In this research project, the PIs investigate the possibility that social rationality explains the emergence of one type of bubble in competitive asset markets: a bubble referred to as a "credit market bubble." The bubble is defined as a situation where (i) the debt is priced above its commonly known intrinsic value and (ii) the debt is rolled over even though each creditor should cash in because everyone knows that the debtor will never be able to repay. Building on evidence from behavioral game theory, the PIs conjecture that such credit market bubbles emerge whenever the debtor's payment ability, although never sufficient, grows over time. Pilot experimental data confirm the emergence of bubbles in this setting. The researchers will conduct experiments to further examine the robustness of bubbles in this environment and test the hypothesis that norms are driving the observed behavior.
In terms of broader impacts, this research will provide a better understanding of price bubbles. Credit bubbles and accompanying asset price run-ups re-occur with alarming frequency in the real world. This research suggests that tension between individual and social rationality is the root cause for their existence. It will lead to a better understanding of this ubiquitous phenomenon in modern capitalist society, and inspire novel and effective government policy and regulation to minimize their negative effects.
This project studied bubbles (and corresponding crashes) in credit markets. We posited that bubbles may emerge every time debt needs to be refinanced/rolled over. We defined bubbles as situations where the price of debt is higher than its intrinsic value — the market value of the assets against which debt is issued. Whenever debt needs to be rolled over and the market value of the assets is insufficient to cover the principal, debt is technically in default, and hence assets need to be liquidated (at the market value). However, there are situations where future cash flows will grow sufficiently to make everyone better off than if the assets are liquidated, even if there may never be sufficient cash to pay the originally contracted principal. This creates a "prisoner’s dilemma" problem for individual debt holders, however, because they would rather be paid the full principle immediately in the hope that others would roll over their share of debt. Indeed, if most debt holders re-finance, there will be enough assets so that those who do want to cash in can get full repayment through the sale of assets. Effectively, individual rationality ("greed") stands in the way of social rationality (everyone is better off waiting). Notice that social rationality is different from other-regarding preferences such as altruism: individual debtors do not care about other debtors’ welfare; they only care about the common good, because it will eventually make them better off as well (than if everyone were selfish). Social rationality explains behaviour in many strategic games that is at odds with classical game theory, such as in the prisoner’s dilemma, the trust game, the centipede game, public goods procurement games, etc. Here, we wondered whether it would show up in credit markets as well. The situation depicted above occurs often in real-world debt markets. As a matter of fact, the eurozone sovereign debt crisis was a stunning example of a credit market bubble and near-crash, as were the recent problems with Puerto Rican municipal debt or Argentinian default. Private companies in distress can sometimes avoid the problem if there is a single, deep-pocketed investor who is ready to buy all the debt and keep the company alive (in fact, in the experimental sessions we ran, we did not allow anyone to take such a monopsonistic position). We studied debt roll-overs both in the absence, and in the presence of, markets where debt holders could re-sell their debt or speculators could short-sell. Without markets, we readily observed bubbles (debt was rolled over when it was not individually rational to do so). The bubbles were robust, but slowly decayed as we repeated the same situation with the same cohort. Small changes in cohorts, through addition of newcomers (who were fully aware what happened in past sessions) ensured that bubbles continued to emerge. Eventually, before the end of the life of the assets behind the debt, a crash occurred and the assets were liquidated. Everyone was better off on average though than if everyone had been individually rational. Still, there were substantial transfers of wealth, mostly from investors who cashed in late, to late short-sellers. The introduction of markets exacerbated the bubbles; they ensured more value was created, but the effect of the crash (loss in value when the assets were eventually liquidated) was commensurate. Curiously, when debt could be traded in a market, the size of the bubble and the improvement in average earnings increased with the number of participants. This is in sharp contrast with, e.g., public goods provision, where an increase in the number of participants decreases the chance that the public good will be provided. Prices behaved so that, if one had not know the fundamental value (of the assets underlying debt), one would have concluded that our credit markets were informationally efficient: price changes from one round (roll-over) to another were not predictable; and the price level correlated positively with the amount of money individual debtors made on average (the higher the price of debt in the market, the more individuals ended up making on average). Our study, for the first time, demonstrates that social rationality (the belief that everyone will eventually be better off doing something that is individually irrational) emerges also in financial markets. As a matter of fact, financial markets enhance the effect of social rationality, presumably because assets initially flow from those who do not believe in others’ social rationality to those who do, even if eventually short-sellers make more money in later rounds. As part of the project, we have also worked on incorporating our experiments in the teaching of finance. We have been teaching finance theory using eight purposely designed trading sessions. The credit market session teaches students where and why classical finance theory can be grossly wrong.
