Rethinking Asset Bubbles: Reflections for the Age of Institutional Investing

Abstract

Upon surveying a contentious topic that has occasioned much debate, this paper offers reflections on the likelihood that asset booms, bubbles and busts continue posing a threat to financial stability despite financial markets becoming increasingly informationally-efficient, complete, and heavily influenced by sophisticated (presumably rational) investors. Rather than arise from widespread behavioral irrationality as is commonly assumed, this paper suggests procyclical mispricings stand to increasingly reflect institutional frictions — benchmarking, incentive and organizational design pressures — in the rapidly-growing institutional investment industry. These influences may make bubble riding ‘rational,’ or at the very least, discourage institutions from leaning against the wind. Moreover, even in the absence of leverage, systemic risk could increasingly be shaped by large shifts in risk premia owing to the rational herding motivations of institutional investors. To the extent procyclicality owes less to ‘irrational exuberance’ and more to performance evaluation practices, traditional countercyclical policy measures could be of reduced efficacy unless reinforced by reforms to institutional incentives.