Arnold Kling  

What is a Bubble?

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Scott Sumner writes,


if the term "bubble" is to mean anything useful, it must contain an implied prediction of the future course of asset prices.

I read this as saying that a bubble is when someone can correctly predict that an asset price will fall. I think this is not a useful definition, for a number of reasons.

Instead, I would borrow from Robert Shiller the notion that a bubble is characterized by unreasonably high expectations for continued appreciation. When the housing market was bouyant, Shiller undertook surveys of people and found that their expectations for house price appreciation were 10 percent per year. One can raise questions about the survey methods, but the intent is to capture what to me is the essence of a bubble: prices rise because people expect them to rise.

In my high school econ class, I use an equation for determining the profitable of buying an asset:

profitability = rental rate plus appreciation minus interest cost

Whenever the expected appreciation exceeds the interest cost, the asset appears profitable to buy as long as its rental rate is not negative. If mortgage rates are less than 10 percent and people expect 10 percent house price appreciation, they are going to want to buy houses.

In general, I would say that when people expect an asset price to rise for a long period of time at a rate that is much higher than the long-term nominal interest rate, we are going to see a bubble in that asset. There will be strong demand for that asset until expectations change.

This issue of expectations is an interesting one right now when one considers gold and long-term bonds. As I have noted before, people buying gold probably have much higher expectations for inflation than people buying long-term nominal bonds. It would be interesting to see if surveys bear this out. If the discrepancy exists, it also would be interesting to try to figure out a way to arbitrage against it.


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COMMENTS (13 to date)
Ironman writes:

Try this definition instead:

An economic bubble exists whenever the price of an asset that may be freely exchanged in a well-established market first soars then plummets over a sustained period of time at rates that are decoupled from the rate of growth of the income that might be realized from owning or holding the asset.

Here is the definition applied to detecting a bubble in national housing markets.

Philo writes:

You write that "a bubble is characterized by unreasonably high expectations for continued appreciation." Fair enough; but then, in the rest of your post, you forget about the term 'unreasonably'. People's expectations for house-price appreciation turned out to be wrong, but you do not even attempt to show that they were *unreasonable*.

Philo writes:

Ironman's definition refers to "the rate of growth of the income that might be realized from owning or holding the asset." But 'might' is ambiguous. Is this the income that *would actually have been realized*, or the income that *people expected would be realized*? Or is it something else?

mark writes:

It seems to me that you can only hope to estimate the probability of a bubble, not predict it with certainty (and should you be allowed to intervene to preclude it from growing further, of course, your prediction will never be tested). Any method of prediction should involve looking for the extent of standard deviation from past returns over aome significant data periods.

Brian Clendinen writes:

No a bubble is were there is an almost 100% change of prices (after inflation) falling. The problem is predicting the timing of it. Housing prices were at a level that it was almost a 100% bubble probility unless one considered a sudden huge increase in real wage over many years or a huge increase in immigration over many years.

Ironman writes:

Philo,

In this context, 'might' refers to the income that "people reasonably expect will be realized from owning or holding the asset", so the focus is upon future expectations.

As an example, in the case of stock prices, those reasonable expectations are quantified in the form of dividend futures - the amount of dividend payments that are anticipated in future quarters.

David N writes:

I think a necessary condition of a bubble is that the existing models or methods of valuing assets don't explain the bubble pricing. To sustain the bubble a new story has to be crafted to justify or rationalize the new valuations.

marcus nunes writes:

David N is right. The "technology story" was behind the bubble in the Nasdaq (no bubble in the S&P or Dow)

Thomas DeMeo writes:

David N-

With regard to housing, the real bubbles occurred in places like Los Vegas and Florida. There was a very standard story there. Growth was initiated by significant long term population movement toward warmer climates, low taxes and low land prices. Appreciation was real for a time. Then the speculation followed those gains.

David N writes:

Thomas,

While Nevada, Florida, and California exemplify the bubble, I think it actually existed all over the world. Anecdotally, I saw evidence of the bubble in New York, Spain, and South Korea. The most common tactic of the bubble deniers was to use national statistics to downweight what was happening on the coasts.

For example, in the early 2000s in New York City, one would see condo / co-op listings with existing tennants, selling at negative cash flow prices. The new paradigm was that appreciation would eventually make it a sound investment.

Norman writes:

I think there needs to be a compromise between Sumner's falsifiable prediction requirement for the term 'bubble' and your definition. You need to define which "people" are expecting the price to rise for a long period of time (The average buyer? The average speculator?), how "long" that period of time needs to be (A year? five? Indefinitely?), how we can distinguish "much higher than the long-term nominal interest rate" from merely higher (Two standard deviations?), and how we can distinguish "unreasonably high expectations" from merely uncommonly high expectation (Outside what confidence interval?).

Until these terms are clarified, whether the market is a 'bubble' is still in the eye of the beholder.

Thomas DeMeo writes:

David N-

While I agree with what you are saying, my point was that I don't think the new story led to the change, but followed it.

It seems to me bubbles start as legitimate pockets of opportunity which cause asset prices to rise quickly and gets things rolling. At a certain point, the appreciation starts to fund itself in a ponzi like way until it crashes.

David N writes:

Thomas,

That's exactly my point. First, people start to notice that the way they used to value things doesn't justify today's price. In most cases they simply don't buy and the price falls. But once in a while a great new story is invented to justify not only today's price but a much higher price. And if the prices rise above what that story can support, well, here's another, weaker story for you. The stories follow increased prices, but they also sustain them.

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