In the United States, these include the run-up in the value of the dollar in the mid-1980s, the stock market rise and crash in 1987; the compression of spreads due to convergence trades in the run-up to the Long-Term Capital Management debacle in 1998; the technology stock market boom of the late 1990s; and the credit and housing price bubble and crash of recent years. All these episodes were marked by spectacular price booms, followed by subsequent collapses. An examination of some of these recent bubbles suggests that while asset bubbles are idiosyncratic in terms of their causes, institutional features, duration and severity, they often share several significant features. These shared features are important in assessing how policy might be used to temper incipient bubbles in the future. In my view, asset bubbles often come about through a particular sequence of events. First, there is typically an innovation that changes the fundamental valuation in a meaningful, but uncertain way. 3 Asset valuations associated with the innovation change (as they should), but there is significant uncertainty about how valuable the innovation will turn out to be. This leads to a divergence in expectations concerning how much the fair value of the assets should increase. I believe that this uncertainty about what constitutes fair value is important in fueling the bubble. 1  See Vernon L. Smith, Gerry L. Suchanek, and Arlington W. Williams. 1988. “Bubbles, Crashes, and Endogeneous Expectations in Experimental Spot Asset Markets.” Econometrica 56, no. 5 (September): 1119–51.
Those that had doubts about the importance of the innovation or the persistence of the gain in asset prices lose confidence in their opinions as they underperform and lose business and market share. Those who believed that the large gains in asset prices were justified by the innovation and who benefited from those beliefs become more dominant. Casual investors see the large rise in prices and jump in. This shift is important because, in markets, prices are driven by the marginal investor. As new and often less well-informed investors plunge in to participate in the boom, they can overwhelm the so-called “smart money” that gets frustrated after having lost repeatedly trying to take the other side. In this respect, a bias toward optimism may also play an important role. Studies have found that most people believe that they are above average in terms of their acumen, be it as investors, car drivers or in other activities. 5 This overconfidence may cause some people to keep investing in the asset, even when they are skeptical about its valuation because they are overly confident that they will anticipate the end of the bubble and be able to get out in time. Fifth, asset bubbles occur more easily when it is difficult to short the assets.