Lunchtime Must-Read: Jose Scheinkman: Speculative Trading and Bubbles

Jose Scheinkman: Bubbles: “One question left unanswered in this lecture…

…is whether one could use the signals associated with bubbles such as inordinate trading volume or high leverage, to detect and perhaps stop bubbles. One of the difficulties in using these signals is that we know next to nothing about false positives…. Even if we could effectively detect bubbles, it is not obvious that we should try to stop all bubbles. Although credit bubbles have proven to have devastating consequences, the relationship between bubbles and technological innovation suggests that some of these episodes may play a positive role in economic growth. The increase in the price of assets during a bubble makes it easier to finance investments related to the new technologies.

The most straightforward policy recommendation that arises from the bubble models discussed in this lecture, is that to avoid bubbles, policy makers should limit leverage and facilitate, instead of impede, short-selling. In the panic that followed the implosion of the credit bubble, the SEC banned short-sales of financial stocks. In August 2011, as the markets questioned the health and funding needs of European financial institutions, France, Italy, Spain and Belgium imposed bans on short-sales of financial stocks. Each of these interventions may have have given a temporary respite to the markets for these assets, but caused losses to investors that were short these assets and had to cover their positions. Investors learned one more time that it is dangerous to bet against overvalued assets–a lesson that they will surely keep in mind in the next bubble.