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Popping Bubbles Isn't as Easy as You Would Think

11/26/2009 05:12 am ET | Updated May 25, 2011

The economic blogsphere has done a fair amount of discussing on financial bubbles. The primary argument is if the Federal Reserve had acted more quickly regarding the housing market then the current problems would have been avoided. However, there is one problem with this argument: what is the exact definition of a bubble? While it may seem easy, there are several problems with actually defining it. And it is this inability to adequately define a bubble that makes popping them that much harder.

First, here is a definition of an asset bubble from Investopedia.com:

A spike in asset values within a particular industry, commodity, or asset class. A speculative bubble is usually caused by exaggerated expectations of future growth, price appreciation, or other events that could cause an increase in asset values. This drives trading volumes higher, and as more investors rally around the heightened expectation, buyers outnumber sellers, pushing prices beyond what an objective analysis of intrinsic value would suggest.

There are two keys to this definition: price relative to some historical norm or benchmark and volume. Let's take this in the order presented.

Here is a simple question regarding asset prices: how do we determine an assets real value? If you ask different people, you'll probably get different answers. For example, two of the most common methods of valuing a stock are price to book value and price to earnings (PE). We already have a problem -- there are two popular methods of valuing a company, each with its pros and cons. In other words, there is no single generally agreed to valuation model. Let's take this one stop forward and assume that a single benchmark is accepted. What is the highest amount prices can stretch beyond that benchmark? For example, suppose we all agreed to use PE as the primary benchmark. How far could prices extend beyond that level before action was required? What if prices crossed a line one day just slightly? Would that warrant action? Or would prices have to extend beyond that level for a period of time? If so, how long? In other words, even if we create or accept a single method of valuation the relationship of prices to that valuation create further problems is identifying when prices are "out of sync."

The second part of the bubble definition implies volume, or the number of people participating in the market. There is a problem with this part of the definition as well: how do you identify the difference between a legitimate increase in the number of people who want to buy or sell a particular item and a speculative mania? For example, a central theme to the last expansion was commodities demand. Both China and India were growing at strong rates. As a result, a large number of people (over 2 billion) would start to demand more raw materials like copper for the production of goods and oil. So, over the last 10 years the number of people demanding these commodities increased greatly. As a result we saw a huge spike in the prices of natural resources. As the correction started these prices dropped hard, leading some to argue this drop proved there was a speculative bubble in commodities. But again, how do you prove the difference between a change in demand caused by more people legitimately demanding more of an item and "speculators" participating in a mania ?

By now the point should be clear. Identifying a bubble is nowhere near as easy as many people think. There are clear problems in identifying the proper valuation to be used in identifying a bubble along with when there is a legitimate market driven change in the number of people participating in the market as opposed to a speculative mania. In short, central bankers have an incredibly difficult task in dealing with this matter.

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