Advancing a Free Society

Social Interactions and Bubbles

Sunday, May 16, 2010

Bubbles in prices of stocks, houses, or other assets are usually defined to mean sizable and somewhat prolonged deviations in these prices from the fundamental determinants of the prices. These price deviations are supposed to get larger and larger until the bubble bursts, and then price rather abruptly go back close to the levels expected from fundamentals. Do bubbles so defined exist? I believe they do, although I applaud economists who work hard to find explanations of such price movements in more subtle changes in fundamentals. But we do not have good explanations for when bubbles arise and when they end.

Bubbles depend on expectations that get out of whack and become self-fulfilling for a while. In recent years, one of the most glaring examples of what appears to be a bubble is the pricing of young Internet and biotech companies during the period 1995-2000. Many companies in these fields that had no earnings or even any sales, and objectively had little prospects of earning anything in the reasonable future, were deluged with money from venture capitalists and others. Their stocks if they went public had enormous market values relative to any likely discounted earnings. After a few years the market realized the folly of what had been happening, the bubble burst, values came back to earth, and most of these companies went out of business.

Continue reading on The Becker-Posner Blog…