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Noah Smith: Why Asset Bubbles?

 March 15, 2012 01:14 PM

Noah Smith:

Noahpinion: An interesting model of asset bubbles: Gadi Barlevy of the Chicago Fed, one of the people whose work on bubbles inspired me to tackle the topic…. Why would people pay more for an asset than it is fundamentally worth? There are many possible answers, but most of them involve some irrationality on the part of some subset of traders. It's difficult, but also very interesting, to try to imagine a situation in which a market made up of fully rational individuals would still overpay for something. The Barlevy (2011) model does precisely that. Instead of irrationality, the culprit is asymmetric information.

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In the Barlevy (2011) model, which is based on some earlier models by Franklin Allen, people overpay for financial assets because they don't fully bear all of the risk - they buy the asset with borrowed money, so if the price crashes they can just default on their loans.

So why would anybody loan money to people who intend to use the money to buy overpriced financial assets? That sounds like a bum deal! The answer is that the people lending the money may not know what the borrowers are going to do with it…. Lenders can't necessarily tell the difference between these people and the "speculators" who will just dump the money into risky financial assets. So if lenders want the chance to lend to productive borrowers, they have to accept some of the risk that the people they're lending to are actually just unproductive speculators….

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Now how about the rise-and-crash pattern of pricing? This gets a little trickier. It has to do with uncertainty about the payoff from the risky asset. In the model, there is a chance that the payoff will be revealed sooner, and a chance that it will be revealed later. If the payoff is revealed later - in other words, if traders suddenly discover that they have to wait to find out how much income they can get from the asset - then the bubble will grow….

Anyway, I encourage everyone who's interested in bubbles to take a look at Gadi Barlevy's work. The financial crisis right refocused the econ profession on financial instability and asset market failures...but Barlevy was doing it before it was cool!

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