Market bubbles and crashes

TL;DR

This paper reviews various hypotheses and models explaining market crashes following asset bubbles, emphasizing the roles of heterogeneous agents, limits to arbitrage, social imitation, and complex system dynamics.

Contribution

It synthesizes historical accounts and theoretical models to provide a comprehensive perspective on the causes and mechanisms of market bubbles and crashes.

Findings

Bubbles exhibit super-exponential growth due to positive feedback.

Heterogeneous agents and limits to arbitrage contribute to bubble formation.

Social imitation and herding can lead to market regime shifts and crashes.

Abstract

Episodes of market crashes have fascinated economists for centuries. Although many academics, practitioners and policy makers have studied questions related to collapsing asset price bubbles, there is little consensus yet about their causes and effects. This review and essay evaluates some of the hypotheses offered to explain the market crashes that often follow asset price bubbles. Starting from historical accounts and syntheses of past bubbles and crashes, we put the problem in perspective with respect to the development of the efficient market hypothesis. We then present the models based on heterogeneous agents and the limits to arbitrage that prevent rational agents from bursting bubbles before they inflate. Then, we explore another set of explanations of why rational traders would be led to actually profit from and surf on bubbles, by anticipating the behavior of noise traders or by realizing the difficulties in synchronizing their actions. We then end by discussing a complex system approach of social imitation leading to collective market regimes like herding and the phenomenon of bifurcation (or phase transition) that rationalize what crash can occur in unstable market regimes. The key insight is that diagnosing bubbles may be feasible when taking into account the positive feedback mechanisms that give rise to transient "super-exponential" price growth, the bubbles.