A Rational Theory of Irrational Exuberance (original) (raw)
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A model of endogenous investment booms and busts with rational agents is presented where outside investors are uncertain about both industry (aggregate) and firm-specific capital productivity, and insiders manipulate information through strategic productivity disclosures. For intermediate and high levels of agency conflict, there are aggregate investment distortions along the equilibrium path, investment dynamics are historydependent, and depict patterns of persistent investment booms or investment busts even though investors design optimal incentive contracts based on Bayes-rational beliefs. Moreover, the aggregate uncertainty may not be resolved in the limit, as the number of firms and disclosures gets arbitrarily large.
Financial Fragility with Rational and Irrational Exuberance
Journal of Money, Credit and Banking, 1999
This article formalizes investor rationality and irrationality, exuberance and apprehension, to consider the implications of belief formation for the fragility of an economy's financial structure. The model presented generates a financial structure with portfolio linkages that make it susceptible to contagious financial crises, despite the absence of coordination failures. Investors forecast the likelihood of loss from contagion and may shift preemptively to safer portfolios, breaking portfolio linkages in the process. The entire financial structure collapses when the last group of investors reallocates their portfolios. If some investors are irrationally exuberant, the financial structure remains intact longer. In fact, financial collapse occurs sooner when almost all investors are rationally exuberant than when they are irrationally exuberant. Additionally, a financial crisis initiated by real shocks is indistinguishable from one caused solely by the presence of rationally apprehensive investors in a fundamentally sound economy. Policies that make portfolio linkages more resilient can improve welfare.
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Rational Pessimism, Rational Exuberance, and Asset Pricing Models
Review of Economic Studies, 2007
The paper estimates and examines the empirical plausibiltiy of asset pricing models that attempt to explain features of financial markets such as the size of the equity premium and the volatility of the stock market. In one model, the long run risks model of , low frequency movements and time varying uncertainty in aggregate consumption growth are the key channels for understanding asset prices. In another, as typified by , habit formation, which generates time-varying risk-aversion and consequently time-variation in risk-premia, is the key channel. These models are fitted to data using simulation estimators. Both models are found to fit the data equally well at conventional significance levels, and they can track quite closely a new measure of realized annual volatility. Further scrutiny using a rich array of diagnostics suggests that the long run risk model is preferred.
IV Coloquio Internacional de Bioética - PUCRS, 2019
One of the explanations for the Great Crisis of 2007-2008 was that should financial authorities should have issued stricter regulations to prevent the housing bubble which ended up compromising banks. According to Alan Greenspan, President of the Federal Reserve System (FED) from 1987 to 2006, this is to judge from hindsight: since the real estate bubble and the following crash could not be predicted, he could not have avoided it (Greenspan, 2013, 10) . No one can guess when a “bubble” begins, nor when it ends; they happen because of the emotional “irrational exuberance” of investors’ behavior, that causes the boom and bust of business cycles: first, bullish markets make investors greedy and uncareful, concerned with short-term profits; then they are succeeded by a crash that spreads panic, and a bearish environment of increased risk-aversion yields recession – to be overcome by monetary stimulus (Greenspan, 2013: 89) . For Greenspan, regulators are not in a better situation for assessing risks. Since market participants supposedly know their own risks better than the regulator (a kind of informational asymmetry), an intervention (except to ensure law-enforcement) would be unjustified paternalism. That seems to be a good point: according to Joseph Raz’s (1986: 53) normal justification thesis (NJT), an authority is justified if one is more likely to attend to the reasons that apply to him by abiding by his directives than to pursue these reasons directly, by oneself. So, if regulators don’t know better than regulated agents, NJT wouldn’t apply to them. Relying on the self-interest of lenders to protect shareholder equity, he considered that more restrictive regulation and supervision was not a good alternative, because it can be counterproductive. However, a regulator does not have to be conceived as a paternalistic authority, necessary but to correct a subject’s deviation from rationality. In the article, we’ll sketch a theory concerning financial markets uncertainty and the risk of financial crisis, in order to provide an objection to Greenspan's argument. We argue that crises don’t require a defective reasoning such as the “irrational exuberance” – our usual bounded rationality might be enough to provide the kind of “self-fulfilling prophecy” observed in the rise and fall of bubble assets value. Actually, by invoking an example from Greenspan himself, we suggest he might have been biased by his background as a businessman and economist and neglected the auditing reasoning typical of a financial supervisor. Given the possibility of grave externalities, authorities are justified in adopting measures to ensure investors behave in a prudent way. So regulatory constraints and banking supervision can be legitimate even if the supervisee is supposed to know better their own risks – actually, this might be necessary to encourage investors and institutions to act in a responsible way.
Rational Markets: Yes or No? The Affirmative Case
With the recent flurry of articles declaiming the death of the rational market hypothesis, it is well to pause and recall the very sound reasons this hypothesis was once so widely accepted at least in academic circles. Although academic models often assume that all investors are rational, this is clearly an expository device not to be taken seriously. However, what is in contention is whether or not markets are rational in the sense that prices are set as if all investors are rational. Even if markets are not rational in this sense, there may still not be abnormal profit opportunities. In that case, we say the markets are minimally rational. This article maintains that developed financial markets are minimally rational and, with two qualifications, even achieve the higher standard of rationality. In particular, it contends that realistically, market rationality needs to be defined so as to allow investors to be uncertain about the characteristics of other investors in the market. It also argues that investor irrationality, to the extent it affects prices, is particularly likely to be manifest through overconfidence, which in turn is likely to make the market in an important sense hyper-rational. To illustrate, the paper ends by reexamining some of the most serious evidence against market rationality: excess volatility, the risk premium puzzle, the size anomaly, closed-end fund discounts, calendar effects and the 1987 stock market crash. † I would like to thank the UC Berkeley Finance Group, who prepped me at several " research lunches " prior to the debate described in this paper, in particular, Jonathan Berk and Greg Duffee who commented as well on the written version.