Market Bubbles and Chrashes

Abstract

Episodes of market crashes have fascinated economists for centuries. Although many academics, practitioners and policy makers have studied questions related to collapsing asset price bubbles, there is little consensus yet about their causes and effects. This review and essay evaluates some of the hypotheses offered to explain the market crashes that often follow asset price bubbles. Starting from\nhistorical accounts and syntheses of past bubbles and crashes, we put the problem in perspective with respect to the development of the efficient market hypothesis. We then present the models based on heterogeneous agents and the limits to arbitrage that prevent rational agents from bursting bubbles before they inflate. Then, we explore\nanother set of explanations of why rational traders would be led to actually profit from and surf on bubbles, by anticipating the behavior of noise traders or by realizing\nthe difficulties in synchronizing their actions. We then end by discussing a complex system approach of social imitation leading to collective market regimes like herding\nand the phenomenon of bifurcation (or phase transition) that rationalize what crash can occur in unstable market regimes. The key insight is that diagnosing bubbles may\nbe feasible when taking into account the positive feedback mechanisms that give rise to transient “super-xponential” price growth, the bubbles.

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