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In an economy with a central bank, the bank may therefore attempt to keep an eye on asset price appreciation and take measures to curb high levels of speculative activity in financial assets. Historically, this is not the only approach taken by central banks.
It has been argued  that they should stay out of it and let the bubble, if it is one, take its course. In the s, excess monetary expansion after the U. These bubbles only ended when the U. Similarly, low interest rate policies by the U. Federal Reserve in the — are believed to have exacerbated housing and commodities bubbles. The housing bubble popped as subprime mortgages began to default at much higher rates than expected, which also coincided with the rising of the fed funds rate.
It has also been variously suggested that bubbles may be rational,  intrinsic,  and contagious. Puzzlingly for some, bubbles occur even in highly predictable experimental markets, where uncertainty is eliminated and market participants should be able to calculate the intrinsic value of the assets simply by examining the expected stream of dividends.
Experimental bubbles have proven robust to a variety of conditions, including short-selling, margin buying, and insider trading. While there is no clear agreement on what causes bubbles, there is evidence [ citation needed ] to suggest that they are not caused by bounded rationality or assumptions about the irrationality of others, as assumed by greater fool theory. It has also been shown that bubbles appear even when market participants are well-capable of pricing assets correctly. More recent theories of asset bubble formation suggest that they are likely sociologically-driven events, thus explanations that merely involve fundamental factors or snippets of human behavior are incomplete at best.
Pessimists are predicting a global crash in 2020. You can see why
For instance, qualitative researchers Preston Teeter and Jorgen Sandberg argue that market speculation is driven by culturally-situated narratives that are deeply embedded in and supported by the prevailing institutions of the time. One possible cause of bubbles is excessive monetary liquidity in the financial system, inducing lax or inappropriate lending standards by the banks , which makes markets vulnerable to volatile asset price inflation caused by short-term, leveraged speculation.
Weber , the former president of the Deutsche Bundesbank , has argued that "The past has shown that an overly generous provision of liquidity in global financial markets in connection with a very low level of interest rates promotes the formation of asset-price bubbles. According to the explanation, excessive monetary liquidity easy credit, large disposable incomes potentially occurs while fractional reserve banks are implementing expansionary monetary policy i. Those who believe the money supply is controlled exogenously by a central bank may attribute an 'expansionary monetary policy' to said bank and should one exist a governing body or institution; others who believe that the money supply is created endogenously by the banking sector may attribute such a 'policy' with the behavior of the financial sector itself, and view the state as a passive or reactive factor.
Explanations focusing on interest rates tend to take on a common form, however: When interest rates are set excessively low, regardless of the mechanism by which it is accomplished investors tend to avoid putting their capital into savings accounts. Instead, investors tend to leverage their capital by borrowing from banks and invest the leveraged capital in financial assets such as stocks and real estate.
Risky leveraged behavior like speculation and Ponzi schemes can lead to an increasingly fragile economy, and may also be part of what pushes asset prices artificially upward until the bubble pops. Paul Krugman . Simply put, economic bubbles often occur when too much money is chasing too few assets, causing both good assets and bad assets to appreciate excessively beyond their fundamentals to an unsustainable level.
This may involve actions like bailouts of the financial system, but also others that reverse the trend of monetary accommodation, commonly termed forms of 'contractionary monetary policy'. Ideally, such countermeasures lessen the impact of a downturn by strengthening financial institutions while the economy is strong. Advocates of perspectives stressing the role of credit money in an economy often refer to such bubbles as "credit bubbles", and look at such measures of financial leverage as debt-to-GDP ratios to identify bubbles.
Typically the collapse of any economic bubble results in an economic contraction termed if less severe a recession or if more severe a depression; what economic policies to follow in reaction to such a contraction is a hotly debated perennial topic of political economy. The importance of liquidity was derived in a mathematical setting  and in an experimental setting   see Section "Experimental and mathematical economics".
Greater fool theory states that bubbles are driven by the behavior of perennially optimistic market participants the fools who buy overvalued assets in anticipation of selling it to other speculators the greater fools at a much higher price. According to this explanation, the bubbles continue as long as the fools can find greater fools to pay up for the overvalued asset.
The bubbles will end only when the greater fool becomes the greatest fool who pays the top price for the overvalued asset and can no longer find another buyer to pay for it at a higher price. This theory is popular among laity but has not yet been fully confirmed by empirical research.
Clifford Asness . Extrapolation is projecting historical data into the future on the same basis; if prices have risen at a certain rate in the past, they will continue to rise at that rate forever. The argument is that investors tend to extrapolate past extraordinary returns on investment of certain assets into the future, causing them to overbid those risky assets in order to attempt to continue to capture those same rates of return. Overbidding on certain assets will at some point result in uneconomic rates of return for investors; only then the asset price deflation will begin. When investors feel that they are no longer well compensated for holding those risky assets, they will start to demand higher rates of return on their investments.
Another related explanation used in behavioral finance lies in herd behavior , the fact that investors tend to buy or sell in the direction of the market trend. Investment managers, such as stock mutual fund managers, are compensated and retained in part due to their performance relative to peers. Taking a conservative or contrarian position as a bubble builds results in performance unfavorable to peers. This may cause customers to go elsewhere and can affect the investment manager's own employment or compensation. The typical short-term focus of U.
In attempting to maximize returns for clients and maintain their employment, they may rationally participate in a bubble they believe to be forming, as the risks of not doing so outweigh the benefits. Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. A person's belief that they are responsible for the consequences of their own actions is an essential aspect of rational behavior. An investor must balance the possibility of making a return on their investment with the risk of making a loss — the risk-return relationship.
A moral hazard can occur when this relationship is interfered with, often via government policy. President George W. Bush on 3 October to provide a Government bailout for many financial and non-financial institutions who speculated in high-risk financial instruments during the housing boom condemned by a story in The Economist titled "The worldwide rise in house prices is the biggest bubble in history".
Other causes of perceived insulation from risk may derive from a given entity's predominance in a market relative to other players, and not from state intervention or market regulation. A firm — or several large firms acting in concert see cartel , oligopoly and collusion — with very large holdings and capital reserves could instigate a market bubble by investing heavily in a given asset, creating a relative scarcity which drives up that asset's price.
Because of the signaling power of the large firm or group of colluding firms, the firm's smaller competitors will follow suit, similarly investing in the asset due to its price gains. When the large firm, cartel or de facto collusive body perceives a maximal peak has been reached in the traded asset's price, it can then proceed to rapidly sell or "dump" its holdings of this asset on the market, precipitating a price decline that forces its competitors into insolvency, bankruptcy or foreclosure.
The large firm or cartel — which has intentionally leveraged itself to withstand the price decline it engineered — can then acquire the capital of its failing or devalued competitors at a low price as well as capture a greater market share e. Some regard bubbles as related to inflation and thus believe that the causes of inflation are also the causes of bubbles. Others take the view that there is a "fundamental value" to an asset , and that bubbles represent a rise over that fundamental value, which must eventually return to that fundamental value.
There are chaotic theories of bubbles which assert that bubbles come from particular "critical" states in the market based on the communication of economic factors. Finally, others regard bubbles as necessary consequences of irrationally valuing assets solely based upon their returns in the recent past without resorting to a rigorous analysis based on their underlying "fundamentals".
Bubbles in financial markets have been studied not only through historical evidence, but also through experiments , mathematical and statistical works. Smith, Suchanek and Williams  designed a set of experiments in which an asset that gave a dividend with expected value 24 cents at the end of each of 15 periods and were subsequently worthless was traded through a computer network.
They found instead that prices started well below this fundamental value and rose far above the expected return in dividends.
Pessimists are predicting a global crash in You can see why | Business | The Guardian
The bubble subsequently crashed before the end of the experiment. This laboratory bubble has been repeated hundreds of times in many economics laboratories in the world, with similar results. The existence of bubbles and crashes in such a simple context was unsettling for the economics community that tried to resolve the paradox on various features of the experiments.
To address these issues Porter and Smith  and others performed a series of experiments in which short selling, margin trading, professional traders all led to bubbles a fortiori. Much of the puzzle has been resolved through mathematical modeling and additional experiments. In particular, starting in , Gunduz Caginalp and collaborators   modeled the trading with two concepts that are generally missing in classical economics and finance.
First, they assumed that supply and demand of an asset depended not only on valuation, but on factors such as the price trend. Second, they assumed that the available cash and asset are finite as they are in the laboratory. This is contrary to the "infinite arbitrage" that is generally assumed to exist, and to eliminate deviations from fundamental value.
Utilizing these assumptions together with differential equations, they predicted the following: a The bubble would be larger if there was initial undervaluation. Initially, "value-based" traders would buy the undervalued asset creating an uptrend, which would then attract the "momentum" traders and a bubble would be created. An epistemological difference between most microeconomic modeling and these works is that the latter offer an opportunity to test implications of their theory in a quantitative manner.
This opens up the possibility of comparison between experiments and world markets. These predictions were confirmed in experiments   that showed the importance of "excess cash" also called liquidity, though this term has other meanings , and trend-based investing in creating bubbles. When price collars were used to keep prices low in the initial time periods, the bubble became larger. This provided valuable evidence for the argument that "cheap money fuels markets. Caginalp's asset flow differential equations provide a link between the laboratory experiments and world market data.
Since the parameters can be calibrated with either market, one can compare the lab data with the world market data.