Thursday, May 28, 2009

Behavioral bubles

Virginia Postrel's article on financial bubbles articulates what some have always believed - that asset bubbles are part of the human pyschology. It also shows the limitations of experimental economics because all of the examples cited in her article are based on experiments using mostly students. The limitations are not that the participants are students but that the experiments cannot approximate actual conditions that allow the observer to make informed decisions.

While asset bubbles are inevitable in all of the settings, learning quickly takes place and for the most part the bubbles disappear. In the real world, the markets can stay irrational longer than most investors can stay solvent. This cannot be explained by the experimental asset markets.

Interestingly, the article highlights the finding that bubbles form when either participants are "new" to the game or the security or rules of the game are "new" to the participants. Here is where human psychology takes over: Who can become the greater fool is perhaps a better name for this new game.

Is the lesson here that regulation should be more stringent when new securities are introduced? What happens if new regulations introduce new uncertainties which sets the greater fool game into motion? Should regulations be introduced to regulate regulations?

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