The Economist thinks bubbles are rational

Or at least is what they suggest in the popular blog Free Exchange. They bring back Peter Garber's research on the Tulipmania, and more recent research by Earl Thompson, which suggests that "the market for tulips was an efficient response to changing financial regulation." They conclude by arguing that:
"It is easy to claim that bubbles are irrational. They seem to represent a deviation of prices from fundamental values—and they contradict basic economic theory. But there has been little attempt to understand how speculation actually works. The example of tulipmania shows the importance of doing that—rather than relying on lazy quips about 'animal spirits' or irrationality."
The notion is related to the idea of the Arrow-Debreu models in which short term prices (they don't have long term prices associated with a uniform rate of profit) do reflect the fundamental values associated to the preferences of agents and the given technology and factor endowments. In this context, the efficient market hypothesis (EMH) suggests that the prices of financial assets reflect all market information, and as a result those prices would not deviate from their fundamentals. In other words, according to the EMH, bubbles do not exist.

Rational bubbles assume that rational behavior may still be associated with deviations of asset prices away from their fundamental values. In general, a self-confirming belief that asset prices depend on a variable that is intrinsically irrelevant, that is, not part of market fundamentals, is assumed. Much discussion goes into the behavioral assumptions that would make rational bubbles possible. Justin Fox's The Myth of the Rational Market, which I reviewed here (subscription required) provides an accessible introduction.

John Eatwell (here; subscription required) noted that a more relevant question than the rationality or not of bubbles is whether they are useful or not. Railroads were built on bubbles, and the bubble even left some infrastructure in terms of telecommunications that has been useful. Other bubbles, like the one associated with the subprime, are less obviously useful.

Finally, note that the old capital debates are still important to understand the limitations of much of this literature. Garegnani and Petri have noted that even the short run Arrow-Debreu models must bring investment to equality to full employment savings, and as a result some notion of a natural rate of interest is implicitly needed. And then all the problems of the aggregative model apply. So it is not possible to show that long term prices do reflect fundamentals associated with preferences, technology and endowments.

PS: On the related topic of whether the Bubble Act (financial regulation), that followed the South Sea Bubble, led to lower rates of growth see here. For the capital debates go here.


  1. emh: a beauty contest where the contestants remain behind the curtain


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