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Bursting the Bubble-Bubble

The word “bubble” must be in some kind of bubble.   I’m serious.   A few months ago, oil (according to some) was supposed to be in a bubble (it wasn’t) while at the same time, government bonds were supposed to be in a ‘bubble’ as well (see here and especially here). Today Matt Yglesias points out (citing this)  that Norway is in a property bubble.   Of these, this last example is likely to the only bubble.

We need to think more seriously about what it means to be in a bubble.

What is a “Bubble”?

I think the problem here starts with the fact that no one seems to agree, precisely, what a bubble is.  For Karl Smith an asset is apparently in a ‘bubble’ if it has high liquidity value (it can be sold quickly and without loss).   On the one hand, every bubble that has ever existed has had this property.  On the other hand, what about this definition wouldn’t apply to the run-up in oil prices?

So, I would argue that this definition is far too broad and it obscures more than it illuminates.   In particular, adopting this definition of bubble would gives us absolutely no idea when a bubble would be considered dangerous and when not.   If government bonds are “in a bubble” (like oil prices were last year), it is not a dangerous bubble.

For the Fed note that Matt Yglesias points to, the definition of bubble is a falling risk premium.   The problem, of course, with this idea is actually buried in the note iteself.   On the one hand, there is a clear expectational channel necessary for bubbles to form;

One way that a bubble might be distinguished from a situation with rationally low risk premiums is to examine investor expectations about returns. Rational investors with low risk premiums would expect low returns after a sustained price run-up. By contrast, irrationally exuberant bubble investors would expect high returns because they simply extrapolate recent price movements into the future

But on the other hand,  this is the case far too often to be called a ‘bubble’ every time it appears;

Shiller (2000) developed a questionnaire to study investor expectations about future stock market returns in Japan and the United States during the 1990s. From the data, he constructed an index of “bubble expectations,” that is, the belief that stock prices would continue to rise despite being high relative to fundamentals. He found that the index moved roughly in line with movements in the stock market itself, suggesting that investors tend to extrapolate recent market trends when making predictions about future returns.

In other words, this definition is also too broad.   The typical ups and downs of the stock market should not be lumped in with the real deal (the US housing bubble circa 2005, the Norwegian housing bubble).

A better definition

To get a useful definition for bubble, we need that definition to capture;

  1. that a “bubble” should be dangerous–a bubble represents a true instability in the economy
  2. that prices no longer reflect market “fundamentals”
  3. that this is an unusual situation

To capture all three at the same time, I would start by (only partly) agreeing with Karl Smith–a high value for the liquidity premium is necessary, but not sufficient.   I can think of at least two reasons; a) a bubble occurs for goods with significant resale value or equivalently in markets for particularly long-lived goods–this means asset markets primarily, or possibly durable goods markets if the rate of depreciation is slow enough, b) a bubble occurs when the expected resale price of the asset rises; or equivalently the implied yield rises, ceteris paribus

Both a) and b) imply that liquidity premia are critical for bubbles to form.   But are these enough?  If a market is simply in backwardation, then the price would rise in the future and it would be expected to rise.    Moreover, the asset would almost certainly be liquid in this kind of scenario, since the reason a commodity market might be in backwardation is that there is an expected future shortage, i.e. you will expect to be sell the asset without taking a loss (storing the commodity may be difficult).

Relatedly, liquidity premia are a kind of insurance–a liquid asset is one that could be sold quickly in the event that you need cash for an emergency.   But, at what point is liquidity premium so high that it can’t be explained by the insurance value of liquidity?

Liquidity and leverage

I think liquidity premia capture much of the bubble dynamic, but I think I’ve argued sufficiently that it doesn’t capture everything.   So what’s missing?   As a first thought, I think we really need to seperate out price and income effects.   So, let me try the following definition;

An asset is in a Bubble if it is behaving as both a giffen good (demand increases as its price rises) and a normal good (demand increases as buyer income increases).

[For the rest of this post, don’t think an “income effect” with regard to current income, but rather “wealth effect”, since purchases of the asset are funded–for a particular buyer–out of wealth, not necessarily income, so that the budget constraint shifts outward with rising wealth. ]

This definition is completely descriptive.   Still, thinking through the dynamics of a good that is both giffen and normal suggests a circular feedback process where demand for the asset rises, bounded only by funds available for purchase.   Prices rise, so that demand rises (giffen) so that the wealth of asset holders rises (the asset itself is a part of one’s portfolio) and so demand rises (normal) and so price rises (scarcity).   Basically, the supply and demand curves are shifting outward together, and the demand curve, in particular, is upward sloping.

This unstable situation suggests (but doesn’t require) the use of leverage–if the process is limited by the supply of funds available, then funds will be drawn from elsewhere.   This is the missing ingredient.   Asset purchases in the context of rising prices are being funded in part from those same asset price increases, but also from increased borrowing.   If that is the case, then this “bubble” as I’ve defined it is also very dangerous.

And that covers every requirement I set out.   It’s a dangerous (combined with leverage), unusual market in which the price of the asset does not reflect fundamentals in the sense that the pattern of supply/demand cannot possibly continue in the same way indefinitely.

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Categories: Finance, macro, Micro
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