The Bank of Canada Has Been Studying If Telling People A Bubble Exists Makes It Worse

Canada’s central bank has had researchers quietly studying bubbles overseas. The study, Bubbles, Crashes and Information Contagion In Large-Group Asset Market Experiments, appeared in the June issue of Experimental Economics. It was the centerfold issue, so obviously, I had to pick it up.

In the study, Bank of Canada (BoC) researchers looked at the role of news in bubble cycles, and its impact on consumers. They found people coordinate their expectations of price growth. When people are told, and believe, an asset is overvalued, they lower future price growth. This helps to stabilize the market for the most part, but large groups were a little more complicated. While they lowered their expectations, it was more difficult to break coordination. This resulted in larger bubbles that were difficult to stop. Though all bubbles pop, it just depends on how far they’ll deviate from fundamentals.

About The Bubble Experiment

The researchers conducted multiple experiments, where people forecast the price of assets. They did so for 50 periods, and the average forecast produced the price. Subjects were paid according to performance, giving it a real-world incentive structure. People were grouped into both small (6 people) and large (92 to 104 people) groups.

When the valuation of the asset became overvalued, random participants received a message. The asset had to reach 3x the fundamental value, then each person had a 25% chance of receiving a headline. The headline was simple, like “experts say the stock market is overvalued.”

The researchers had four major takeaways:

  1. Large asset bubbles are “robust” in larger groups. Basically, they were more difficult to break. 
  2. Information contagion occurs. When participants were told an asset was more expensive, they forecast smaller gains. Other participants, regardless of seeing the news, followed in line. 
  3. Time-varying heterogeneity provides an explanation of bubble formation and crashes. That is, when expectations amongst the group become uniform, bubbles form. When expectations vary, some think it’s a bubble and others think it’s fairly valued, a market crashes.  
  4. Bubbles are strongly amplified by coordination on trend extrapolation. If people see prices rise, they’re more likely to expect future price growth. This tends to accelerate price growth even faster, leading to bigger bubbles.

Here are some of the more interesting points, you no doubt will find relatable these days. 

Larger Groups of Investors Make Bigger Bubbles, And They Take Longer To Pop

Conventional wisdom holds that larger markets are more stable than small ones. If a market only has 5 people, one irrational person makes it 20 percent irrational. When that irrational person is in a group of 100, they’re only one percent. The research generally showed this as well, but with an important twist — coordination.

Once a large group entered a bubble, it was more difficult to break the “coordination” of investors. They based their expectations of future prices on what their peers were thinking. It produced groupthink, which made an even larger bubble. “Strong coordination of expectations amplifies the bubble,” wrote the researchers. 

It wasn’t until prices became extreme that some people started to think there may be a problem. Once the group became less uniform about the expectation, prices would crash. Though sometimes they pushed the valuation to the extreme.

News Produces Information Contagion And Helps Break Bubbles

Participants that read news on overvaluation made smaller future forecasts, relative to peers. Since humans coordinate expectations, other people generally adjusted their forecasts lower as well. This helped to create a market crash earlier in some cases.

The market crashing sounds like a bad thing, but crashing sooner than later is better. It prevented the absolute maximum losses that could possibly occur. Not all people saw the newsflash, but enough people coordinated to lower expectations. Though in some cases, the participants kept pushing prices to the absolute limit. Overall though, the researchers conclude the bubble news was stabilizing.

People Get Really Comfortable In Asset Bubbles

People get more comfortable as they experience more bubbles, even if they shouldn’t be. After gaining experience with the first bubble, crash and news included, expectations increased. By the second bubble, they began forecasting larger gains, deviating further from fundamentals. They lost more money, but they were willing to push it to the extreme, while thinking about it less. Inoculation against the fear of losing money, of sorts.

Investors Coordinate On Expectations

The researchers found people coordinate with others naturally, adopting similar expectations. It didn’t matter if they saw the overvaluation news or not. Most would coordinate their expectations of future price growth with those that did.

When prices climbed due to higher expectations amongst the cohort, so did expectations. This occurred even with knowledge of an overvaluation. The reality was less interesting than doing what their friends were doing. Real chimps with pants stuff.

In some groups lowered expectations weren’t enough to stop extreme bubbles. In these cohorts, the market reached the absolute upper bound of overvaluation. Due to coordination, they were willing to risk the maximum they could. Risk was less important than doing what others did.

Circling back to the point, the focus of the study was to determine if news impacts behavior. It not only does, but can play a crucial role in helping to deflate bubbles faster. As people see warnings, they adjust their expectations of price growth lower. Due to market coordination, this can help to stabilize the market over the long-term. Though sometimes it’s not enough to trigger a crash.

For a bubble to pop, participants need to have a varied opinion on where the valuation should be. Either information changes enough opinions and there’s no consensus, or prices hit an extreme. The latter, aka a hard limit, is when prices can no longer rise. It has the worst outcome possible, with maximum losses. What a fun topic for the Bank of Canada to explore now for no particular reason.

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  • Tom Wolfe 2 years ago

    That’s a super interesting study, but I think it leaves out a key factor that the bubble increasing or decreasing has a direct impact on the affected persons ability to borrow money to maintain their IG lifestyle. In the housing-bubble case, the resulting money is bigger than almost anyone’s income from working. Headlines be damned, the subjects are literally vested to the bubble continuing to grow.

    • Gerald Haw 2 years ago

      Always, but the lowered expectations mean it’s the more sustainable way to manage expectations going forward. I imagine it’s not a coincidence the BOC conducted a study around the same time it released information saying it was a bubble in Toronto.

      • Tom Wolfe 2 years ago

        I agree it may lower expectations but, as I see it, the problem is now fulfilling an unsustainable need. #snowball

        • Tom Wolfe 2 years ago

          Like a junkie that needs a fix – the problem isn’t just going to go away regardless of wagging fingers, warnings, or expectations.

  • Omar 2 years ago

    LOL. Yeah, I think the best part is this paper isn’t on their website, but two of the authors are BOC researchers.

  • D 2 years ago

    Indirect admission by the BOC of what’s going on.

  • Jupiter 2 years ago

    Toronto and Vancouver are huge bubbles, but there are other cities with higher median income with way lower prices. The government will not raise rates because unemployment rate is still horrible. Which means, its a better idea to invest in other cities where the median income is higher. They have the potential to see greater gain than Toronto.

  • David 2 years ago

    The price of housing is in canadian dollars, CAD are backed by trust in the Canadian government.

    In the last year+ the bank of canada has increased the amount of canadian dollars in existence by 500%+, (google “m0 money supply canada”, look at 10 year and 25 year graphs, m0 is canadian dollars in existence, easy to google to confirm)

    In last year+ the canadian government has been going in debt per month what used to be considered bad amount to go per year. It isn’t really government printing money to pay for the debt like what brought Germany 1920s to hyperinflation, but even dumber… the banks buy the canadian bonds from canadian government then quickly resell them back to bank of canada for a small profit, so government is really paying others a commision (making private bankers richer) to print money to pay for the debt.

    Housing is a bubble because the alternative, cash/currency is also a bubble. US, EU are doing similar creating vast amounts of money out of thin air.

    Meanwhile China, Russia, Sweden are not creating vast amounts of money or going crazy into debt… so they will likely benefit. China is doing more trading than US, and the gap has widened lots in last year+ with covid, so good chance China Yuan will replace USD as the reserve currency which will make the people of China 10%+ richer, the people of US 10%+ poorer and give China the 2% business competitive advantage that US used to have for not needing to convert currency when doing international trading.

    In real value, Canadian housing may go down in value, but likely not as fast as canadian currency will go down. One downside of housing, if you don’t live in the house you own… in canada capital gains taxes (including on housing) is not indexed to inflation like US, so if crazy inflation, you will be paying lots of taxes on increase of house value if you sell even if value of house really went down because of inflation.

    • Paul 2 years ago

      ⬆️ Someone is worried about not making enough money on the sale of property…

    • D 2 years ago

      The CCP wants deflation. They have the money to buy up everything in a deflation.

  • Bob Walter 2 years ago

    If a purchase an overpriced house and nobody talks about it, its not a bubble. Genius.

    I guess if people don’t talk about their mortgage payments either that is not going to be a problem in the future either.

  • Dar Robbins 2 years ago

    In Central Banking parlance: To lie or not to lie, that is the question.

  • Rene Albert 2 years ago

    In my opinion, the bubble in housing and stock markets will burst as it is based on pure hype and greed and not sustainable. Before the Great Depression about a century ago few people believed it could happen, and the same applies now…

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