This fascinating article about experimental economists’ research into financial bubbles suggests that bubbles are a natural event on the way to equilbrium. The researchers set up an artifical market with identical assets, known dividends and a finite end period. With the value of the asset clearly defined in each period by the remaining dividend payments, the researchers expected prices to closely track the asset value.
Again and again, in experiment after experiment, the trading price runs up way above fundamental value. Then, as the [final] round nears, it crashes.
. . .
Based on future dividends, you know for sure that the security’s current value is, say, $3.12. But… you don’t know that I’m as savvy as you are. Maybe I’m confused. Even if I’m not, you don’t know whether I know that you know it’s worth $3.12. Besides, as long as a clueless greater fool who might pay $3.50 is out there, we smart people may decide to pay $3.25 in the hope of making a profit. It doesn’t matter that we know the security is worth $3.12. For the price to track the fundamental value, says Noussair, “everybody has to know that everybody knows that everybody is rational.”
Essentially, people push up the price because they believe that they’re smarter than at least someone out there and can get them to purchase the asset at well above its value. Sadly, it appears that they’re right. The researchers term the people who jump on the bandwagon as the price rises ‘momentum traders’ and these are the people who lose out: “[b]ubbles start to pop when the momentum traders run out of money and can no longer push prices up”, and that’s when the market crashes.
How can we regulate to curb bubbles and speculation when it’s not uncertainty about the value of the assets that’s pushing up prices? Even with the best intentioned regulation there will always be those who think they can make money off those less sophisticated than themselves. Maybe we just have to learn to live with financial bubbles the way we live with the boom and bust of the business cycle.
ht: Matt Yglesias