightforward and fairly well under- underlying asset is overvalued. That said, these models stood. By contrast, greater-fool theories of bubbles unambiguously capture a separate phenomenon, specula- raise a host of complications, even though the idea they tive trading, by which I mean that agents trade assets represent is simple and resonates with many people. not because they expect mutually beneficial gains from For example, Edward Chancellor titled his 1999 book trading with others, but because they expect to profit on the history of speculation Devil Take the Hindmost, at the expense of others. Speculative trading may well alluding to the fact that whoever is the last to be stuck be something policymakers should be concerned about, with the asset ends up losing.6 Academics and non- but the appropriate policy response to it need not be academics both refer to investors “riding the bubble” framed in terms of driving asset prices back toward to evoke the way one might ride up an air bubble in a fundamentals, as policy prescriptions for responding champagne flute, letting go right before the bubble to bubbles often are. reaches the surface and pops. The problem is that It turns out that it is not easy to construct economic constructing a model where such bubbles arise can be models that give rise to bubbles in the sense I have daunting. First and foremost, if we assume traders are just described. The reason is that people will naturally rational and understand the underlying environment be reluctant to pay more for an asset than the value they face (as is common in most economic models), of the dividends it generates. Nevertheless, there are the greater-fool theory may not hang together: The settings in which this phenomenon can occur. One traders one expects to profit off of would be aware explanation is that when asset prices are equal to fun- that others are trying to exploit them and might refuse damentals, there will be a shortage of assets relative to buy the asset. Economists have figured out ways to to the amount agents require for saving or liquidity or get around this problem. But even if we succeed in to earn a satisfactory return. According to this view, a getting rational agents to trade an asset in the hope shortage will lead agents to pile into whatever assets of profiting at the expense of other traders, it is not are available. Even if assets trade above their fundamen- clear whether this asset can be legitimately viewed tals, agents might still be willing to buy them given as a bubble. As noted earlier, if traders hold different their inherent usefulness.3 views about how valuable the asset is, it is not obvi- A different explanation for bubbles is based on risk ous how to define the asset’s fundamental value. Is it shifting: If agents can buy risky assets and borrow the highest value of dividends any trader in the econ- against them, they would be willing to pay more for omy expects the asset to generate? As I discuss later assets than their expected payoff, since they can shift on, some models—which I shall call asymmetric in- their losses on to their creditors by defaulting.4 formation models of bubbles—can be understood as A third explanation for why bubbles can arise— proper models of bubbles.

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