A Model of Bubbles and Crashes

Abstract

This paper presents a model in which an asset bubble may persist despite the presence of a large mass of rational arbitrageurs whose joint responses would suffice to burst the bubble. The resilience of the bubble stems from the inability of arbitrageurs to temporarily coordinate their selling strategies. This synchronization problem together with the individual incentive to time the market results in the persistence of bubbles over a substantial period. The analysis suggests that behavioral influences on prices are immune to arbitrage in the short and medium run. The model provides a natural setting in which news events, by enabling synchronization, may have a disproportionate impact relative to their intrinsic informational content.

This note is based on a lecture I gave at the IGIDR Silver Jubilee International Conference on “Development: Successes and Challenges Achieving Economic, Social and Sustainable Progress” in 2012. The lecture in turn derives from joint research with Markus Brunnermeier and, in particular, our paper “Bubbles and Crashes”, Econometrica (2003). I thank him for permitting me to draw on this work. The attempt here is to present the core ideas in a simplified and compressed way and offer intuition for some key results. The reader is referred to the cited paper for all proofs, for a more detailed and general presentation, and for a more extensive list of references. Sincere thanks to S. Mahendra Dev, director IGIDR and P. Babu for their hospitality and patience, and to David Pearce for expositional advice.