Neither traditional explanations of asset price booms and crashes as irrational outbursts of speculative mania nor more recent explanations as cases of multiple equilibria account for why and when such episodes occur. In Discussion Paper No. 823, Research Fellow Joseph Zeira develops a model that abstracts from irrational speculation. Rational speculators undergo an optimal learning process in the face of incomplete information, leading to a unique equilibrium. Once dividends on a stock start to rise, both its price and the expected duration of this process rise so long as the dividends continue to increase; the rise in expected future dividends accounts for the price boom. When this process finally stops, the public updates its expectations of future dividends downward and the price of the stock crashes to its long-run level. Such `informational overshooting' may also contribute to price volatility in real estate and currency markets.

Zeira extends this model to consider entry to the stock market, which he assumes to be costly, gradual and characterized by increasing returns up to an unknown level. If a reduction in entry costs induces new entry, productivity increases until increasing returns cease to apply; again stock prices overshoot. This also has empirical implications, since it relates the `boom-and-bust' cycle to entry by new groups of investors. He surveys the US stock market booms and crashes of the 1920s and 1980s and finds that data on the numbers of securities company offices operating in the 1920s and share ownership surveys conducted by the New York Stock Exchange for the 1980s indicate massive new entry. Both periods also witnessed increasing returns to scale (in the real sector in the 1920s and the financial sector in the 1980s) and particular developments that triggered new entry: the development of new means of communication in the 1920s and the financial deregulation and liberalization of the early 1980s. A brief survey of recent booms and crashes reveals that most of them followed financial liberalizations or deregulations.

Informational Overshooting, Booms and Crashes
Joseph Zeira

Discussion Paper No. 823, September 1993 (IM)