2  In a more restrictive experiment in which speculation is not possible, bubbles and crashes still occur. See Vivian Lei, Charles N. Noussair, and Charles R. Plott. 2001. “Nonspeculative Bubbles in Experimental Asset Markets: Lack of Common Knowledge of Rationality vs. Actual Irrationality.” Econometrica 69, no. 4 (July): 831–59. 3  One might argue that an innovation is not a necessary condition for an asset bubble. For example, the run-up of the dollar in the mid-1980s was not associated with any particular innovation. Instead, a sharp shift in fiscal policy led to high real interest rates that stimulated a strong demand for the dollar, which caused the dollar to appreciate sharply. This eventually unwound as the dollar’s rise undercut U.S. trade competitiveness. This caused the U.S. economy to slow, interest rates to decline and the dollar to fall. The lack of experience with a floating exchange rate regime undoubtedly played a role here. The world moved to a floating exchange rate system in the early 1970s. There was not much experience with how an expansive fiscal policy would affect exchange rates. This undoubtedly increased uncertainty about the sustainability of the dollar’s appreciation. 2  BIS Review 43/2010  For example, the technology stock market boom in the late 1990s coincided with the development of the Internet, which fostered the reorganization of many business processes and generated significant productivity improvements.
For example, the technology stocks associated with initial public offerings were very difficult to short because the available supply or “float” was small – a high proportion of the shares in the companies were held by the original venture capital investors and subject to lock-up periods before the shares could be lent out to short sellers or sold. Similarly, housing is notoriously difficult to short. The option of selling one’s home in order to rent is expensive not only in terms of time and effort, but also in terms of transaction costs. And, shorting complex structured finance products was difficult because there were no standardized instruments; the securities rarely traded and were very difficult to value. It was not until the development of the ABX indexes – which allowed investors to buy and sell credit default swaps on pools of structured finance obligations – that investors had a vehicle that allowed them to short subprime mortgagebacked securities more easily. 6 Asset bubbles often come to an end when the basic belief system is contradicted by events. This can happen very naturally as a matter of course because economic fundamentals deteriorate, or because there is a change in rules or regulations that disrupts the balance between supply and demand. In the technology boom, this might occur because each company cannot get to the market first. So even if there is a first-mover advantage, not everyone will be able to take advantage of it.