What is a bubble? Today’s economies often experience large movements in asset prices that have significant macroeconomic effects. Given that many of these movements in asset prices seem unrelated to economic conditions or fundamentals, they have come to be called bubbles, whether swelling or bursting. Typically, these bubbles are unpredictable and generate substantial macroeconomic effects. Consumption, the capital stock, and output all tend to surge when a bubble arises and then collapse or stagnate when the bubble bursts. Despite the recurrent nature of bubbles and their macroeconomic implications, however, we still lack a stylised model to answer the basic questions:
- What is the origin of bubbly episodes?
- Why are they unpredictable?
- How do bubbles affect consumption, the capital stock, and output?
Of course, economists have long thought about asset bubbles. To do so, they have found it useful to think of an economy with two idealised asset classes: productive assets or “capital” and pyramid schemes or “bubbles”. Both assets are used as a store of value or savings vehicle, but they have different characteristics. Capital is costly to produce but it is then useful in production. Bubbles play no role in production, but initiating them is costless. A successful theory of bubbles should then explain why rational and informed agents optimally choose to hold bubbles in their portfolios, and it should also characterise the macroeconomic consequences of their choice.
Samuelson (1958) and Tirole (1985) laid the foundations for such a theory by portraying bubbles as a remedy to the problem of dynamic inefficiency. Their argument is based on the dual role of capital as a productive asset and a store of value. To satisfy the need for a store of value, economies sometimes accumulate so much capital that the investment required to sustain it exceeds the income that it produces. This investment is inefficient and lowers the resources available for consumption. In this situation, bubbles can be both attractive to investors and feasible from a macroeconomic perspective. For instance, a pyramid scheme that absorbs all inefficient investments in each period is feasible and its return exceeds that of the investments it replaces.
The Samuelson-Tirole model provides an elegant and powerful framework to think about bubbles. However, the picture that emerges from this theory is hard to reconcile with historical evidence.
- First, the model features deterministic bubbles that exist from the very beginning of time and never burst. This is contrary to the observation that, in real economies, bubbles pop-up and burst. We therefore need a model in which bubbles are transient, that is, a model of bubbly episodes.
- Second, and most importantly, in the Samuelson-Tirole model bubbles raise consumption by reducing inefficient investments. As a result, bubbles slow down capital accumulation and lower output. In the real world, bubbly episodes tend to be associated with consumption booms indeed. But they also tend to be associated with expansions in the capital stock and output.
A successful model of bubbles must come to grips with these correlations.
Towards a realistic theory of bubbles
In recent research (Martin and Ventura 2011a and 2011b), we build such a model by introducing investor sentiment shocks and imperfect financial markets into the theory of rational bubbles. Since bubbles have no intrinsic value, their current size depends on market expectations regarding their future size, i.e. on "investor sentiment". Introducing shocks to investor sentiment is therefore crucial to generate realistic bubble dynamics in the model. Introducing financial frictions is also crucial because these create rate-of-return differentials and allow efficient and inefficient investments to coexist. Our key observation is then quite simple. Bubbles not only reduce inefficient investments, but also increase efficient ones. In our model, bubbly episodes are booms in consumption and efficient investments financed by a reduction in inefficient investments. If efficient investments increase enough, bubbly episodes expand the capital stock and output. This turns out to be the case under a wide range of parameter values.
To understand these effects of bubbly episodes, it is useful to analyse the set of transfers that bubbles implement. In the theory, a bubble is nothing but a pyramid scheme by which the buyer surrenders resources today expecting that future buyers will surrender resources to him/her. The economy enters each period with an initial distribution of current and future bubble owners. Some of these owners bought their bubbles in earlier periods, while others just created them or are expected to do so in the future. In this setup, there are two natural channels through which bubbles may transfer resources from inefficient to efficient investment.
- First, they do so directly through the market for bubbles. On the demand side of this market we find investors who cannot obtain a return to investment above that of bubbles; while on the supply side we find consumers and investors who can obtain a return to investment above that of bubbles. When the market for bubbles closes, resources have thus been transferred from inefficient investors to consumers and efficient investors, leading to an increase in consumption and efficient investments at the expense of inefficient investments (Martin and Ventura 2011a).
- Second, bubbles may also transfer resources towards efficient investments through the credit market. This happens when the prospect of a future bubble raises the net worth of efficient investors, therefore allowing them to expand their borrowing and investment (Martin and Ventura 2011b).
Introducing financial frictions can thus explain how bubbles can lead to expansions in the capital stock and in output. It also solves a nagging problem of the theory of rational bubbles, which was first pointed out by Abel et al. (1989). In the Samuelson-Tirole model, bubbles can only exist if the investment required to sustain the capital stock exceeds the income that it produces. Abel et al. (1989) examined a group of developed economies and found that, in all of them, investment falls short of capital income. This finding has often been considered evidence that rational bubbles cannot exist in real economies. Introducing financial frictions into the theory shows that this conclusion is unwarranted. The observation that capital income exceeds investment only implies that, on average, investments are dynamically efficient. But this does not exclude the possibility that the economy contains “pockets” of dynamically inefficient investments that could support a bubble. Nor does it exclude the possibility that an expansionary bubble, by lowering the return to investment, creates itself the pockets of dynamically inefficient investments that support it. In such situations, the test of Abel et al. would wrongly conclude that bubbles are not possible.
Our research is part of a growing body of work that studies the effects of bubbles in the presence of financial frictions:
- Caballero and Krishnamurthy (2006) and Farhi and Tirole (2011) show that bubbles can be a useful source of liquidity;
- Kocherlakota (2009) shows that bubbles can also raise collateral or net worth; and
- Ventura (2011) shows that bubbles can lower the cost of capital.
Models of rational bubbles have also been used to interpret recent events, like global imbalances (Kraay and Ventura 2007) and the recent financial crisis (Martin and Ventura 2010b). The exciting next step in this research agenda is to assess whether these effects of asset bubbles can be quantitatively significant within the class of models used by modern macroeconomics. Doing so requires the introduction of investor sentiment shocks into a quantitative model of the business cycle. That is, we need a model with bubbly business cycles – something we are working on now.
Abel, A, G Mankiw, L Summers, and R Zeckhauser (1989), “Assessing Dynamic Efficiency: Theory and Evidence”, Review of Economic Studies, 56:1-19.
Caballero, R and A Krishnamurthy (2006), “Bubbles and Capital Flow Volatility: Causes and Risk Management”, Journal of Monetary Economics, 53(1):33-53.
Farhi, E and J Tirole (2011), “Bubbly Liquidity”, mimeo, Harvard University.
Kocherlakota, N (2009), “Bursting Bubbles: Consequences and Cures”, Minneapolis Fed.
Kraay, A and J Ventura (2007), “The Dot-Com Bubble, the Bush Deficits, and the US Current Account”, in R Clarida (ed.), G7 Current Account Imbalances: Sustainability and Adjustment, The University of Chicago.
Martin, A and J Ventura (2011a), “Economic Growth with Bubbles”, CREI working paper.
Martin, A and J Ventura (2011b), “Theoretical Notes on Bubbles and the Current Crisis”, forthcoming, IMF Economic Review.
Samuelson, P (1958), “An Exact Consumption-loan Model of Interest with or without the Social Contrivance of Money”, Journal of Political Economy, 66:467-482.
Tirole, J (1985), “Asset Bubbles and Overlapping Generations”, Econometrica, 53(6): 1499-1528.
Ventura, J (2011), “Bubbles and Capital Flows”, Journal of Economic Theory, forthcoming.