Bubbles: Rational or Irrational?

In my previous post, I argued that irrational markets is a more convincing explanation of the dot-com bubble than the mechanism involving rational investors set out by Pastor and Veronesi. This conclusion should not, however, be applied generally. Peter Garber (1990) describes the Mississippi and South Sea bubbles convincingly without accounting for irrational traders. The pre-crash price, Garber argues, was indicative of the chance that these revolutionary economic 'experiments' might work. With hindsight, we know that they failed, but prior investors were perfectly rational to account for a chance of success.

Garber also argues that the tulip bubble is something of a myth, and that despite the fact that few experienced or skilled investors were involved in the trade, the observed price trends are not actually uncommon for rare or new flowers. The interesting point here is that markets may have been rational despite consisting mostly of irrational traders. This is a point argued directly by Ross (2004), who states that markets can be efficient even in the presence of a majority of irrational investors provided there is a handful of 'arbitrageurs' involved.

This theory seems perfectly plausible, but herding that is rational from an individual perspective can also result in stock prices that appear unusually inefficient. Irrational investors could produce rational markets, and rational investors could produce irrational markets.

This illustrates why the framework of Maureen O'Hara (2008), presented in the table below, is much more useful than a simple irrational/rational dichotomy.

Traders
Markets		Rational	Irrational
	Rational	Rational Traders, Rational Markets: Traders are rational and Efficient Market Hypothesis holds	Irrational Traders, Rational Markets: Efficient Market Hypothesis holds in spite of herding or overconfidence
	Irrational	Rational Traders, Irrational Markets: Traders are rational, but markets are inefficient for agency/game theory reasons	Irrational Traders, Irrational Markets: Markets are inefficient as a result of psychological flaws in investors

These four categories of theory, and their implications for the identification of bubbles, will be presented in my final post later this week.

References:

Garber, Peter, 'Famous First Bubbles', The Journal of Economics Perspectives 4 (1990), pp.35-54.

O'Hara, Maureen, 'Bubbles: Some Perspective (and Loose Talk) from History', The Review of Financial Studies 21 (2008), pp. 11-17.

Ross, Stephen, Neoclassical Finance, Princeton University Press (2004).