Book Review: Speculation, Trading, and Bubbles
Speculation, Trading, and Bubbles. 2014. José Scheinkman, Kenneth J. Arrow, Patrick Bolton, Sanford J. Grossman, and Joseph E. Stiglitz.
Investment professionals often need to work through speculative trading bubbles without losing their proverbial shirts (and clients). They might be intrigued by, if not convinced of, the regular pattern of such bubbles as presented in this short volume by José Scheinkman. It consists of adapted transcripts from a November 2010 lecture at which the author’s 51-minute presentation was supplemented by more than 112 minutes of valuable observations by several discussants. Those discussions — involving Scheinkman and the eminent academics Kenneth Arrow, Patrick Bolton, Sanford Grossman, and Joseph Stiglitz — are worth the price of the book.
The author’s main message is the utility of his new economic model, which allows for the divergence of asset prices from their fundamental valuations. It is based largely on the asymmetry in actions and beliefs between buyers and sellers. Scheinkman correlates asset price bubbles with increases in trading volume and financial or technological innovations; he relates their implosions to increases in the supply of those assets. The text includes an analysis of the famous South Sea Bubble and the application of the new model to that episode. This updated version of the 2010 lecture also references two colleagues’ 2011 review of the 2005–08 bubble in warrants on Chinese stocks. After briefly explaining his model and referring to an appendix for some sophisticated mathematics, Scheinkman leaves unanswered the question of whether one could use the signals of bubbles to detect or even stop them. He does suggest that well-meaning impediments to short selling, such as those imposed by regulators in the United States and Europe in 2011, should not be counted on to prevent bubbles’ rise and fall.
In their remarks, the discussants do not restrict themselves to commenting on his proposed model. Instead, they pose larger questions about the utility of the efficient market hypothesis, regulatory paternalism, excessive leverage and risk taking, and skewed compensation incentives. Their eschewing statistics is refreshing. While acknowledging other economists’ work on the equilibrium of prices and the nature of “fundamental value,” they frequently address the irrational decision-making processes of the humans who ultimately set asset prices — both on the way up and on the way down. Some particularly illuminating fragments of conversation revolve around the fact that bursting asset bubbles negatively affect not only the limited number of buyers of those assets but also the larger number of people and institutions affected by “externalities.”
With the benefit of hindsight, it is easy to identify the causes and effects of asset price bubbles. Predicting them in advance is difficult, despite the best efforts of the economists who contributed to Speculation, Trading, and Bubbles. Open-minded investors should try to benefit from such examinations.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.