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Bursting the Bubble: Rationality in a Seemingly Irrational Market

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Bursting the Bubble: Rationality in a Seemingly Irrational Market

The presence of speculative bubbles in capital markets (an important area of interest in financial history) is widely accepted across many circles. Talk of them is pervasive in the media and especially in the popular financial press. Bubbles are thought to be found primarily in the stock market, which is our main interest, although bubbles are said to occur in other markets. Bubbles go hand in hand with the notion that markets can be irrational.

The academic community has a great interest in bubbles, and it has produced scholarly literature that is voluminous. For some economists, doing bubble research is like joining the vanguard of a Kuhnian paradigm shift in economic thinking. Not so fast.

If bubbles did exist, they would pose a serious challenge to neoclassical finance. Bubbles would contradict the ideas that markets are rational or work in an informationally efficient manner. That’s what makes the topic of bubbles interesting.

This book reviews and evaluates the academic literature as well as some popular investment books on the possible existence of speculative bubbles in the stock market. The main question is whether there is convincing empirical evidence that bubbles exist. A second question is whether the theoretical concepts that have been advanced for bubbles make them plausible.

The reader will discover that I am skeptical that bubbles actually exist. But I do not think I or anyone else will ever be able to conclusively prove that there has never been a bubble. From studying the literature and from reading history, I find that many famous purported bubbles reflect inaccurate history or mistakes in analysis or simply cannot be shown to have existed. In other instances, bubbles might have existed. But in each of those cases, there are credible rational explanations. And good evidence exists for the idea that even if bubbles do exist, they are not of great importance to understanding the stock market.

About the Author

David Deosa
David DeRosa

David DeRosa is the founder and president of DeRosa Research and Trading, Inc. He is an economist who specializes in foreign exchange, equity markets, central banking, monetary policy, and derivative instruments. Dr. DeRosa has taught extensively at Columbia University, the Yale School of Management, and the Graduate School of Business of the University of Chicago (now the Booth School of Business). He has served for several decades on the boards of directors of major hedge funds. Dr. DeRosa is the author of numerous books on the foreign exchange market, derivatives, central banking, and public policy issues surrounding the regulation of the capital markets. He received his undergraduate degree in economics from the College of the University of Chicago and his doctorate from the Graduate School of Business of the University of Chicago.