Rational Bubbles Research Articles

The Gilded Bubble Buffer and Optimal Macroprudential Policy

We provide a microfounded framework for the welfare analysis of macroprudential policy within a model of rational bubbles. For this we posit an overlapping generation model where productivity and credit supply are subject to random shocks. We find that when real interest rates are lower than the rate of growth, credit financed bubbles may be welfare improving because of their role as a buffer in channeling excessive credit supply and inefficient investment at the firms' level, but its sudden price decrease may cause a systemic crisis. Therefore a well designed macroprudential policy plays a key role in improving efficiency while preserving financial stability. Our theoretical framework allows us to compare the efficiency of alternative macroprudential policies. Contrarily to conventional wisdom, we show that (i) macroprudential policy may be efficient even in the absence of systemic risk, (ii) it has to be contingent on productivity shocks and (iii) it must be contingent upon the level of real interest rates.

Bubbles, wage rigidity, and persistent slumps

We embed downward wage rigidity into a rational bubble model. We analytically characterize how the collapse of bubbles can interact with wage rigidity to generate deep and protracted recessions with involuntary unemployment, such as those in Japan or Spain.

Secular Stagnation, Rational Bubbles, and Fiscal Policy

It is well known that rational bubbles can be sustained in balanced growth path of a deterministic economy when the return to capital r is equal to the growth rate g. When there is a lack of stores of value, bubbles can implement an efficient allocation. This paper considers a world where r fluctuates over time due to shocks to the marginal productivity of capital. Then, bubbles further efficiency, though they cannot implement first best. While bubbles can only be sustained when r = g in a deterministic economy, r > g on average in a stochastic economy.Fiscal policy improves welfare by adding an extra asset. Where only the elderly contribute to shifting resources between investment and consumption in a bubbly economy, fiscal policy allows part of that burden to be shifted to the young. Contrary to common wisdom, trade in bubbly assets implements intergenerational transfers, while fiscal policy implements intragenerational transfers. Hence, while bubbles and fiscal policy are perfect substitutes in the deterministic economy, fiscal policy dominates bubbles in a stochastic economy. For plausible parameter values, a higher degree of dynamic inefficiency should lead to a higher sovereign debt.

Monetary Policy and Mispricing in Stock Markets

This paper investigates whether central banks can attenuate excessive mispricing in stocks as suggested by the proponents of a leaning against the wind (LATW) monetary policy. For this, we decompose stock prices into a fundamental component, a risk premium, and a mispricing component. We argue that mispricing can arise for two reasons: (i) from false subjective expectations of investors about future fundamentals and equity premia; and (ii) from the inherent indeterminacy in asset pricing in line with rational bubbles. We show that the response of the excessive stock price component to a monetary policy shock is ambiguous in both the short- and long-run, and depends on the nature of the mispricing. Subsequently, we evaluate the scope for a LATW policy empirically by employing a time-varying coefficient VAR with a flexible identification scheme based on impact and long-run restrictions using data for the S&P500 index from 1962Q1 to 2014Q4. We find that a contractionary monetary policy shock in fact lowers stock prices beyond what is implied by the response of their underlying fundamentals.

Searching for rational bubble footprints in the Singaporean and Indonesian stock markets

We re-examine the presence of rational speculative bubbles in the Singaporean and Indonesian stock markets in light of contradictory results in the literature. We employ a mix of descriptive statistics, explosiveness tests and duration dependence tests for an expanded dataset from 1970 to 2013 that covers at least two suspected bubble episodes - the 1997 Asian Financial Crisis (AFC) and the Global Financial Crisis (GFC). We find bubble footprints in Singapore and Indonesia using descriptive statistics and explosiveness tests. However, we find no evidence of rational bubbles in Singapore using the duration dependence test. On the other hand, in Indonesia we find evidence of rational bubbles in weekly but not in monthly data. Our results indicate that the duration dependence test could be sensitive to data frequency suggesting that the duration dependence test results are not always conclusive and that it should be used in conjunction with other tests.

Fundamentals and rational bubbles in the Korean housing market: A modified present-value approach

This paper employs the present-value approach to examine the dynamics of the Korean housing market. To capture the large swing in the price-rent ratio accompanied by intermittent ups and downs, we incorporate a periodically collapsing bubble in an otherwise standard present value model. We then decompose the movements in the actual price-rent ratio into those explained by the expectations of housing market fundamentals (i.e., the rent growth, risk-free interest rate, and excess returns from housing investment) and the bubble. The bubble part set aside, most of the variations in the price-rent ratio are explained by the expected risk premium of housing investment, whereas the expected real interest rate and rent growth account for relatively small fractions of the variations. It is also found that the bubble has continuously accumulated since the early 2000s, reaching as high as 51% of the house price around the end of 2014. Finally, the recent increases in house price over 2007–2014 are likely to have been driven by self-fulfilling expectations typical of a bubble.

Representative Bubbles and Deleveraging

I explore the causes for the formation of a bubble in the collateral market (in which house values work as collateral) when agents are provided with homogeneous expectations. Furthermore, I shall define a sufficient condition for deleveraging: a bubble driven by a representative bubbly collateral. The role of the heuristic of representativeness in shaping expectations turns out to be crucial: the bubble’s formation is driven by a gap between the fundamental value defined in terms of rational expectations and the error in processing information driven by representativeness. This behavioral bubble can explain bubbles in housing markets since the classic rational bubble models seem to not describe properly the issue.

Inequality and Risky Asset Bubbles

We provide a simple rational bubble model demonstrating that a concentration of income is necessary and sufficient for the existence of equilibria with risky speculative bubbles. Income concentration among top earners leads to excess savings and depressed interest rates, which facilitate the emergence of risky bubbles and increase their equilibrium size. In this context, policies such as progressive taxation can have a macroprudential effect of reducing the existence region, riskiness and size of bubbles.

What Drives Housing Markets: Fundamentals or Bubbles?

This study applies the dynamic Gordon growth model which is in the circumstance of rational bubbles to decompose log price-rent ratio into three parts, i.e., rational bubbles, discounted expected future rent growth rates and discounted expected future returns. The latter two terms represent housing fundamentals. The magnitudes of the components of price-rent ratio’s variance are estimated to distinguish the relative impact of the three parts on housing prices. Using time series data from the housing markets in the four largest cities in China (1991:Q1–2011:Q1 for Shanghai, Guangzhou and Shenzhen; 1993:Q2–2011:Q1 for Beijing), this paper presents a number of empirical findings: (a) the variance of rational bubbles is much larger than the variance of price-rent ratio, and rational bubbles contribute more fluctuations directly to price-rent ratio than the expected returns or the expected rent growth rates do; (b) the covariance between rational bubbles and expected returns or expected rent growth rates is also large; (c) the positive covariance of rational bubbles and expected returns implies that high expected returns coexist with bubbles, which differs from previous findings that lower expected returns drive asset prices; (d) the negative covariance of rational bubbles and expected rent growth rates indicates that the larger the bubbles are, the lower the expected rent growth rates are; (e) the positive covariance of expected returns and expected rent growth rates reveals under-reaction of the housing markets to rents.

Switching bubbles: From Outside to Inside Bubbles

The United States has recently experienced two asset price bubbles: the Dot-Com and the Housing Bubbles. These bubbles had very different effects on investment and debt of manufacturing firms. In this paper I develop a framework to understand the differential effect of two types of rational bubbles. I distinguish between (i) Outside Bubbles, which I define as savers purchasing and selling costless assets not-attached to inputs of production and (ii) Inside Bubbles, which I define as savers buying an input of production (e.g., land or houses) only as a store of value. The model is an OLG economy with savers and entrepreneurs. Savers save to consume when they are old. Entrepreneurs can borrow to invest but they face a collateral constraint. In this environment, rational bubbles can emerge. I show that the size of an Inside Bubble is larger. I also find that when the economy switches from an Outside to an Inside Bubble, manufacturing (or non-housing) investment and debt is lower, consistent with the U.S. experience. Finally, I show that even though steady-state consumption is higher with an Outside Bubble, a social planner would prefer an Inside Bubble when the productivity of entrepreneurs is low.

Are Bubbles Bad? Is a Higher Debt Target for the Eurozone Desirable?

Bubbles are usually viewed as a threat to financial stability. This paper takes a more nuanced view. The world economy is going through an episode of Secular Stagnation, where the equilibrium rate of return on capital r is below the growth rate of the economy g. As is well-known, rational bubbles are sustainable when r ≤ g in a steady-state equilibrium. Bubbles can then implement a dynamically efficient equilibrium. We show that from a structural point of view, bubbles, Pay-As-You-Go pensions, and sovereign debt are perfect substitutes. However, when dealing with unexpected short-run fluctuations in investment, sovereign debt is far more efficient than bubbles in shifting consumption over time and in risk-sharing between generations. An increase in sovereign debt is, therefore, an efficient response to Secular Stagnation. Instead, the current Stability and Growth Pact for the eurozone embarks on an opposite course. (JEL codes: E44 and E62).

Modeling property bubble dynamics in Greece, Ireland, Portugal and Spain

Purpose Greece, Ireland, Portugal and Spain have been in the spotlight of the recent economic crisis in Europe. With their economy strongly reliant on the construction industry, these countries have become widely exposed to the downturn in the property sector. This paper aims to examine residential property bubble dynamics in the period from 2003 to 2014 and investigate the role of financing conditions in the formation of these bubbles. Design/methodology/approach Building on the present value model in conjunction with the rational bubble assumption, the study applies the discounted cash flow (DCF) approach and applies weighted average cost of capital (WACC) to capture real estate bubble dynamics in the four countries. Reduced form vector autoregression models are used to examine the relationship between financing conditions and the bubble indicator. Findings The bubble indicator suggests that Spain and Ireland experienced a large rise in the bubble relative to moderate increases in Portugal and Greece in the period from 2003 up to the collapse in 2008. Our findings from the empirical analysis indicate that central bank policy shifts that impact interest rates and lending volumes on the domestic level have a significant and leading effect on the formation of residential property bubbles. Originality/value Only little research on real estate bubbles takes financial leverage into account. This paper bridges this gap by applying the WACC in the DCF model to identify real estate bubbles. While using a distinct bubble indicator, this analysis provides new insights into the linkage between financing conditions and real estate bubbles.

Complex stock price dynamics under Max Weber’s spirit of capitalism hypothesis

We introduce Max Weber’s spirit of capitalism hypothesis into a benchmark Lucas’ tree asset pricing model by assuming that economic agents derive direct utility from wealth. We prove the existence of perfect foresight equilibria where the price-dividend ratio displays explosive rational bubble solutions, endogenous periodic cycles and chaotic dynamics.

Are grain markets in Niger driven by speculation?

Over the last two decades, millet prices in Niger have enjoyed periods of spectacular increase during which they seem to go well above their fundamental value. These episodes of price bursts followed by rapid reversals could be attributed to the presence of rational speculative bubbles. Considering millet as a food asset we have developed a pricing model, and tested for the presence of periodically and partially collapsing bubbles for 15 millet markets in Niger. The test strategy consists of estimating the fundamental value of millet and investigating the dynamic properties of price deviations from fundamentals. A battery of unit root tests aimed at controlling for skewness and kurtosis, and for non linearity in the bubble process, is implemented. These tests do not reject the presence of rational bubbles for some of the sample markets, and allow the identification of expanding and collapsing phases in bubble processes. The results show that small markets, located in deficit and remote areas are more prone to speculation than large markets in the main producing and consuming regions.

Taxation, bubbles and endogenous growth

We study the interplay between taxation, bubble formation and economic growth. A rational bubble may be beneficial when growth is fueled by public investment (or R&D externalities) and the government levies taxes on bubble returns to finance this investment. Our main result challenges the conventional view about the negative effect of bubbles in endogenous growth (Grossman and Yanagawa, 1993).

Price Bubbles and Policy Interventions in the Chinese Housing Market

The recent, dramatic increases in house prices have led to considerable attention being focused on housing markets in China. Using a unique dataset of city-level house prices and rents, this paper investigates the presence of price bubbles in major Chinese city housing markets. Our findings show evidence of price bubbles in most housing markets, even though the bubbles might be, to a large extent, mitigated by strong government intervention. In order to distinguish rational bubbles from irrational bubbles, we extend the existing work to allow a deterministic time trend and break points in the unit root test of house price-rent ratios. As a consequence, our results demonstrate that the price-rent ratios in most of the sample cities are no longer non-stationary, implying the non-existence of rational bubbles in the housing markets.

Price bubbles and policy interventions in the Chinese housing market

The recent dramatic increases in house prices have led to considerable attention being focused on housing markets in China. Using a unique dataset of city-level house prices and rents, this paper investigates the presence of price bubbles in major Chinese city housing markets. Our findings show evidence of price bubbles in most housing markets, even though the bubbles might be, to a large extent, mitigated by strong government intervention. In order to distinguish rational bubbles from irrational bubbles, we extend the existing work to allow a deterministic time trend and break points in the unit root test of house price–rent ratios. As a consequence, our results demonstrate that the price–rent ratios in most of the sample cities are no longer non-stationary, implying the non-existence of rational bubbles in the housing markets.

Do the Rational Bubbles Exist in the Gangnam Housing Market?

Do the Rational Bubbles Exist in the Gangnam Housing Market?

Micro-Foundation Using Percolation Theory of the Finite-Time Singular Behavior of the Crash Hazard Rate in a Class of Rational Expectation Bubbles

Micro-Foundation Using Percolation Theory of the Finite-Time Singular Behavior of the Crash Hazard Rate in a Class of Rational Expectation Bubbles

No-Bubble Condition: Model-Free Tests in Housing Markets

We test for the existence of housing bubbles associated with a failure of the transversality condition that requires the present value of payments occurring infinitely far in the future to be zero. The most prominent such bubble is the classic rational bubble. We study housing markets in the United Kingdom and Singapore, where residential property ownership takes the form of either leaseholds or freeholds. Leaseholds are finite-maturity, pre-paid, and tradeable ownership contracts with maturities often exceeding 700 years. Freeholds are infinite-maturity ownership contracts. The price difference between leaseholds with extremely-long maturities and freeholds reflects the present value of a claim to the freehold after leasehold expiry, and is thus a direct empirical measure of the transversality condition. We estimate this price difference, and find no evidence of failures of the transversality condition in housing markets in the U.K. and Singapore, even during periods when a sizable bubble was regularly thought to be present.