Financial Bubbles and Crises: Questions for Future Research

The literatures on bubbles and financial crises have grown tremendously in the past decades. While these literatures have provided us with a number of important insights regarding financial bubbles and crises, a number of important research questions remain.

"Open questions that future research might address:"

1. How do bubbles start? In most models of bubbles, the bubble cannot start within the model; it has to be present from the time the asset starts trading. Hence, while the existing literature has given us a number of insights for why bubbles may survive, we know much less about their origin.

2. More research is also needed on how bubbles burst. In particular, most theory models of bubbles predict that bubbles burst essentially instantaneously. In prac- tice, however, bubbles often deflate over time. What determines the dynamics of how bubbles burst?

3. The recent crisis has rekindled the debate on whether and how central banks should target bubbles as part of their policy actions. Should they? If yes, how? If not, why?

4. There is an emerging informal consensus that bubbles fueled by credit differ from bubbles that are not fueled by credit. For example, it is sometimes argued that regulators and central banks should lean against credit bubbles, but not against bubbles not fueled by credit. However, more research is needed on this issue, both theoretical (why are credit bubbles more costly from a social perspective?) and empirical (how would one identify credit bubbles?).

5. What macroprudential tools should regulators and central banks deploy? How effective are different macroprudential tools and how do they interact with mon-71etary policy? This raises the broader question of the interaction between price stability and financial stability and how those goals should be traded off.

6. The corporate finance literature has developed a number of models that capture the sources of financial frictions, but has taken dynamics and calibration less seriously. The macro literature has taken dynamics and calibration seriously, but often is less specific about the source of the underlying frictions. There seems to be large potential in developing a literature that bridges this divide between finance (especially research on financial frictions) and macroeconomic models. For a survey of existing work in macroeconomics, see Brunnermeier, Eisenbach, and Sannikov (2013).

7. The measurement of systemic risk is still in its infancy. To the extent that future regulation should target systemic risk, good measures of such risk are important. An analogy can be made to the development of the national account system after the Great Depression. Part of this question is theoretical: How should we define an operational measure of systemic risk? Part of this question is of an empirical nature: Which data should be collected for financial stability purposes, especially in light of the newly created Office of Financial Research? 

8. The policy response to the recent financial crisis has mostly focused on incentive distortions, both as explanations for the crisis and also as the primary point of at- tack for regulatory interventions. An important open issue is the extent to which behavioral factors drove the crisis, and how regulation should incorporate them. An important challenge in this research agenda is the development of welfare cri- teria within models with behavioral distortions such that policy recommendations are possible.

Source: a new paper by Brunnermeier and Oehmke.