Financial Market Bubbles and Crashes: Features, Causes, and Effects

Financial asset price bubbles are defined as episodes where prices rise rapidly and depart from established asset valuation multiples and relationships. Economists have studied these bubbles through various theories, but a consistent and reliable theory is still lacking. This book proposes a new approach based on the notion of urgent short-side rationing, where considerations of quantities owned or not owned displace considerations of price during extreme conditions.

Format: Paperback / softback
Length: 579 pages
Publication date: 18 December 2022
Publisher: Springer Nature Switzerland AG

Economists broadly define financial asset price bubbles as episodes in which prices rise with notable rapidity and depart from historically established asset valuation multiples and relationships. Financial economists have for decades attempted to study and interpret bubbles through the prisms of rational expectations, efficient markets, equilibrium, arbitrage, and capital asset pricing models, but they have not made much, if any, progress toward a consistent and reliable theory that explains how and why bubbles (and crashes) evolve and are defined, measured, and compared. This book develops a new and different approach that is based on the central notion that bubbles and crashes reflect urgent short-side rationing, which means that, as such extreme conditions unfold, considerations of quantities owned or not owned begin to displace considerations of price.

Bubbles and crashes are phenomena that have fascinated economists and financial markets for centuries. While the causes of these events are still debated, there is a growing consensus that they are driven by a combination of factors, including irrational exuberance, herd behavior, and structural imbalances.

One of the most commonly cited theories of financial asset price bubbles is the rational expectations hypothesis. According to this theory, investors are rational and make decisions based on available information and economic fundamentals. When prices rise rapidly, investors may become overconfident and start to bid up prices, leading to a bubble. However, when economic conditions change or new information becomes available, investors may revise their expectations and sell their assets, leading to a crash.

Another theory of financial asset price bubbles is the efficient markets hypothesis. According to this theory, markets are efficient and prices reflect all available information. Therefore, it is impossible to make abnormal profits in the long run, as prices will always adjust to reflect new information. However, this theory has been challenged by the fact that markets can be inefficient and can experience periods of irrational exuberance.

Equilibrium theory is another approach to understanding financial asset price bubbles. According to this theory, markets are in equilibrium when supply and demand are equal. When prices rise rapidly, supply becomes constrained, leading to higher prices. However, when demand falls or supply increases, prices may fall.

Arbitrage theory is another approach to understanding financial asset price bubbles. According to this theory, investors can profit from price discrepancies between different markets or assets. For example, investors may buy a stock in one market and sell it in another market at a higher price, earning a profit. However, this theory is limited by the fact that investors must have access to all available information and must be able to execute trades quickly.

Capital asset pricing models (CAPM) are a popular tool used by financial economists to explain financial asset price bubbles. These models assume that investors are risk-averse and that they will only invest in assets that offer a higher expected return than the risk-free rate. However, these models have been criticized for failing to explain the extent of price bubbles and crashes.

Despite the numerous theories and models that have been proposed to explain financial asset price bubbles, there is still no consensus on a single, consistent theory that can explain how and why bubbles (and crashes) evolve and are defined, measured, and compared. This book develops a new and different approach that is based on the central notion that bubbles and crashes reflect urgent short-side rationing.

Urgent short-side rationing refers to the situation where there is a shortage of assets that are desirable to investors. When prices rise rapidly, investors may become desperate to own these assets, leading to a rush to buy. This can lead to a bubble, as prices become inflated and investors become overconfident. However, when economic conditions change or new information becomes available, investors may revise their expectations and sell their assets, leading to a crash.

The book argues that urgent short-side rationing is a key factor in the evolution of financial asset price bubbles and crashes. It suggests that investors are motivated by a desire to own assets that are expected to appreciate in value, rather than by a desire to generate income. This can lead to a misallocation of resources, as investors chase after high-risk assets while neglecting low-risk assets.

The book also suggests that urgent short-side rationing can be influenced by a variety of factors, including economic conditions, political events, and market sentiment. For example, during periods of economic growth, investors may become more optimistic and chase after high-risk assets, leading to a bubble. However, during periods of economic uncertainty, investors may become more risk-averse and sell their assets, leading to a crash.

The book also provides a framework for measuring and comparing financial asset price bubbles and crashes. It suggests that investors should focus on the quantity of assets that are being bought and sold rather than on the price of the assets. This can help to identify bubbles and crashes more accurately and prevent them from occurring in the future.

In conclusion, financial asset price bubbles and crashes are complex phenomena that are driven by a combination of factors, including irrational exuberance, herd behavior, and structural imbalances. While numerous theories and models have been proposed to explain these events, there is still no consensus on a single, consistent theory that can explain how and why bubbles (and crashes) evolve and are defined, measured, and compared. This book develops a new and different approach that is based on the central notion that bubbles and crashes reflect urgent short-side rationing. By focusing on the quantity of assets that are being bought and sold, investors can identify bubbles and crashes more accurately and prevent them from occurring in the future.

Weight: 961g
Dimension: 235 x 155 (mm)
ISBN-13: 9783030791841
Edition number: 3rd ed. 2021