Speculative Bubbles and Overreaction to Technological Innovation - FRBSF Economic Letter

Summary:
Paper by the SF Fed on the relationship between speculative bubbles, technological innovation, and capital misallocation. History tells us that periods of major technological innovation are often accompanied by speculative bubbles as investors overreact to genuine advances in productivity. Excessive run-ups in asset prices can have important consequences for the economy as firms and investors respond to the price signals, resulting in capital misallocation. On the one hand, speculation can magnify the volatility of economic and financial variables, thus harming the welfare of those who are averse to uncertainty and fluctuations. On the other hand, speculation can increase investment in risky ventures, thus yielding benefits to a society that suffers from an underinvestment problem. (Published: 20/06/08)


Notes:

• Greenspan (2002):
  
• "Bubbles are often precipitated by perceptions of real improvements in the productivity and underlying profitability of the corporate economy. But as history attests, investors then too often exaggerate the extent of the improvement in economic fundamentals."
• Numerous empirical studies have shown that stock prices appear to exhibit "excess volatility"
  
• i.e. prices move too much to be explained by changes in the underlying fundamentals, such as dividends or cash flows
• difficult to reconcile with framework of rational, efficient markets
• Another prominent feature of asset prices is the intermittent occurrence of sustained run-ups above estimates of fundamental value
• so-called speculative bubbles
• can be found throughout history in various countries and markets
• e.g. dramatic rise in U.S. stock prices during the late 1990s
• was accompanied by a boom in business investment
• e.g.U.S. house prices during the mid-2000s
• was accompanied by a boom in residential investment
• Both booms were later followed by falling asset prices and severe retrenchments in the associated investment series
• as firms and investors sought to unwind the excess capital accumulated during the bubble periods
• Shiller (2000): argues that investors overreact to technological innovations
• shows that major stock price run-ups have generally coincided with the emergence of some superficially plausible "new era" theory in the popular culture that extols the virtues of new technology
• new era economic thinking is then used to justify a meteoric rise in asset prices and the abandonment of traditional valuation metrics
• four major run-ups in the real (inflation-adjusted) S&P 500 stock index
• Shiller associates each run-up with the following technological advances that contributed to new era enthusiasm
1. Early 1900s: High-speed rail travel, transatlantic radio, long-line electrical transmission.
2. 1920s: Mass-production of automobiles, travel by highways and roads, commercial radio broadcasts, widespread electrification of manufacturing.
3. 1950s and 60s: Widespread introduction of television, advent of the suburban lifestyle, space travel.
4. Late 1990s: Widespread availability of the internet, innovations in computers and information technology, emergence of the web-based business model.



• Compare Business Week:
  
1. September 7, 1929: "For five years at least, American business has been in the grip of an apocalyptic holy-rolling exaltation over the unparalleled prosperity of the 'new era' upon which we, or it, or somebody has entered."
   
1. March 8, 1999: "The high-tech industry is on the cusp of a new era in computing in which digital smarts won't be tied up in a mainframe, minicomputer, or PC. Instead, computing will come in a vast array of devices aimed at practically every aspect of our daily lives."

• Caballero et al. (2006): argue that rapidly rising stock prices provided firms with a low-cost source of funds from which to finance their investment projects
• resulting surge in capital accumulation served to increase measured productivity growth
• in turn, helped to justify the enormous run-up in stock prices
• Alan Greenspan on January 13, 2000, near the peak of the stock bubble
  
• raised the possibility that investors might have overreacted to recent productivity-enhancing innovations
• Feldstein (2007): argues that the rapid growth in subprime lending from 2001 to 2006 was driven in part by "the widespread use of statistical risk assessment models by lenders."
• Greenspan (2005): offered the view that the financial services sector had been dramatically transformed by advances in information technology, thus enabling lenders "to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately."
• In retrospect, enthusiasm for a "new era" in credit risk modeling appears to have been overdone
• Persons (1930 pp. 118-119), describes the fallout from an earlier era of rapid credit expansion as follows:
  
• "It is highly probable that a considerable volume of sales recently made were based on credit ratings only justifiable on the theory that flush times were to continue indefinitely….When the process of expanding credit ceases and we return to a normal basis of spending each year...there must ensue a painful period of readjustment."
• Conclusion
• History tells us that periods of major technological innovation are often accompanied by speculative bubbles as investors overreact to genuine advances in productivity.
• Excessive run-ups in asset prices can have important consequences for the economy as firms and investors respond to the price signals, resulting in capital misallocation.
• On the one hand, speculation can magnify the volatility of economic and financial variables, thus harming the welfare of those who are averse to uncertainty and fluctuations.
  
• On the other hand, speculation can increase investment in risky ventures, thus yielding benefits to a society that suffers from an underinvestment problem.
• financial fraud has typically accompanied historical bubble episodes
• Meeker (1922, p. 419), regarding the merits of speculation
• "Of all the peoples in history, the American people can least afford to condemn speculation....The discovery of America was made possible by a loan based on the collateral of Queen Isabella's crown jewels, and at interest, beside which even the call rates of 1919-1920 look coy and bashful. Financing an unknown foreigner to sail the unknown deep in three cockleshell boats in the hope of discovering a mythical Zipangu [land of gold] cannot, by the widest exercise of language, be called a 'conservative investment."