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Friday, May 16, 2008

How and Why Do Bubbles Form?

What causes bubbles? Here's one set of views:

Bernanke's Bubble Laboratory, by Justin Lahart, WSJ [Open Link]: First came the tech-stock bubble. Then there were bubbles in housing and credit. Chinese stocks took off like a rocket. Now, as prices soar on every material from oil to corn, some suggest there's a bubble in commodities.

But how and why do bubbles form? Economists traditionally haven't offered much insight. ... Now, the study of financial bubbles is hot. Its hub is Princeton..., home to a band of young scholars hired by ... Ben Bernanke...

[T]he Princeton squad argues that the Fed can and should try to restrain bubbles, rather than following former Chairman Alan Greenspan's approach: watchful waiting while prices rise and then cleaning up the mess after a bubble bursts. ...

The Fed is giving the activist approach some thought. ... Yet the very concept of bubbles is at odds with the view of some that market prices reflect the collective knowledge of multitudes. There are economists who dispute the existence of bubbles -- arguing, for instance, that what happened to prices in the dot-com boom was a rational response to the possibility that nascent Internet firms might turn into Microsofts. But these economists' numbers are thinning. ...

Bubbles don't spring from nowhere. They're usually tied to a development with far-reaching effects: electricity and autos in the 1920s, the Internet in the 1990s, the growth of China and India. At the outset, a surge in the values of related businesses and goods is often justified. But then it detaches from reality. ...

Mr. [Harrison] Hong ... argues that big innovations lead to big differences of opinion between bullish and bearish investors. But the deck is stacked in favor of the optimists.

One who believes a stock is too high can short it, borrowing shares and selling them in hopes of replacing them when they're cheaper. But this can be costly, both in the fees and in the risk of huge losses if the stock keeps rising. Many big investors rarely short stocks. When differences between bullish investors and bearish ones are extreme, many of the bears simply move to the sidelines. Then, with only optimists playing, prices go higher and higher.

In housing and the credit markets, the innovation was slicing and dicing loans in novel ways. As investors bought the resulting mortgage securities, they provided abundant capital for home buyers; buoyed by this and falling interest rates, house prices surged.

Betting against house prices is hard; only a few sophisticated investors found roundabout ways to do it, in derivatives markets. Most skeptics about the housing boom just sat it out; the optimists were unchecked.

At some point in a bubble, optimists' enthusiasm runs its course. Prices turn down... -- and then they tumble. ... Mr. Hong and Harvard's Jeremy Stein ... say ... prices fall more rapidly than they go up. ... That ... offers a strong argument, in Mr. Hong's view, for government to restrain bubbles and the borrowing that fuels them.

At the height of the tech bubble, Internet stocks changed hands three times as frequently as other shares. "The two most important characteristics of a bubble," says Wei Xiong, are: "People pay a crazy price and people trade like crazy." ...

According to a model [Wei Xiong] developed with Mr. Scheinkman, investors dogmatically believe they are right and those who differ are wrong. And as one set of investors becomes less optimistic, another takes its place. Investors figure they can always sell at a higher price. That view leads to even more trading, and, at the extreme, stock prices can go beyond any individual investor's fundamental valuation. ...

Bubbles often keep inflating despite cautions such as Mr. Greenspan's famous warning of "irrational exuberance." Tech stocks rose for more than three years after he said that, in late 1996. Markus Brunnermeier ... thinks he understands why this happens. ...

Inspired by Mr. Hayek's work, Mr. Brunnermeier studied economics. But in the 1990s, soaring tech stocks made him skeptical of the quality of information that prices convey. ...

Under the Hayek view, bubbles don't make sense. As soon as some group of traders irrationally pushes prices way up, more-rational traders should take advantage of the mispricing by selling -- bringing prices back down. But the tech boom reinforced an oft-quoted warning from John Maynard Keynes: "The market can stay irrational longer than you can stay solvent."

So investors who spot the bubble attack only if each is confident that other skeptics are on board. In work done with Mr. Abreu, Mr. Brunnermeier concluded that if all the rational investors could agree to bet against the bubble, they could make big profits. But if they can't coordinate, it's risky for any one of them to bet against a bubble. So it makes sense to ride it up and then get out quickly as soon as the bubble's existence becomes common knowledge. ...

Looking through security filings, Mr. Brunnermeier and Stanford's Stefan Nagel found that hedge funds on the whole "skillfully anticipated price peaks" in individual tech stocks, cutting back before prices collapsed and shifting into other tech stocks that were still rising. Hedge funds' overall exposure to tech stocks peaked in September 1999, six months before the stocks peaked. They rode the bubble higher and got out close to the right time.

Mr. Brunnermeier saw the bubble, too. He thought people were crazy for buying tech stocks. But as both the hedge funds' gains and his theoretical work suggest, even if you know there's a bubble, it might be smart to go along.

"I was always convinced that there was an Internet bubble going on and never invested in Internet stocks," he says. "My brother-in-law did. My wife always complained that I studied finance and her brother was making a lot of money on Internet stocks."

    Posted by on Friday, May 16, 2008 at 02:16 AM in Economics, Financial System | Permalink  TrackBack (0)  Comments (38)

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