May 1, 2023

The impact of bubbly episodes

How do economic bubbles and crashes affect long-run economic growth?

Statues of a bull and a bear, symbols of market upswings and downswings, sit outside of the entrance to the Frankfurt Stock Exchange.

Source: rissix

Economic bubbles are a persistent feature of modern economies. But the question of their impact on economic growth and how governments should respond to them remains an ongoing debate among economists, investors, and policymakers.

In a paper in the American Economic Journal: Macroeconomics, authors Pablo A. Guerron-Quintana, Tomohiro Hirano, and Ryo Jinnai take a step toward a better understanding of the long-run role asset bubbles play in the economy by building a model with recurrent bubbles, crashes, and endogenous growth and applying it to recent data from the United States. 

Their findings may help macroprudential policymakers weigh the tradeoffs between intervening to stop bubbles before they get started and cleaning them up after they burst.

Our model offers another reason to intervene and prevent bubbles, because the sheer expectation of the bubble is already a bad thing.

Ryo Jinnai 

Previous macroeconomic studies have looked at recurrent asset bubbles ending up with large crashes through the lens of overlapping generation models. But there is an important limitation to this approach: households only exist for a short time in these models. This means that they do not live long enough to form expectations about bubbles. 

The authors believed that including expectations of bubble formation was crucial to capturing the role that these economic swings have on investment and economic growth. 

Introducing bubble dynamics into an endogenous growth model with long-lived households revealed some key insights into how bubbles influence households’ incentives to work, save, and consume.

First, the researchers noticed a positive crowding-in effect. Once asset bubbles appear, they make households feel richer and mitigate investors’ funding problems by speeding up capital accumulation, which in turn stimulates economic growth.

But at the same time, long-lived households see these bubbles come and go, and so expect them to happen in the future, which has a perverse, crowding-out effect. 

“If people expect bubbles to arise in the future, they think that it's okay to enjoy consumption and leisure right now rather than investing and working today,” Ryo Jinnai told the AEA in an interview. “And that is a headwind against growth.”

Whether the costs of this crowding-out effect outweighs the benefits of the crowding-in effect depends on how developed a country's financial sector is. 

When financial sectors are underdeveloped, they do a poorer job of getting funding to worthwhile projects efficiently. In that case, bubbles can actually help smooth these financial frictions by making it easier to obtain investments. However, as the financial sector develops, this problem becomes less severe, and so there is less benefit from the crowding-in effect.

The authors applied these modeling insights to US GDP and stock market data from 1984 to 2017. They were able to identify two prominent bubbles: one from 1997 to 2001, corresponding to the dot-com boom, and the other from 2006 to the onset of the Great Recession, corresponding to the housing bubble.


A look at the data
The chart below shows quarterly US data on GDP growth and the stock market to GDP ratio from 1984 to 2017. The red line—a 10-year rolling-window average—shows that GDP growth slowly declined from the 1990s to after the Great Recession in 2008.


From this modeling exercise, the authors found that the US economy benefited from the bubble-driven economic booms. They estimated that the combination of the two bubbly episodes permanently raised the level of US GDP by about 2 percentage points. 

However, they also found that if there had been no expectations that bubbles would form at all, then the US economy would have grown even faster. The crowding-out effect of future bubbles more than outweighed the benefits of the crowding-in effect from the two bubbles.

The findings suggest that macroprudential policymakers should be more cautious about letting bubbles arise in the first place.

“Our model offers another reason to intervene and prevent bubbles, because the sheer expectation of the bubble is already a bad thing,” Jinnai said. “Financial regulations that reduce expectations of bubbles may be a good idea especially in developed economies.”

Bubbles, Crashes, and Economic Growth: Theory and Evidence appears in the April 2023 issue of the American Economic Journal: Macroeconomics.