Bubbles, Crises, and Heterogeneous Beliefs

Abstract

This paper reviews the quickly growing literature that builds on heterogeneous beliefs, a widely observed attribute of individuals, to explain bubbles, crises, and endogenous risk in financial markets.Wei Xiong Princeton University Department of Economics Bendheim Center for Finance Princeton, NJ 08450 and NBER wxiong@princeton.edu 1The history of financial markets has been dotted with episodes of bubbles, during which market values of assets vastly exceeded reasonable assessments of their fundamental value. Asset price bubbles can lead to severe economic consequences ranging from wasteful over-investment and frenzied trading during booms to devastating financial crises and depressed real economies during busts. Economists have emphasized many aspects of bubbles and crises. Minsky (1974) advocated the view that excessive expansion of bank credit due to optimism can fuel a speculative euphoria and slowly lead the economy to a crisis. Kindleberger (1978) stressed that irrationally optimistic expectations frequently emerge among investors in the late stages of major economic booms and lead firm managers to over-invest, over-promise, and over-leverage, which sow the seeds for an eventual collapse after they fail to deliver on their promises.Shiller (2000) highlighted a host of psychological biases people use in forming a feedback mechanism, through which initial price increases caused by certain initial precipitating factors such as new technology innovations feed back into even higher asset prices through increased investor confidence and expectations. Allen and Gale (2007) focused on agency problems of professional managers who actively seek unwarranted risk, which leads to bubbles and crises.This chapter reviews a quickly growing body of work that was started by Harrison and Kreps (1978) that studies bubbles and crises based on heterogeneous beliefs, a widely observed attribute of individuals.In a market in which agents disagree about an asset's fundamental and short sales are constrained, an asset owner is willing to pay a price higher than his own expectation of the asset's fundamental because he expects to resell the asset to a future optimist at an even higher price. Such speculative behavior leads to a bubble component in asset prices. This approach does not require a substantial amount of aggregate belief distortions to generate a significant price bubble. Instead, the bubble component builds on the fluctuations of investors' heterogeneous beliefs. Even when investors' aggregate beliefs are unbiased, intensive fluctuations of their heterogeneous beliefs can lead to a significant price bubble through frenzied trading (e.g., Scheinkman and Xiong (2003)). This approach is flexible enough to incorporate several important aspects of bubbles and crises, such as over-investment (e.g., Bolton, ) and crashes (e.g., Abreu and Brunnermeier (2003) and Hong and Stein (2003)). Heterogeneous beliefs can also lead to credit cycles (e.g., Geanakoplos (2010)). The speculation induced by heterogeneous beliefs also lea...

Extrapolation and Bubbles

“…It is impossible to do justice here to all the important contributions in the literature on bubbles, recently surveyed by Brunnermeier and Oehmke (2013) and Xiong (2013). Instead, we focus on two classes of models-rational bubble models and disagreement-based modelsand compare our framework to those.…”

Explanations of Asset Price Bubbles

“…3 The definition of asset price bubbles varies slightly. The definition used in this study is the dominant variety (see Brunnermeier 2008, Brunnermeier -Oehmke 2013, Hirshleifer 2001, Scherbina 2013and Xiong 2013, although this is not accurate either, since it only roughly distinguishes asset price bubbles from overvaluation. As we detail later, the inaccuracy is due to the fact that these are two very similar phenomena, which primarily differ in their magnitude.…”

Economically Irrational Pricing of 19th Century British Government Bonds

“…Most papers are devoted either to documenting the existence of an anomaly, and trying to fit it into some model, or else to explaining away the observations as outcomes of rational trading. Some references are [3,6,10,13,23,36,37,38,46,48,49]. They provide more references and overviews of the literature in this area.…”