Market psychology, high unemployment and rational bubbles

It is all about psychology they tell us. Here is a little more. By Farmer.

One explanation for the 2007-09 global crisis is that consumers, markets, and politicians were gripped by “irrational exuberance” that led them to believe the record-high house prices and stock prices were sustainable. This column proposes a new explanation based on rational behaviour and microeconomic theory. It argues that however high stock prices rise, there is always an equilibrium in which they can rise further.

According to a popular narrative (e.g. Shiller 2008), the Great Recession was caused by a bubble in the housing market. When the bubble burst, households were left with mortgages that exceeded the values of their houses. When they stopped spending, the resulting fall in consumer demand triggered an increase in unemployment. The drop in housing wealth was accompanied by a stock market crash, precipitated by the failure of Lehman Brothers in the fall of 2007.

Although this narrative fits the facts, it poses two major difficulties for conventional microeconomic theory.

• First, the existence of an asset price bubble is inconsistent with the theory of forward-looking rational agents interacting in markets (Santos and Woodford 1997).
• Second, conventional theory has no good explanation for why the bursting of an asset price bubble should be associated with the emergence of high and persistent unemployment.

Full article here.