Why Asset Bubbles Should Not Be Popped

In the past, many financial bubble bursts had negative consequences on the real economy in many countries. Recent examples are the burst of the bubble in Japan in 1991 leading to the “Lost Decade” and the burst of the U.S. real estate bubble in 2006 resulting in the Global Financial Crisis. The question is: “can something be done about bubbles in order to minimize losses from bursting?"

Typically, bubbles arise in economies where liquidity is abundant. Central banks, in turn, have instruments such as money supply and interest rates to adjust the liquidity. Consequentially, it can be argued that central banks can react to asset bubbles and can try to destroy them by fine-tuning the monetary policy. Many analytic models provide evidence that this approach can be successful (Roubini, 2006). However, whether central banks should have the obligation to respond to financial bubbles stays highly controversial in academic literature because costs of reacting to bubbles may in many cases exceed the benefits. 

There are difficulties associated with central banks’ interventions in bubble economy. Recognition and forecasting of bubbles is a very complex task because decisions have to be made based on indirectly observable parameters. Given the uncertainty of information (Bernanke, 2002) central banks may adjust the monetary policy incorrectly so that it may cause harm to the economy rather than protecting it implying that central bank interventions involve high risks. Monetary policy itself may also be a too weak instrument (Posen, 2003) for bursting bubbles. Bubbles are believed to be caused for the most part by irrational behaviour of investors and not by changing fundamentals such as interest rates or credit availability. Thus adjusting interest rates and money supply will not necessarily stop a bubble’s growth. In addition, it must be said that not all bubble bursts cause losses in real terms to economy, only economies with undeveloped, fragile banking systems are subject to serious harm when a bubble bursts. Mishkin and White (2002) analysed 15 US stock crashes and found that only about half of crashes led to strong negative effects.

It is obvious that some bubbles can lead to serious harm for the real economy. However, the research shows that proactive intervention in the economy by central banks is a very risky business without guarantee of positive outcome. Therefore central banks should only react to bubbles when the potential losses of foregoing the action are tremendous.

Football And Stock Market?

Human irrationality plays a big role when it comes to financial bubbles. In academic literature, investors’ feedback and judgement mechanisms, based on the information available about the market, have been suggested as main explanations for the illogical behaviour (Schiller, 2002). However, there is also evidence that investors, including professional traders, make irrational investment decisions depending on events that have no or very little influence on the performance of the market. For instance, Edmans et al. (2007) showed that market performance decreases after national football teams lose their matches and Hirshleifer and Shumway (2003) demonstrated that stock returns tend to be higher on sunny days than on cloudy days. This has to do with the emotional state of investors.

Many physiological studies have been made to analyse how mood affects individuals’ behaviour. Humans in a good mood make different decisions than people in a bad mood, people in a good mood tend to evaluate different situations in a more optimistic way (Wright and Bower, 1992), while people in a bad mood filter information in a way that negative interpretation is more appealing to them (Isen et al., 1978).

In general, many sources proved that a lot of sunshine is correlated with positive emotions (Rind, 1996) and lack of sunshine with depression (Eagles, 1994) implying that humans feel happier on sunny days and more depressed on cloudy days. They shift their behaviour and interpret information more optimistically or pessimistically. Interestingly, people often attribute their emotions to wrong events. For example, people may feel happy while working on a new project not because of the inspiring content of the project itself but because of the sunny weather outside. The same logic can be applied to markets. Investors may evaluate stocks better on sunny days than on cloudy days increasing stock returns without any rational reason. Indeed, Hirshleifer and Shumway (2003) found that sunshine is strongly correlated with stock returns after analysing stock market indexes returns across 26 countries.

To analyse whether there is a correlation between financial bubbles and emotions Andreale et al. (2011) made an experiment. Andreale et al. showed traders videos that triggered different emotions in them and evaluated their trading behaviour in an experimental market. The researchers found that emotional state of participants affected magnitude of bubbles in markets thus providing evidence that events such as winning or losing of national football team or simply the weather may have an effect on financial bubbles.

Taken together, when analysing markets and trying to make realistic forecasts about the future performance of stocks not only news about the markets and financial data should be considered but also weather forecasts, the condition of football teams and many other factors that may appear irrelevant at first glance.

"Anti-Bubbles"

Speculative financial bubbles occur when assets or whole markets start becoming overvalued due to too optimistic expectations of investors. Often followed by bubbles, there is also a phenomenon called "anti-bubble" associated with the situation where assets are massively undervalued (1999, Johansen and Sornette).

Source:Yahoo! Finance UK & Ireland

One prominent example of anti-bubble is the Japanese Nikkei stock index since the end of 1980s. The graph above depicts a strong increase of Nikkei during the late 1980s followed by, first, a crash and then by decelerating market devaluations which can be viewed as an "anti-bubble". The difference between crashes and "anti-bubbles" is that an "anti-bubble" is a statistically time-symmetric process with the respect to a critical time (1999, Johansen and Sornette). In other words, it is the reverse process of the growing of a speculative bubble that takes the same time.

Speculative bubbles occur because the feedback from price increases gives rise to an increased enthusiasm of investors and hence increased prices. The media plays here an important role. It propagates the information to more investors who then make subjective judgments about investments boosting the bubble even further. All this contributes to an increase in value (2001, Shiller). Anti-bubbles appear because the same process takes place with the only difference that pessimism is the driving force about future performance and not optimism.

Many other examples such as gold anti-bubble during the 1980s and anti-bubble of 2000 are events that had a great influence at the global economy. However, only little attention is paid to them in the academic literature. Recognizing and considering anti-bubbles in market analyses could help to gain deeper understanding of current market conditions and thus help to make better investment decisions.

Bitcoin: Currency Of The Future Or Just Another Speculative Bubble?

The video shows that there are different opinions on whether Bitcoin is the currency of the future or just the next speculative bubble. The value of one Bitcoin has increased from £0.04 in August 2010 to £347.62 in February 2014 reaching even £751.38 for a short time in December 2013. For many investors, such a strong increase leads to the question whether Bitcoin may be the next tulip mania?

Nobel Prize winner 2013 Robert Shiller (2002) in his book "Irrational Exuberance" defines speculative bubble as “a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increase.” In fact when applying this definition to Bitcoin’s value increase it seems that there are signs of a bubble. For instance, the appearance in media has been intense and has driven investors’ enthusiasm during the last few months. Bitcoin unlike other currencies is neither accepted nor backed by any government (Greenberg, 2011), its value has soared suggesting that the increase is based only on the investors' perception.

However, Bitcoin also has some innovative features that may justify the rise of the value. First of all, Bitcoin is similar to the US Dollar because it is also a fiat currency that to a large extent exists only on databases. In other words, Bitcoin is not as different from existing currencies as many may think. Secondly, Bitcoin starts to become a generally accepted medium of exchange which is the main purpose of money. Many shops accept Bitcoin as the medium of exchange already now and many plan to do so. Thirdly, according to Mengerian Theory (Menger, 1982) uncontrolled currency can exist and Bitcoin can be the first modern decentralized currency. And finally there are many advantages for retail users of Bitcoin such as almost free transactions and universality.

Instead of thinking of Bitcoin as a bubble or evolutionary form of money, it can be argued that it may be both at the same time. Like Internet companies after the Dotcom bubble, some digital currencies e.g. Bitcoin may disappear, if there is indeed a bubble, but the idea of digital currencies will probably remain giving rise to new forms of money.