The Madness Of Crowds And The Likelihood Of Bubbles
54 Pages Posted: 5 Feb 2020
Date Written: November 17, 2019
The limits-to-arbitrage framework explains how a speculative bubble can be sustained. But, it does not explain how often you should expect one to occur. To do that, you need to model the on/off switch which sporadically amplifies speculator biases, causing arbitrageur constraints to bind and a bubble to form. I propose a first such model with an on/off switch based on social interactions between speculators. In the model, bubbles occur more often when small increases in past returns make an asset’s speculators much more persuasive to their peers. I use industry-level stock returns to empirically verify this ex ante prediction about bubble likelihoods. And, in the process, I show it is possible to test such predictions even in the presence of ex post disagreement about how to define a speculative bubble.
Keywords: Limits To Arbitrage, Speculative Bubbles, Social Interactions
JEL Classification: G02, G11, G12
Suggested Citation: Suggested Citation