Noah Smith is a terrific economics writer IMHO. Please follow link to his article or simply read the excerpt below.
A Better Theory to Explain Financial Bubbles
DEC 8, 2016
By Noah Smith
What causes asset bubbles? This question is the great white whale of finance theory. We know that asset prices are given to spectacular rises and falls over short periods of time. Answering this question is hugely important, not just for people’s pensions and retirement, but for the whole economy, since crashes in asset prices can leave growth in the doldrums for years.
Watching for Bubbles
But despite decades of research, finance academics have been unable to agree on a cause for this phenomenon. Do investors suddenly become optimistic about asset fundamentals, only to realise a couple of years later that it was all a mirage? Do they buy at prices they know are inflated, hoping to find a greater fool to sell to before the crash? Or do they simply follow the herd?
One possibility is that investors simply make mistakes when projecting future asset returns. If stocks have had an outstanding run for the past five years, or if earnings growth seems to have shifted to a faster trend, people might decide that this is the new normal, and pay prices that later turn out to be ludicrous.
In much of the economics profession, it’s still almost taboo to even consider this kind of human mistake. Most econ models are still based on rational expectations, the idea that people don’t systematically make errors when forecasting the future. This idea was advanced by many star economists of the 1970s and '80s, including the highly influential macro economist Robert Lucas. But in finance theory, economists have had more freedom to experiment. So a small but increasing number of papers are asking how markets would behave if investors improperly extrapolate recent trends into the future.