The most compelling model of a speculative bubble has two ingredients:

First, people need to disagree about the fundamental value of the security,  with the possibility that the identity of the most optimistic people changes through time.

Second, there needs to be some barriers to shorting so securities so that prices don’t reflect the average opinion, but instead the securities end up being held by the most optimistic.

Together, these two things mean that assets can be priced at higher than anyone’s estimate of  ‘buy and hold’ values, because of the possibility of finding someone more optimistic than you in the future.  That person will value the security more than their buy and hold value if they think that there could be a more optimistic person in the future they could sell to.  Recursively, this means that the security is higher than anyone’s buy and hold value.

The bubble ends when people stop disagreeing about the buy and hold values.  We don’t have any good story for why people’s beliefs could suddenly converge–but it seems plausible to me that they might.

This is a model of Keynes’ famous beauty contest theory of bubbles.  It also implies a lot of trading today, or the potential of a lot of trading in the future in order to get the bubble to work.

The formal model was written by Harrison and Kreps in the 70s.  It was a popular explanation of some of the anomalies during the dot com days.

Real estate may satisfies the two requirements, especially in periods in which it is hard to estimate fundamentals.  This is one reason that Shiller argued that we needed housing futures, I think.

Now it looks like short selling general financial securities is getting harder and harder:

AllAboutAlpha.com» Institutional Investing Today’s Post » Securities lending starting to dry up a little?

Eeeck.

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