Rethinking why bubbles occur

One of the strongest orthodoxies in modern economics is being challenged, and there could be big implications for the state of the profession. The new, rebellious ideas might also help us understand why financial bubbles happen.

Economists have realized for a very long time that expectations are crucial to economic behavior. If you expect to lose your job, you might consider holding off on buying a car. If you expect inflation in the future, you might consider buying things now, before prices go up. And so on.

The problem is that it’s very tricky to make mathematical models that capture how people set their expectations. Do they form them from long-term trends? Do they look at recent changes? Do they make predictions based on theories, and if so, what theories do they use?

In a pair of papers in 1972 and 1976, University of Chicago economist Robert Lucas constructed a theory that economists would use for decades to come. This was something called rational expectations.

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Rational expectations means that, on average, people make correct guesses about the future of the economy.

Economists flocked to rational expectations, and pretty soon it had become canon. But there has always been one big problem with rational expectations – it might just not be right.

Why might rational expectations be wrong? For one thing, people aren’t born knowing how the economy functions. They have to learn. Another problem is that getting things exactly right is probably too taxing for the human brain – we probably use approximations.

In a recent presentation for the National Bureau of Economic Research, Jesse Bricker, Jacob Krimmel and Claudia Sahm showed some very interesting findings.

The Fed threesome looked at data from the Survey of Consumer Finances, from before and after the housing crash in 2008. They found that more-optimistic ZIP codes – that is, places where people had unrealistically high expectations for their own incomes – were more likely to overpay for houses in the bubble run-up before 2008. These overoptimistic people also took on more debt, and they were more likely to increase borrowing in response to rising house prices.

This looks an awful lot like a systematic mistake.

In other words, rational expectations might really be wrong. If that’s the case, then it will require the economics profession to abandon one of its strongest orthodoxies. But the payoff could be big if the profession devises models that successfully explain phenomena like bubbles and crashes. •
Noah Smith is an assistant professor of finance at Stony Brook University and a Bloomberg View columnist.

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