As the NYT Freakonomics Blog notes, few principles of economics texts mention market bubbles and crashes. Princeton economists are studying bubbles. Here's Henry Bloget's take on bubbles in The Atlantic. Note to self - include this in the next class.

New York Times columnist Tom Friedman points out that Charles Mackay wrote a classic history of financial crises called “Extraordinary Popular Delusions and the Madness of Crowds,” first published in London in 1841. “Money … has often been a cause of the delusion of multitudes. Sober nations have all at once become desperate gamblers, and risked almost their existence upon the turn of a piece of paper. To trace the history of the most prominent of these delusions is the object of the present pages. Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.”

The point is that some prices - like housing or dotcom stocks - depend on expectations about other people's expectations. If everybody expects that someone else thinks that prices will go higher, they will buy assets to try to profit from them. That works until expectations change, and then prices crash.

So there's a more or less "rational" explanation of bubbles. It's rational even for people who believe there's a bubble to run with it for a while. Other approaches to understanding bubbles use behavioral economics and neuroscience to show how people behave "irrationally," as described in this Scientific American article.

The San Francisco Fed points out that bursting a bubble presents some tough choices for monetary policy. Now, this is a microeconomics wiki, so we're not concerned with monetary policy. However, microeconomics is concerned with individual markets, so we want to understand why they can go crazy.

Here's a link to a Sheinkman and Xiong paper with a model of asset price bubbles. Here's an overview of Brunnermeier's work on bubbles at Princeton.

Here's [http://www.sedlabanki.is/lisalib/getfile.aspx?itemid=5238 another paper I need to read.

Brad DeLong cites the lack of understanding of the volatility of asset prices as evidence in a crisis of economics.

Experimental Evidence

Hussam, Porter and Smith (2008)1 show that even experienced asset traders can generate bubbles.

Theories about Bubbles

Here's a useful video where Brunnemeier explains the theory behind bubbles. The basic problem is one of common knowledge: even if you know there is a bubble, you don't know that everyone else knows it.

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