The unchanged global growth projections mask somewhat different contributions at the country level.
Clifford Asness  Extrapolation is projecting historical data into the future on the same basis; if prices have risen at a certain rate in the past, they will continue to rise at that rate forever. The argument is that investors tend to extrapolate past extraordinary returns on investment of certain assets into the future, causing them to overbid those risky assets in order to attempt to continue to capture those same rates of return.
Overbidding on certain assets will at some point result in uneconomic rates of return for investors; only then the asset price deflation will begin. When investors feel that they are no longer well compensated for holding those risky assets, they will start to demand higher rates of return on their investments.
Herding[ edit ] Another related explanation used in behavioral finance lies in herd behaviorthe fact that investors tend to buy or sell in the direction of the market trend. Investment managers, such as stock mutual fund managers, are compensated and retained in part due to their performance relative to peers.
Taking a conservative or contrarian position as a bubble builds results in performance unfavorable to peers. The typical short-term focus of U. In attempting to maximize returns for clients and maintain their employment, they may rationally participate in a bubble they believe to be forming, as the risks of not doing so outweigh the benefits.
An investor must balance the possibility of making a return on their investment with the risk of making a loss — the risk-return relationship.
A moral hazard can occur when this relationship is interfered with, often via government policy. Bush on 3 October to provide a Government bailout for many financial and non-financial institutions who speculated in high-risk financial instruments during the housing boom condemned by a story in The Economist titled "The worldwide rise in house prices is the biggest bubble in history".
The large firm or cartel — which has intentionally leveraged itself to withstand the price decline it engineered — can then acquire the capital of its failing or devalued competitors at a low price as well as capture a greater market share e.
Other possible causes[ edit ] Some regard bubbles as related to inflation and thus believe that the causes of inflation are also the causes of bubbles.
Others take the view that there is a "fundamental value" to an assetand that bubbles represent a rise over that fundamental value, which must eventually return to that fundamental value.
There are chaotic theories of bubbles which assert that bubbles come from particular "critical" states in the market based on the communication of economic factors.
Finally, others regard bubbles as necessary consequences of irrationally valuing assets solely based upon their returns in the recent past without resorting to a rigorous analysis based on their underlying "fundamentals".
Experimental and mathematical economics[ edit ] Bubbles in financial markets have been studied not only through historical evidence, but also through experimentsmathematical and statistical works. Smith, Suchanek and Williams  designed a set of experiments in which an asset that gave a dividend with expected value 24 cents at the end of each of 15 periods and were subsequently worthless was traded through a computer network.
They found instead that prices started well below this fundamental value and rose far above the expected return in dividends. The bubble subsequently crashed before the end of the experiment. This laboratory bubble has been repeated hundreds of times in many economics laboratories in the world, with similar results.
The existence of bubbles and crashes in such a simple context was unsettling for the economics community that tried to resolve the paradox on various features of the experiments. To address these issues Porter and Smith  and others performed a series of experiments in which short selling, margin trading, professional traders all led to bubbles a fortiori.
Much of the puzzle has been resolved through mathematical modeling and additional experiments. In particular, starting inGunduz Caginalp and collaborators   modeled the trading with two concepts that are generally missing in classical economics and finance.
First, they assumed that supply and demand of an asset depended not only on valuation, but on factors such as the price trend.
Second, they assumed that the available cash and asset are finite as they are in the laboratory. Utilizing these assumptions together with differential equations, they predicted the following: An epistemological difference between most microeconomic modeling and these works is that the latter offer an opportunity to test implications of their theory in a quantitative manner.
This opens up the possibility of comparison between experiments and world markets. When price collars were used to keep prices low in the initial time periods, the bubble became larger. Since the parameters can be calibrated with either market, one can compare the lab data with the world market data.
The asset flow equations stipulate that price trend is a factor in the supply and demand for an asset that is a key ingredient in the formation of a bubble. While many studies of market data have shown a rather minimal trend effect, the work of Caginalp and DeSantis  on large scale data adjusts for changes in valuation, thereby illuminating a strong role for trend, and providing the empirical justification for the modeling.
The asset flow equations have been used to study the formation of bubbles from a different standpoint in  where it was shown that a stable equilibrium could become unstable with the influx of additional cash or the change to a shorter time scale on the part of the momentum investors.
This phenomenon on a short time scale may be the explanation for flash crashes. Stages of an economic bubble[ edit ] According to the economist Charles P.
Kindleberger, the basic structure of a speculative bubble can be divided into 5 phases: Economic or asset price bubbles are often characterized by one or more of the following: Unusual changes in single measures, or relationships among measures e.
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