Bubbles in Asset Prices

The severe world-wide recession of 2008-09 has focused attention on the role of asset-price bubbles in exacerbating economic instability in capitalist economies. The boom in house prices in the United States from 2000 through 2006 is a case in point. According to the Case-Shiller 20-city index, the inflation-adjusted price of a median-sized house in the United States doubled over the period 2000-2006. House prices rose far more than the underlying fundamental drivers of home prices such as family income and rents. The bursting of the bubble was followed by a sharp rise in foreclosures and massive declines in the value of mortgage-backed securities and a variety of derivatives tied to these securities. The collapse of these prices led to the weakening, and in some cases the collapse, of major financial institutions around the world and contributed to one of the most serious recessions in the United States in the entire post-World War II period. The housing bubble is the most recent example of the asset-price bubbles that have often afflicted capitalist economies. Sharp increases in asset prices have frequently led to crashes and subsequent sharp declines in economic activity. Many economists have argued, controversially, that central banks should adjust their policy instruments to account not only for their forecasts of future inflation and the gap between actual and potential output, but for asset prices as well. This paper will address three topics. First, I will describe what economists mean when they use the term bubble, and I will contrast the behavioral-finance view of asset pricing with the efficient-market paradigm in an attempt to understand why bubbles might persist and why they may not be arbitraged away. Second, I will review some major historical examples of asset-price bubbles as well as the (minority) view that they may not have been bubbles at all. I will also examine the corresponding changes in real economic activity that have followed the bursting of such bubbles. Finally, I will examine the most hotly-debated aspect of any discussion of asset-price bubbles: what, if anything, should policy makers do about them? Should they react to sharp increases in asset prices that they deem to be unrelated to fundamentals? Should they take the view that they know more than the market does? Should they recognize that asset-price bubbles are a periodic flaw of capitalism and conduct their policies so as to temper any developing excesses? Or should they focus solely on their primary targets of inflation and real economic activity? In my discussion I will pay particular attention to bubbles that are associated with sharp increases in credit and leverage.