Possible Causes of Bubbles: Beta and New Technology

I noted in a previous post how often historical bubbles have appeared to follow the emergence of new technology. This is extremely widely observed. The Economist goes as far to say that 'Every previous technological revolution has produced a speculative bubble... America's railway boom, electricity, telephones, radio and cars.'

Why is this the case? Shiller (2005) attributes it to sociological phenomena, hypothesizing that new technology leads some investors to believe that previous rules governing the stock market no longer apply: 'new era' thinking. In this post, however, I will be focusing on a theory by Pastor and Veronesi (2009) that explains the emergence of a bubble in a market of fully rational investors.

Pastor and Veronesi develop a model in which bubbles emerge as a result of uncertainty over whether new technology will be adapted by the existing economy. If the new technology is not widely adapted, the risk associated with its stock will remain idiosyncratic: in other words, it will tend to have a very low beta. This justifies a premium on the stock price of these firms. When the technology is widely adapted, however, the risk associated with these stocks becomes systematic, and the price of the stock collapses as a result. Investors are behaving rationally, and the appearance of a bubble only emerges in hindsight when we know that the new technology was widely adapted.

Pastor and Veronesi present some empirical evidence from the dot-com bubble and railway mania to support their model. Personally, however, I do not find it very convincing. The implication that dot-com stock steeply rose in 2000 because of investors who believed the internet was not likely to be widely adapted by the economy is very counter-intuitive, and seems to contradict a lot of qualitative evidence. Popular contemporary justifications for the high price of dot-com stock in 2000 were very different to the rational explanations presented by Pastor and Veronesi. 

Furthermore, the focus of the article primarily concerns whether each action is game theory optimal, rather than whether it is what actually happened. It is assumed, for example, that existing firms will wait until the prospects of a technology become clear, rather than implement it at an early stage or discard it. This assumption is not based on empirical evidence concerning what such firms typically do in reality, but on the fact that this would be the optimal choice within their model. The result is a theory that, while interesting, explains how such a bubble might emerge in a world of fully rational people rather than how it emerged in the real world.

References:

Pástor, Ľuboš, and Pietro Veronesi, 'Technological Revolutions and Stock Prices.' American Economic Review, 99 (2009), pp.1451-83.

Shiller, Robert, Irrational Exuberance: Second Edition, Princeton University Press (2005).

The Economist, 'Bubble.com: All Technological Revolutions Carry Risks as well as Rewards' (2000), retrieved from: http://www.economist.com/node/375561