Bubbles, liquidity, and the macroeconomy.

• Author: Brunnermeier, Markus K.
• Position: Research Summaries

The recent financial crisis has shown that financial frictions, such as asset bubbles and liquidity spirals, have important consequences, not only for the financial sector but also more generally for the macroeconomy. This forces economists to reevaluate firmly held beliefs about market efficiency, the appropriate regulation of financial markets, and approaches to macroeconomic policymaking. The subsequent paragraphs summarize my ongoing research in these domains.

Asset Price Bubbles

Under the efficient market hypothesis, bubbles burst before they even have a chance to emerge. Hence, an asset's market price should correctly reflect its underlying fundamental value. However, bubbles historically have emerged as investors were willing to hold assets, even when their prices exceeded their fundamental value--they hoped to sell these assets at an even higher price to some other investor in the future. In a setting in which a single investor alone cannot bring down a bubble, it can be rational for an individual to ride the bubble. In other words, the uncertainty of not knowing when other investors will start trading against the bubble makes each individual rational investor anxious about whether he can afford to be out of (or short) the market until the bubble finally bursts. Consequently, each investor is reluctant to lean against the bubble and might even prefer to ride it. Thus price corrections only occur with delay, and often abruptly. (1) My empirical research with Stefan Nagel studies hedge funds' holdings of technology stocks during the internet bubble, and it confirms that even sophisticated investors were riding the bubble rather than leaning against it.

The second important message of this line of research is that small, fundamentally unimportant news can trigger large price swings. Such information can serve as a synchronization device that triggers the attack on a bubble. This explains why most large asset price movements are not associated with important news announcements. (2) It also suggests that communication by central bankers and regulators is a very important policy tool.

The bubble-riding hypothesis also provides a different view of risk measures. Even though risk seems to be tamed while the bubble is inflating, risk and imbalances are building up below the surface, and volatility suddenly spikes when the bubble bursts. This is in contrast to the efficient market view, which asserts that contemporaneous risk measures appropriately capture current risk exposure.

Credit Bubbles and Liquidity Spirals

One important lesson from the current crisis is that credit bubbles, like the recent housing bubble or the stock market bubble in the 1920s, can be much more detrimental than the bubbles that are not financed with debt, such as the internet bubble. The reason...