By now, enough has been written
about the sequence of events
that led to the subprime crisis and how it has finally culminated
in the recession that the world is now going through.
So let us take a look at the role of an asset price
bubble, especially in the real estate sector, that
would have aggravated the crisis, how it could have pushed up the prices of an
asset (real estate in this case) to unsustainable levels by clearly identifying
the motives of the players involved in doing so, and what leads to its
burst eventually.
The price of an asset comprises two elements: one that is determined by
the fundamental earning capacity of the asset; and the other, a bubble
component. The fundamental component of the asset price is easy to
understand since it is the discounted present
value of its future expected earnings. Whenever the price of an asset deviates
too far from the price path warranted by its fundamentals, i.e., the future
expected earnings, a bubble is supposed to exist. This poses a great problem
in ex ante identification of a bubble since the future expected earnings can be
uncertain. Also, since the relationship between current and expected
economic fundamentals and asset prices is difficult to model and measure, it is
often hard to assess whether a change in asset prices is justified by changing
economic fundamentals or whether such an asset price movement has a
bubble (that is, non-fundamental) component. Hence, empirical research by the
academic community into various past instances of suspected bubbles has
not resulted in any unanimous conclusion as to whether a given price rise
contained a bubble or not. |
