2
S. BASCO
Even though all bubble episodes have elements in common, each bubble is different in its own way. In this book, we focus on one particular type of asset price bubble: housing bubbles. There are two main reasons for this choice. First, bubbles in house prices are recurrent in different countries and over different periods of time. Second, housing bubbles tend to exacerbate the effects of asset price bubbles on the economic activity, as the bust of the recent housing bubbles illustrates. We start the book with a formal definition of asset price bubble. Everyone recognizes a bubble after it has crashed. However, it is not easy to spot a bubble in real time. Chapter 2 defines the bubble component of an asset as the difference between the price and the fundamental value of the asset. Unfortunately, given the uncertainty around the fundamental value of an asset, there is not a scientific procedure to be sure that there is a bubble in real time. Nonetheless, we construct a housing bubble indicator to keep track of past episodes and analyze its evolution over time and across countries. We also review in Chapter 2 three of the most famous asset price bubble episodes in history: (i) the Dutch Tulipmania, (ii) the South Sea Bubble and (iii) the Dot-Com Bubble. By reviewing these episodes, we explain that these famous bubble episodes have some elements in common, which can be extrapolated to most asset price bubble episodes. In particular, their boom-bust behavior can be summarized by the title of the seminal work of Kindleberger and Aliber (2005): “Manias, Panics and Crashes”. Bubble episodes begin with a mania. For some reason, investors get excited about the prospects of purchasing an asset. This mania phase is followed by a panic in which a pessimistic sentiment is spread throughout investors. This pessimistic sentiment is transformed into a massive amount of sales orders, which derives into the ensuing crash of the price of the asset. Once we are familiar with the notion of asset price bubble, Chapter 3 offers two theories on the origin of bubbles. The first theory is based on behavioral economics. The idea is that some investors start to believe, for some unexplained reason, that the return on the asset will be very high. Actually, higher than what well-informed (rational) investors think. These (too) optimistic investors purchase the asset and push the price above its fundamental value. The second theory offers a “rational” view on the origin of bubbles. According to this view, asset price bubbles are the optimal market response to a shortage of assets. This theory implies that bubbles emerge when the demand
