Bubbles and History

The economic definition of an asset pricing bubble is that ‘Ex post asset prices are viewed as having been over-valued and not based on fundamentals’. This simple definition gives rise to a number of lines of thought. Firstly, can we only determine if changes in prices are bubbles after they have collapsed? Secondly, are all increases in asset prices harmful to our economy? Finally, are governments in a position to do anything to prevent bubbles from occurring and if so should they act? My aim in the forthcoming posts is to discuss each of these questions with respect to the US housing bubble and develop my opinion about  future bubbles.

Asset price bubbles have been witnessed many times over the last four hundred years, yet it seems they can still develop and grow with little pre-emptive action form politicians or central banks. This can then lead to devastating consequences for the economy if they are to burst. The earliest bubble was seen in the Netherlands with the dramatic increase in the price of tulip bulbs in 1936 and the subsequent collapse of prices by more than 90% the following year. This bubble lasted only a number of weeks and was limited to a small number of people involved in that particular market and it is therefore not generally regarded as an asset bubble in the modern sense by many such as Garber 1990. It is however in my opinion a good example of how human behaviour in a market can influence prices and how overconfidence can ultimate force prices above their intrinsic values. 

The most recent and possibly the most damaging asset bubble was that of the US housing market which came to a head in 2007 with huge effects globally. Since its inception in January 2000 the widely quoted Case–Shiller composite index for 20 major metropolitan areas in the United States (SPCS20R) seen constant growth in the first six and a half years increasing in value by over 106%. It reached its highest value of 206.52 in July 2006 before suffering just as dramatic a decline of over 20% to a value of 164.57 as of August 2008. (See diagram below) These dramatic changes in the price of assets call into question the rationality of investors and cast doubts over the reliability of some recent academic theories, most notably the Efficient Market Hypothesis.  

In the forthcoming posts I will discuss the housing bubble in the US and the action taken by the Fed both prior to and in response to the bursting of the housing bubble. I will examine in detail what drove the housing bubble and why these driving factors damaged the entire economy when the bubble collapsed. Finally I will examine if it is possible to predict the difference between a bull market and an asset price bubble and what can be done (if anything) to control the effects of bubbles by central banks.