Bubbles in Asset Prices

Abstract This article addresses three topics. First, it describes what economists mean when they use the term “bubble,” and contrasts the behavioral finance view of asset pricing with the efficient market paradigm in an attempt to understand why bubbles might persist and why they may not be arbitraged away. Second, it reviews some major historical examples of asset-price bubbles as well as the (minority) view that they may not have been bubbles at all. It also examines the corresponding changes in real economic activity that have followed the bursting of such bubbles. Finally, it examines the most hotly debated aspect of any discussion of asset-price bubbles: what, if anything, should policy makers do about them? Should they react to sharp increases in asset prices that they deem to be unrelated to “fundamentals?” Should they take the view that they know more than the market does? Should they recognize that asset-price bubbles are a periodic flaw of capitalism and conduct their policies so as to temper any developing excesses? Or should they focus solely on their primary targets of inflation and real economic activity? The discussion pays particular attention to bubbles that are associated with sharp increases in credit and leverage.