Market Bubbles and Crashes as an Expression of Tension between Social and Individual Rationality: Experiments

We investigate the claim that social rationality explains the emergence of one type of bubble in competitive asset markets that we shall refer to as “credit market bubble,” and that individual rationality explains the subsequent crash. The bubble is defined as a situation where (i) the debt is priced above its intrinsic value and (ii) the debt is rolled over even though each creditor should cash in as it is commonly known that the debtor would never be able to repay the debt at face value. Building on evidence from behavioral game theory, we conjecture that credit market bubbles emerge whenever the debtor’s payment ability, although never sufficient, grows over time. As such, bubbles are beneficial, even if they eventually lead to crashes which cause re-distribution of wealth away from those who ride the bubble too long. We argue that this captures the essence of many financial bubbles alleged to have been observed in the real world. Experimental data confirm the emergence of bubbles in this setting. The bubbles are robust – they re-emerge upon replication – but decay can be avoided by adding noise, e.g., through random replacing participants with (informed) newcomers. The presence of financial markets increases the overall beneficial effects of the bubbles. Prices always remain above levels predicted by conventional asset pricing theory. Nevertheless, they exhibit properties of (informational) efficiency, such as: prices cannot be used to predict the length of the bubble, but correlate with the payoffs that the claims eventually generate.