What are asset bubbles and why do they happen?

from noahpinionblog.blogspot.com

Tomorrow I'm going to go the American Economic Association's annual meeting, to interview for economics jobs. (For the uninitiated, most jobs that are specifically for new econ PhDs conduct interviews at this meeting, which is what most economists mean when they talk about "the job market.") One of the key elements of getting a job as an economist is to have a "job market paper," which is generally the first chapter of your dissertation, and which is what shows potential employers that you can do quality research. My job market paper is here in case you want to read it. I'm not going to spend a heck of a lot of time discussing the paper (that can wait until it's ready to send off to journals), but it gives me an opportunity to write a post I've been wanting to write for a while anyway, about the research that motivated my paper in the first place.

That research is the Vernon Smith "bubble experiments." "Bubbles, Crashes, and Endogenous Expectations in Experimental Spot Asset Markets" (Smith, Suchanek and Williams, Econometrica 1988) is definitely a Paper You Should Know.

What is a "bubble"? Well, it's something that looks like this:

Prices go way up, then they crash back down. Look at any long-term plot of any asset price index (stocks, housing, etc.) and you're likely to see some big peaks like this. That's what I call a "bubble." It's also the definition used by Charles Kindleberger in his book Manias, Panics, and Crashes.

But the real question is why we care about bubbles.
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