Are bubbles inevitable?

Financial crises involving bubbles

In this paper, Calomiris and Jaremski examine 10 major financial crises spanning over 2 millennia to identify common patterns and differences across these crises. Five of these crises were preceded by asset bubbles:

1. Mississippi Bubble (1720)
   Context: John Law’s financial innovations in France, including the Banque Générale and the Compagnie d’Occident, led to speculative trading in company shares.
   Bubble Dynamics: Law’s policies, including the issuance of paper money and the consolidation of various trading monopolies, inflated the value of the Compagnie’s shares. The bubble burst when investors lost confidence and began converting shares to gold, leading to a collapse in share prices and a financial crisis .
2. South Sea Bubble (1720)
   Context: The South Sea Company in Britain was granted a monopoly on trade with Spanish colonies and engaged in debt-for-equity swaps with the government.
   Bubble Dynamics: The company’s shares were heavily promoted and manipulated, leading to a rapid increase in prices. The bubble burst when it became clear that the company’s trade prospects were overvalued, leading to a sharp decline in share prices and a financial crisis .
3. Florida Land Boom (1920s)
   Context: Rapid development and speculative investment in Florida real estate, fueled by advertising and easy credit.
   Bubble Dynamics: Land prices soared as investors bought properties sight unseen. The bubble burst when negative press and logistical issues (e.g., shipping moratoriums) reduced demand, leading to a collapse in land prices and bank failures .
4. US Stock Market Crash (1929)
   Context: The “Roaring Twenties” saw a boom in stock prices driven by optimism, financial innovation, and easy credit.
   Bubble Dynamics: Stock prices increased dramatically, particularly for new industrial and utility companies. The bubble burst in October 1929, leading to a massive sell-off, a sharp decline in stock prices, and the onset of the Great Depression .
5. US Subprime Mortgage Crisis (2008)
   Context: A housing bubble driven by low interest rates, easy credit, and government policies promoting homeownership.
   Bubble Dynamics: Home prices increased rapidly as subprime mortgages proliferated. The bubble burst when home prices began to fall, leading to widespread mortgage defaults, a collapse in mortgage-backed securities, and a global financial crisis .

The authors identify several common factors that contribute to the formation and bursting of bubbles. In particular, they cite: a) Excess Liquidity: Easy access to credit and low interest rates often fuel speculative investments and asset price inflation; b) Speculative Behavior: Investors’ irrational exuberance and herd behavior drive prices beyond intrinsic values; c) Regulatory Failures: Inadequate regulation and oversight can exacerbate speculative bubbles; and d) Political Influences: Policies that subsidize risk-taking or promote certain investments can contribute to bubble formation.

Calomiris and Jaremski conclude that bubbles have played a significant role in many historical financial crises by creating unsustainable asset price increases that eventually lead to sharp corrections and economic turmoil. The persistence of financial crises, despite their high social costs, is partly due to the recurring nature of bubbles and the complex interplay of economic, political, and psychological factors that drive them.
The Puzzling Persistence of Financial Crises
Authors: Charles W. Calomiris, Matthew Jaremski
From: Columbia University, Utah State University

Can bubbles be avoided?

In this paper, Hirano and Toda challenge the traditional view that bubbles are either impossible in rational equilibrium models or if they are a situation in which asset price bubbles occur is a special circumstance and hence fragile. The authors establish the Bubble Necessity Theorem, which states that in a plausible general class of economic models, all equilibria are bubbly with non-negligible bubble sizes relative to the economy.
The Bubble Necessity Theorem
The theorem applies when the long-run economic growth rate (G) is faster than the dividend growth rate (Gd), and the counterfactual long-run autarky interest rate (R) is below the dividend growth rate (G<Gd<R).
Economic Models and Examples:
Hirano and Toda provide examples of economies where bubbles necessarily arise. In these models, the conditions (G<Gd<R) naturally arise, leading to the inevitability of bubbles. These include:

• A two-sector growth economy with uneven productivity growth.
• An overlapping generations (OLG) model with capital accumulation.
• Infinite-horizon heterogeneous-agent models with idiosyncratic investment or preference shocks.

Intuition:
The necessity of bubbles is not just a theoretical curiosity but is economically relevant and can naturally arise in modern macro-finance models. The intuition behind the theorem is that if a fundamental equilibrium exists, the asset price must grow at the same rate as dividends. However, if the dividend growth rate is lower than the economic growth rate, the asset price becomes negligible relative to endowments, leading to an autarky-like situation. This results in an infinite present value of dividends, which is impossible in equilibrium, thus necessitating bubbles.

Bubble Necessity Theorem
Authors: Tomohiro Hirano, Alexis Akira Toda
From: University of London, University of California, San Diego