Financial Instability: Some Stylized Facts

Abstract

Financial instability is identified with dramatic swings in the price of financial assets. This instability has been a long-standing concern because of the adverse effect it can have on the efficient allocation of resources. If this instability also increases the likelihood of a financial crisis then financial instability may adversely affect resource employment as well.1 Contemporary theoretical debate focuses on the issue of whether or not asset prices reflect all available information concerning asset profitability (an issue central to the question of allocative efficiency). Efficient markets proponents argue that they do. Instability merely results from a sudden change in this information. The competing explanation argues that competitive bidding; motivated by repetitive and self-fulfilling expectations of capital gains, drives up asset prices in excess of their fundamental values. At some point, this speculative bubble bursts such that the process of accelerating price increases is halted and then reversed, with the bidding excesses in the first period replaced with distress selling in the second period. But there are some serious empirical and logical shortcomings to the conceptualization of instability as deviations or not from a fundamental value. And the debate altogether ignores the second issue of resource unemployment in the wake of a financial crisis. Empirical problems include the fact that econometric attempts to settle the debate encounter an insurmountable specification problem. In trying to establish whether or not speculation was excessive, researchers must assume that expected equal actual fundamentals and that actual fundamentals have been properly specified. The scope for error is wide; an apparent speculative excess may actually be the impact of an omitted fundamental. Logically, the attempt to identify excessive speculation guided by the conventional definition of a bubble is complicated by the possibility that the speculation itself may have altered the object's fundamental value. If such