Recently, the U.S stock market faced major asset bubbles – stocks are overvalued relatively to the real value of the underlying asset – namely, at the beginning of 2000 , the main index of U.S housing prices more than doubled from 100 to over 206, in 2006. In 2008 this bubble burst, causing one of the major worldwide recessions in recent years.
What explains the existence of these bubbles? No one really knows. It is related with investors’ behavior certainly, but there is no agreement on its roots. Financial economists generally argue that asset prices tend to converge to their real sustainable value, pointing out that these type of situations are just anomalies generated by irrational behavior of financial agents. That may not be entirely false, but at the same time there are reasons to belief that elements of rationality sustain this abnormal growth of asset prices. Regarding this issue, John Maynard Keynes argued in “The General Theory of Employment, Interest and Money“ that financial markets can be compared to a “Beauty contest” run by London newspapers in his time. The papers published an array of photos and readers could enter a contest in which the winner was the reader who guessed which faces would be chosen by the majority of other participants. As Keynes pointed out in his work “It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”
What Keynes tried to say is that no one would simply choose the photo that found most attractive neither choose the photo that one thought other entrants would find most attractive, but rather trying to guess what other entrants would guess about which photos most other entrants would choose. Regarding financial markets, the argument follows the same logic. Investing is not a game of perfect information. Individuals maximize their profits by investing in assets which they predict to appreciate in the future. However, future prices of financial assets depend on the expectations of other agents, which further depend on their expectations of what other agents may expect. If this is true, then prices do not reflect what economists call fundamentals – which would correspond to choose the most attractive photo in the “Beauty contest” example given by Keynes.
The real-estate bubble was, at some extent, a consequence of this behavior. At the time U.S was subject to a large capital inflow due to a global saving glut among other reasons, which made investors anticipating what other investors expected the average investor to think it would be. Seems confusing? Well, let me present a small example. Suppose that the sustainable real price of houses is going to increase by 50 units, and there is common knowledge about this fact – everyone knows that there will be an increase of 50 and knows that every other people knows. As an investor would you invest according to a 50 units increase? Well, if you do so you are called a type 1 investor. But there will be other investors (type 2) that know that if everyone invest in that market, then demand will be very high, pushing prices further than 50. Thus, by anticipating this, they will invest more than according to fundamentals, and maybe prices go up to 75. It turns out, that there are type 3 investors, that anticipate what was previously said, and still invest more on houses. Prices may go up until 100 for example. Guess what? There are higher degree types of investors. This type of process can dramatically unhitch the price of an asset from its fundamentals, at least for a while. The reader might wonder why are bubbles that bad, given that it seems everyone is making profit out of this process. It turns out that now-a-days asset’s prices have a major impact in the real economy. For instance, firms make investment decisions based on these prices. And banks lend taking into account the value of collaterals, which are generally houses or buildings. Therefore, one might argue that financial agents do not take into account these effects when taking their investment decisions – there is a negative externality.
How can one avoid this type of behavior? Macroeconomists will probably say that the Central Bank has to intervene. It seems to be quite a good solution, given that if the Central Bank absorb the excess demand for an asset, such as houses, investors will incorporate these in their portfolio optimization problem such that a bubble can be avoided. In practice though, a bubble is difficult to predict or detect. Another option is for policy makers to impose a tax in financial transactions such that prices converge to their real value. In this case, even if investors think that prices of an asset are going to increase, it may not want to invest that much due to the cost of a tax. Moreover, it knows that others will behave like him. Again, in practice it is not easy to put in practice since it relies on the assumption that policy makers know the fundamental equilibrium prices of assets.