Laws against bubbles: An experimental-asset-market approach to analyzing financial regulation

Wisconsin Law Review

Volumn 2007, Issue 5, 2007, Pages 977-1039

  Gerding, Erik F ^a  

^a UNIVERSITY OF NEW MEXICO   (United States)

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EID: 38949213660     PISSN: 0043650X     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Review

References (492)

1. Roger Lowenstein, On the Home front: Pop Psychology, N. Y. TIMES MAG., Mar. 18, 2007, at 14 (comparing popular beliefs and the views of economists on whether U.S. real-estate markets are experiencing a bubble).
2. See, e.g., David Barboza & Keith Bradsher, Tax Increase Batters Chinese Stocks, but There's Little Wider Damage, N. Y. TIMES, May 31, 2007, at C4 (reporting that the Chinese stock market plummeted in response to a new transaction tax designed to curb stock-market speculation "as a growing number of economists and analysts warn about the danger of a market bubble. ").
3. See, e.g., Andrew Ross Sorkin & Michael J. de la Merced, Easy Credit Evaporates, and so Does the Market's Buyout Frenzy, N. Y. TIMES, July 27, 2007, at C1 (reporting that a "buyout bubble," that is, speculation in takeovers and leveraged buyouts in the U.S. stock market, popped on July 26, 2007 as credit tightened);
4. Shawn Tully, Why the Private Equity Bubble is Bursting, FORTUNE, Aug. 20, 2007, at 30-32, available at http://money.cnn.com/2007/08/06/markets/privateequitybubble.fortune/index.htm (analyzing the collapse of the "private equity bubble" that formed due to cheap credit and frenzied investors who were "dazzled by rich returns").
5. See, e.g., Jenny Anderson, How This Boom Differs from the Dot-Com Days: Hedge Funds Make Money, N. Y. TIMES, July 6, 2007, at C5 (noting that money managers and the media have questioned since 2005 whether hedge-fund investments are in a bubble and that concerns have intensified with hedge funds preparing to make public offerings).
6. See Econbrowser, What Is a Bubble and Is This One Now?, http://www.econbrowser.com/archives/2005/06/what_is_a_bubbl.html (June 23, 2005, 23:43) (comparing popular analysis of whether there is a U.S. housing bubble to "Justice Potter Stewart's position on pornography-they haven't defined a bubble, but they think they know it when they see it").
7. In re Merrill Lynch & Co., 273 F. Supp. 2d 351, 364-65, 382 (S.D.N.Y. 2003). The decision also invoked the "bespeaks caution" doctrine to preclude relief for plaintiffs and again employed the bubble metaphor to do so. Id. at 376. For an analysis of this decision and its implications for the loss-causation element of securities-fraud litigation, see Jay W. Eisenhofer et al., Securities Fraud, Stock Price Valuation, and Loss Causation: Toward a Corporate Finance-Based Theory of Loss Causation, 59 BUS. LAW. 1419, 1438 (2004).
8. See, e.g., Chi Lo, China's Slow but Sure Shift to Yuan Flexibility, STRAITS TIMES (Sing.), Aug. 1, 2007 (reporting that "excessive liquidity" is driving asset-price inflation in the Chinese economy and "has boosted stock prices into bubble territory");
9. Floyd Norris, A Mountain of Margin Debt May Not Be Cause for Concern, N. Y. TIMES, Feb. 24., 2007, at C3 (reporting that high levels of margin investing in the stock market generated "concern of excessive speculation").
10. See, e.g.. Jad Mouawad, Report on Amaranth Collapse Is To Be Made Public Today, N.Y. TIMES, June 25, 2007, at C2 (reporting that a U.S. Senate subcommittee investigating the collapse of a hedge fund recommended that Congress "reinvigorate prohibitions against excessive speculation") (internal quotations omitted).
11. See, e.g., Theresa A. Gabaldon, John Law, with a Tulip, in the South Seas: Gambling and the Regulation of Euphoric Market Transactions, 26 J. CORP. L. 225 (2001) (advocating the application of approaches from legal restrictions on gambling to regulation of financial speculation). Roberta Karmel provides a historical account of how combating excessive speculation was one of the key premises of federal securities laws.
12. Roberta S. Karmel, Mutual Funds, Pension Funds, Hedge Funds and Stock Market Volatility- What Regulation by the Securities and Exchange Commission Is Appropriate?, 80 NOTRE DAME L. REV. 909, 935-37 (2005).
13. Karmel argues that the SEC and the Federal Reserve had "regulatory tools for pricking" the technology-stock bubble of the late 1990s, particularly margin regulations, but failed to use these tools or otherwise address excessive speculation. Id. at 948.
14. Frank Partnoy has addressed the broader topic of the role law can play in preventing market crashes, including crashes from speculative bubbles. Frank Partnoy, Why Markets Crash and What Law Can Do About It, 61 U. PITT. L. REV. 741 (2000).
15. Barboza & Bradsher, supra note 2, at C4.
16. See, e.g., Lawrence H. Summers & Victoria P. Summers, When Financial Markets Work Too Well: A Cautious Case for a Securities Transactions Tax, 3 J. FIN. SERVS. RES. 261 (1989) (positing that a transaction tax may curb excessive speculation that results from excess liquidity);
17. Gabaldon, supra note 9, at 281 (advocating increasing short-term-capital-gains tax rates to curb investor gambling);
18. Joseph E. Stigliz, Using Tax Policy to Curb Speculative Short-Term Trading, 3 J. FIN SERVS. RES. 101 (1989).
19. Arbitrage means investment trades that exploit a perceived short-term mispricing of an asset. For example, if an arbitrageur believes a certain stock is overvalued, he or she sells that stock short (i.e., borrows shares of that stock and then sells them). The arbitrageur profits if the stock price declines from the amount owed the lender of the stock (but loses if the price rises). Arbitrageurs hedge their risks when entering into short sales by simultaneously buying a close substitute of the stock. Andrei Shleifer & Robert W. Vishny, The Limits of Arbitrage, 52 J. FIN. 35 (1997) (analyzing how risks cannot be completely removed from arbitrage).
20. For a survey of the economic literature on the role of arbitrage (specifically short sales) in preventing asset-price bubbles and promoting the efficient pricing of stocks and an analysis of the legal restrictions on short sales, see Michael R. Powers et al., Market Bubbles and Wasteful Avoidance: Tax and Regulatory Constraints on Short Sales, 57 TAX. L. REV. 233 (2004).
21. E.g., id. at 264, 270 (advocating repeal of the "uptick rule," which permitted short sales on a security only if the previous trade increased the price of that security).
22. For a comprehensive analysis of the uptick rule, see Jonathan R. Macey et al., Restrictions on Short Sales: An Analysis of the Uptick Rule and Its Role in View of the October 1987 Stock Market Crash, 74 CORNELL L. REV. 799 (1989) (concluding that the uptick rule impairs market efficiency). The uptick rule is codified at 17 C.F.R. § 240.10a-1 (2007).
23. Regulation SHO and Rule 10a-1, 72 Fed. Reg. 36,348 (July 3, 2007) (to be codified at 17 C.F.R. pts. 240, 242). In enacting this rule change, the SEC stated that the benefits of removing this restriction would include improving the "price efficiency" of stock markets but did not explicitly reference the role of short sales in preventing asset-price bubbles. Id. at 36,355.
24. Some scholars have noted that one of the historical purposes for the now-repealed uptick rule was to prevent bubbles. See ROBERT J. SHILLER, IRRATIONAL EXUBERANCE 226 (2001).
25. See SHILLER, supra note 15, at 225-26.
26. The New York Stock Exchange initiated a circuit breaker after the 1987 stock-market crash. See NYSE, Inc., Rules and Constitution, Rule 80B (1998) ("Trading Halts Due to Extraordinary Market Volatility").
27. For background on the introduction of this circuit breaker and a proposal to modify the regulation to take into account how investors experience market time periods in "nonlinear" ways, see Lawrence A. Cunningham, From Random Walks to Chaotic Crashes: The Linear Genealogy of the Efficient Capital Market Hypothesis, 62 GEO. WASH. L. REV. 546, 598-602 (1994).
28. Gabaldon, supra note 9, at 283.
29. In 2003, a member of the Council of Economic Advisors framed a set of disclosure initiatives by the George W. Bush administration, which included a requirement that securities issuers provide investors with more quarterly information, as a means of mitigating the risk of asset-price bubbles and the "likelihood of asset mispricing." Randall S. Kroszner, Asset-Price Bubbles, Information, and Public Policy, in ASSET-PRICE BUBBLES: THE IMPLICATIONS FOR MONETARY, REGULATORY, AND INTERNATIONAL POLICIES 3, 10-12 (William C. Hunter et al. eds., 2003).
30. Legal scholars have seen disclosure as one means to remedy excessive speculation and asset mispricings. E.g., Gabaldon, supra note 9, at 283-84;
31. Lynn A. Stout, Are Stock Markets Costly Casinos?: Disagreement, Market Failure, and Securities Regulation, 81 VA. L. REV. 611, 695-97 (1995) (positing that mandatory-disclosure rules discourage stock speculation by providing investors with uniform information that encourages homogeneous expectations).
32. See, e.g., Robert P. Flood & Peter M. Garber, Market Fundamentals Versus Price-Level Bubbles: The First Tests, 88 J. POL. ECON. 745, 746 (1980);
33. Henry T. C. Hu, Faith and Magic: Investor Beliefs and Government Neutrality, 78 TEX. L. REV. 777, 794 (2000).
34. At times, economists have expanded this basic definition to include the reason that asset prices diverge from their fundamental values. Markus K. Brunnermeier, Bubbles, in THE NEW PALGRAVE DICTIONARY OF ECONOMICS (Steven Durlauf & Lawrence Blume eds., forthcoming 2008) (prepublication edition at 1, available at http://www.princeton.edu/~markus/research/papers/bubbles_survey.pdf) ("Bubbles refer to asset prices that exceed an asset's fundamental value because current owners believe that they can resell the asset at an even higher price in the future.").
35. See, e.g., Ellen R. McGrattan & Edward C. Prescott, Testing for Stock Market Overvaluation/Undervaluation, in ASSET- PRICE BUBBLES, supra note 18, at 271. One alternative to defining fundamental value in terms of future cash flows is to say that the best guess as to fundamental value is whatever the market price is. That tautology would make it impossible for prices ever to be "wrong."
36. Marcel Kahan characterizes these occurrences as "speculative mispricings." Marcel Kahan, Securities Laws and the Social Costs of "Inaccurate" Stock Prices, 41 DUKE L.J. 977, 990-92 (1992).
37. As Kahan explains, stock prices may diverge from fundamental value for other reasons, such as insider trading and liquidity crunches. Id. at 988-93. This Article considers only divergences of asset prices from fundamental values-asset-price bubbles-that result from investor trading behavior. This Article also considers laws that address "excessive speculation" as antibubble laws, even if they are less than clear in articulating what constitutes "excessive speculation" or defining its harms.
38. Infra Part II.A. 1.
39. See David P. Porter & Vernon L. Smith, Stock Market Bubbles in the Laboratory, 1 APPLIED MATHEMATICAL FIN. 111, 121-22 (1994).
40. Ronald R. King et al., The Robustness of Bubbles and Crashes in Experimental Stock Markets, in NONLINEAR DYNAMICS AND EVOLUTIONARY ECONOMICS 183, 183-85 (Richard H. Day & Ping Chen eds., 1993).
41. E.g., id. at 185-86. The design of experimental asset markets is detailed in Part III.B.2.
42. See infra Part III.C.1.A.
43. See infra Part III.C.
44. See infra Part III.C.
45. This conclusion is in line with the findings of Stephen Choi and Adam Pritchard. Stephen J. Choi & A.C. Pritchard, Behavioral Economics and the SEC, 56 STAN. L. REV. 1 (2003) (arguing for circumspection in using behavioral law and economics to justify regulation, as regulators suffer from similar cognitive biases as investors). Choi and Pritchard note that scholarship reviewing behavioral law and economics often has political undertones. Id. at 4.
46. One of the first articles that brought experimental economics to the attention of legal scholars was Elizabeth Hoffman & Matthew L. Spitzer, Experimental Law and Economics: An Introduction, 85 COLUM. L. REV. 991 (1985).
47. Legal scholars have focused on the legal implications of relatively simple experiments such as dictator and ultimatum games. In particular, legal scholars have looked to these experiments to explain the development of norms of reciprocity. E.g., Cass R. Sunstein, Social Norms and Social Roles, 96 COLUM. L. REV. 903 (1996).
48. Other scholars have looked at the implications of basic experiments for a wide range of legal fields. See, e.g., Dan M. Kahan, Reciprocity, Collective Action, and Community Policing, 90 CAL. L. REV. 1513 (2002) (investigating implications of economic experiments and scholarship on development of social norms for community-policing efforts).
49. This Article explores some of the groundbreaking work on asset-price bubbles in experimental asset markets, one of the key achievements for which Vernon Smith was awarded a Nobel Prize in 2002. Mike Lynch & Nick Gillespie, The Experimental Economist, 34 REASON, Dec. 2, 2002, at 34.
50. A handful of legal scholars have referenced some of this research, usually in footnotes. See, e.g., Thomas A. Lambert, Overvalued Equity and the Case for an Asymmetric Insider Trading Regime, 41 WAKE FOREST L. REV. 1045, 1053 n.25 (2006) (noting research on information efficiency of experimental stock markets);
51. Henry G. Manne, Insider Trading: Hayek, Virtual Markets, and the Dog that Did Not Bark, 31 J. CORP. L. 167, 169 n.11 (2005) (same).
52. Vernon Smith calls this necessary condition for drawing implications from results of experimental economics "parallelism." Vernon L. Smith, Microeconomic Systems as an Experimental Science, 72 AM. ECON. REV. 923, 935-38 (1982) (outlining "precepts" for design of laboratory experiments in economics).
53. Infra note 327 and accompanying text.
54. Even policy prescriptions based on other models of bubbles fit roughly within this template and are evaluated in this Article with distinctions and different implications from behavioral finance. Behavioral finance scholars have explained bubble formation as the result of (1) investors trading on "noise" rather than fundamental information, due to cognitive limitations, mental shortcuts, and behavioral biases, which (2) lead investors to chase rising asset prices, creating positive-feedback loops that (3) cannot be corrected by arbitrageurs due to constraints on arbitrage. ANDREI SHLEIFER, INEFFICIENT MARKETS: AN INTRODUCTION TO BEHAVIORAL FINANCE 1-27 (2000) (providing an overview of behavioral finance theory organized as a response to the Efficient Market Hypothesis).
55. See supra note 35.
56. See supra note 19 and accompanying text. This definition has several advantages over a simpler definition used by other historians and economists. See, e.g., CHARLES P. KINDLEBERGER, MANIAS, PANICS AND CRASHES: A HISTORY OF FINANCIAL CRISES 16 (4th ed. 2000) (defining a bubble as "an upward price movement over an extended range that then implodes"). Although this simpler definition captures the intuitive shape of a bubble, it fails to single out any causal explanation for the rise and crash of prices and thus cannot generate any testable hypotheses or predictions. Defining bubbles as a deviation in asset prices from fundamental value leads to the question of whether any divergence constitutes a bubble or whether prices must diverge to a pronounced extent and for a prolonged period.
57. See supra note 20 and accompanying text.
58. For a basic primer on bond valuation, see A. A. GROPPELLI & EHSAN NIKBAKHT, FINANCE 119-22 (5th ed. 2006).
59. See, e.g., Kenneth A. Froot & Maurice Obstfeld, Intrinsic Bubbles: The Case of Stock Prices, 81 AM. ECON. REV. 1189 (1991) (developing a "rational-bubble" model for stocks using dividend payments as determinant of fundamental value);
60. Charles Himmelberg et al., Assessing High House Prices: Bubbles, Fundamentals, and Misperceptions 1-2 (Nat'l Bureau of Econ. Research, Working Paper No. 11643, 2005) (using the "imputed annual rental cost" of owning property to determine the presence of a real-estate bubble).
61. Franklin Allen & Roni Michaely, Payout Policy, in IA HANDBOOK OF THE ECONOMICS OF FINANCE, 408 (George M. Constantinides et al. eds., 2003) (describing the recent historic shift from corporations making payouts to stock investors in dividends to payouts in share repurchases).
62. For example, condominium-association governing documents often prohibit or restrict leasing. See Woodside Village Condominium Ass'n v. Jahren, 806 So. 2d 452, 453 (Fla. 2002) (upholding agreement restricting leases).
63. Logically, the greater the proportion of the income (either expected or possible) from the sale of an asset to the income from dividend or rental streams, the more speculative (in every sense of that word) the fundamental value of the asset becomes (unless the variance in the sales price is less than the variance of dividend and rental income from the assets).
64. SHILLER, supra note 15, at 180-83 (investigating the link between stock dividends, prices, and bubble theories).
65. SEC regulations require this disclosure on advertising by investment companies that include performance data. 17 C.F.R. § 230.482(b)(3)(i) (2007).
66. In fact, many scholars trace the formation of bubbles to widespread adoption of new technologies (e.g., the first financial exchanges in the seventeenth century, railroads in the nineteenth century, radios and airplanes in the 1920s, and the internet in the 1990s), social changes (e.g., the end of wars), or the opening of new geographical markets. KINDLEBERGER, supra note 37, at 38-41.
67. These beliefs represent what economist Robert Shiller calls "new era thinking." SHILLER, supra note 15, at 96.
68. Many adherents to new era thinking, such as investors in technology stocks in the late 1990s, could justify their decisions only with what one economist labels "wildly optimistic expectations of sustained profit growth rates." Allan H. Meltzer, Rational and Nonrational Bubbles, in ASSET-PRICE BUBBLES, supra note 18, at 23, 27-28.
69. But, demarcating when the flavor of reasonable risk taking becomes the poison of wild optimism is unavoidably subjective. The question of whether any particular current or historical asset market was in an asset bubble is beyond the scope of this Article. For an extended argument that the 1990s technology stock market was a bubble, see William O. Fisher, Does the Efficient Market Theory Help Us Do Justice in a Time of Madness?, 54 EMORY L.J. 843 (2005).
70. See Meltzer, supra note 47, at 28-29.
71. This distinction between risk and uncertainty was first made by Frank Knight. See FRANK H. KNIGHT, RISK, UNCERTAINTY AND PROFIT 19-20 (1921).
72. Meltzer, supra note 47, at 28-29.
73. See infra Part II.B.2.
74. SHLEIFER, supra note 35, at 154.
75. For an overview of the EMH and the challenge it faces from behavioral finance, see id. at 5-23.
76. For a seminal work in legal literature on the implications of this challenge for those securities regulations and doctrines based on the EMH, see Donald C. Langevoort, Theories, Assumptions, and Securities Regulation: Market Efficiency Revisited, 140 U. PA. L. REV. 851 (1992).
77. For the seminal article introducing the EMH to legal literature, see Ronald J. Gilson & Reinier H. Kraakman, The Mechanisms of Market Efficiency, 70 VA. L. REV. 549 (1984).
78. E.g., Burton G. Malkiel, The Efficient Market Hypothesis and Its Critics, 17 J. ECON. PERSP., Winter 2003, at 59 (questioning whether behavioral finance meets this standard).
79. See infra Part II.C.1.
80. Furthermore, legal scholars have noted that, in its strict sense, the EMH only contends that market prices reflect all available information regarding an asset and not that prices necessarily reflect that asset's fundamental value. See, e.g., Jeffrey N. Gordon & Lewis A. Kornhauser, Efficient Markets, Costly Information, and Securities Research, 60 N.Y.U. L. REV. 761, 766-71 (1985) (drawing a distinction between arguments that markets are characterized by speculative (i.e., informational) efficiency and those discussing allocational efficiency).
81. Despite this distinction, the economic literature on bubbles often appears to conflate informational and allocational efficiency. See, e.g., Nicholas C. Barberis & Richard H. Thaler, A Survey of Behavioral Finance, in IB HANDBOOK OF THE ECONOMICS OF FINANCE, supra note 41, at 1054, 1056 (defining "fundamental value" as "the discounted sum of expected future cash flows" where investors are operating with all available information).
82. Compare Peter M. Garber, Tulipmania, 97 J. POL. ECON. 535 (1989) (arguing that prices of tulip bulbs during Dutch tulipomania in 1630s may have been justified by fundamentals), with EDWARD CHANCELLOR, DEVIL TAKE THE HINDMOST: A HISTORY OF FINANCIAL SPECULATION 23-26 (1999) (disputing Garber's facts and analysis).
83. Compare McGrattan & Prescott, supra note 20, at 271-75 (presenting evidence that the 1929 U.S. stock market was not overvalued),
84. with Peter Rappoport & Eugene N. White, Was There a Bubble in the 1929 Stock Market?, 53 J. ECON. HIST. 549 (1993) (finding evidence that a bubble contributed to the 1920s stock-market boom and crash despite certain econometric tests that suggest no bubble existed).
85. Compare Lubos Pastor & Pietro Veronesi, Was There a NASDAQ Bubble in the Late 1990's?, 81 J. FIN. ECON 61 (2006) (presenting evidence that there was nota NASDAQ bubble),
86. with SHILLER, supra note 15, at 3-4 (arguing that the late 1990s market for technology stocks was overvalued).
87. See infra Part II.B.2.
88. See infra Part II.B.1.
89. See infra Part II.B.2. This Article follows the classification system for bubble models found in Brunnermeier, supra note 19, at 2.
90. Scholars often look back and see risk, but investors of the past looked forward into uncertainty. Robert J. Shiller, Bubbles, Human Judgment, and Expert Opinion 12-13 (Yale Cowles Found., Discussion Paper No. 1303, 2001), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=275515.
91. Only examples of investor behavior that, at the time, could not be squared with rational expectations or fundamental information on the value of assets would support findings of investor irrationality. See Kenneth L. Fisher & Meir Statman, Cognitive Biases in Market Forecasts, 27 J. PORTFOLIO MGMT. 72, 78-79 (2000) (evaluating behavioral finance and other research for hindsight bias in market forecasts).
92. Only comparisons of ultimate cash flows to historical price changes that show that investors make systematic errors (under- or overestimating cash flows or under- or overreacting to information) weaken support for market efficiency. Many behavioral-finance scholars recognize this and produce evidence of systematic errors. See, e.g., Josef Lakonishok, Contrarian Investment, Extrapolation and Risk, in II ADVANCES IN BEHAVIORAL FINANCE 273, 312-13 (Richard H. Thaler ed., 2005) (responding to criticisms of "data snooping" with evidence of a "systematic pattern of expectational errors" by investors).
93. In fact, behavioral finance has offered evidence of systematic patterns in the marketplace that do not accord with a random walk and has identified examples of market mispricings that indicate investors were not trading on fundamental information, See infra Part III.C.1.
94. See, e.g., Oliver Jean Blanchard, Speculative Bubbles, Crashes and Rational Expectations, 3 ECON. LETTERS 387, 387 (1979).
95. See Robert P. Flood & Robert J. Hodrick, On Testing for Speculative Bubbles, 4 J. ECON. PERSP., Spring 1990, at 85, 86.
96. See, e.g., Jean Tirole, On the Possibility of Speculation Under Rational Expectations, 50 ECONOMETRICA 1163, 1179-80 (1982).
97. Tirole bases this argument on the logic of general equilibrium that, if an initial price is efficient and everyone in the market is informed of that efficiency, no rational buyer would pay more than that price. Id.
98. Brunnermeier, supra note 19, at 5.
99. Meltzer, supra note 47, at 24.
100. Small changes in the assumptions of the rational-bubble models cause them to fail to generate bubbles. M. C. Adam & A. Szafarz, Speculative Bubbles and Financial Markets, 44 OXFORD ECON. PAPERS 626, 634 (1992).
101. Equations underlying rational-bubble models have mathematically indeterminate solutions. Id. at 636.
102. This theoretical indeterminacy, in turn, leads to inconsistent empirical analysis. One pair of critics notes that "researchers working with the same data base and identical models will not necessarily detect the 'same' bubbles." Id. at 638.
103. Moreover, rational-bubble models can generate an infinite number of price patterns, which bear no resemblance to the intuitive "shapes" of bubbles-either the prolonged rise in asset prices or the subsequent sharp crash. Id.
104. Meltzer, supra note 47, at 24.
105. See, e.g., Franklin Allen & Gary Gorton, Churning Bubbles, 60 REV. ECON. STUD. 813 (1993).
106. Franklin Allen & Douglas Gale, Bubbles and Crises, 110 ECON. J. 236, 236 (2000).
107. Theorists have elaborated on this basic model by explaining how agency costs contribute to bubble formation. They posit that bubbles form when banks that cannot perfectly monitor their borrowers' activities over-lend money to entrepreneurs who invest in risky assets and are underdeterred by the risk of default because of the limited liability of the corporate form. Franklin Allen & Douglas Gale, Asset-Price Bubbles and Stock Market Interlinkages, in ASSET-PRICE BUBBLES, supra note 18, at 323, 325-29.
108. Franklin Allen et al., Finite Bubbles with Short Sale Constraints and Asymmetric Information, 61 J. ECON. THEORY 206 (1993).
109. Asymmetric rational bubbles also depend on two additional assumptions. First, before a bubble begins an asset's price equals its fundamental value, and initial purchasers cannot be aware that the price equals fundamental value. See Brunnermeier, supra note 19, at 9-10.
110. Second, for the bubble to persist, this information asymmetry must also persist; subsequent trading cannot reveal to purchasers that prices have exceeded fundamental value. Allen et al., supra.
111. SHLEIFER, supra note 35, at 156-68.
112. See Brunnermeier, supra note 19, at 10.
113. See supra notes 52-53 and accompanying text.
114. Gilson & Kraakman, supra note 52, at 579-88.
115. SHLEIFER, supra note 35, at 10-12 (summarizing principle behavioral finance research that investors are not "fully rational");
116. Barberis & Thaler, supra note 55, at 1065-69.
117. Barberis & Thaler, supra note 55, at 1065-74.
118. See Donald C. Langevoort, Taming the Animal Spirits of the Stock Markets: A Behavioral Approach to Securities Regulation, 97 NW. U. L. REV. 135, 139-52 (2002) (surveying noise-trader research in economic literature).
119. Robert J. Shiller, Stock Prices and Social Dynamics, 2 BROOKINGS PAPERS ECON. ACTIVITY 457 (1984).
120. For an analysis of how emotions affect the decisions of investors, see Peter H. Huang, Regulating Irrational Exuberance and Anxiety in Securities Markets, in THE LAW AND ECONOMICS OF IRRATIONAL BEHAVIOR 501, 505-18 (Francesco Parisi & Vernon L. Smith eds., 2005).
121. See generally Robert J. Shiller, Fashions, Fads, and Bubbles in Financial Markets, in KNIGHTS, RAIDERS AND TARGETS 56 (John C. Coffee, Jr. et al. eds., 1988).
122. Behavioral finance builds off evidence that individuals often exhibit preferences that skew how investors evaluate risky gambles. Barberis & Thaler, supra note 55, at 1069-75.
123. For an introduction to the now-extensive literature on behavioral law and economics, see Christine Jolls et al., A Behavioral Approach to Law and Economics, 50 STAN. L. REV. 1471 (1998).
124. For a discussion of behavioral biases leading to theformation of stock-market bubbles, see Werner De Bondt, Bubble Psychology, in ASSET-PRICE BUBBLES, supra note 18, at 205, 210-12.
125. Amos Tversky & Daniel Kahneman, Judgment Under Uncertainty: Heuristics and Biases, 185 SCI. 1124 (1974).
126. Overoptimism in the context of investing describes how noise traders possess an overly optimistic view of their good fortune in a stock market. See, e.g., J. Bradford De Long & Andrei Shleifer, The Stock Market Bubble of 1929: Evidence from Closed-end Mutual Funds, 51 J. ECON. HIST. 675, 697 (1991) (concluding that over-optimism of investors contributed to the 1929 stock-market bubble).
127. Overconfidence in the context of investing describes how noise traders overestimate their own ability to predict stock-market fluctuations and time their exit before a crash. See J. Bradford De Long et al., The Survival of Noise Traders in Financial Markets, 64 J. BUS. 1, 5 (1991) (arguing that the overconfidence bias leads noise traders to remain in the market despite a risk of severe losses). Behavioral economists have presented substantial empirical evidence that individuals exhibit overoptimism in judging the probability of good outcomes and are overconfident in their own abilities, including their ability to estimate probabilities.
128. See Barberis & Thaler, supra note 55, at 1065-66.
129. The availability bias describes how more recent or salient events tend to overinfluence an individual's estimates of probabilities. See Tversky & Kahneman, supra note 87, at 1127-28.
130. Conversely, the remoteness of the last crash or market downturn causes investors to discount the possibility of incurring heavy losses. Richard J. Herring & Susan Wachter, Real Estate Booms and Banking Busts: An International Perspective 99-127 (The Wharton Fin. Insts. Ctr., Working Paper, 1999) (on file with author);
131. see also J. Bradford De Long et al., Positive Feedback Investment Strategies and Destabilizing Rational Speculation, 45 J. FIN. 379, 383 (1990) (questioning why noise traders do not learn from previous bubbles).
132. See De Bondt, supra note 86, at 208-09.
133. See SHLEIFER, supra note 35, at 11-12.
134. Id. at 12. See SHILLER, supra note 15, at 135-68 (outlining the psychological basis for investment decisions and the effect of herd behavior on capital markets);
135. Shiller, supra note 82, at 457 (arguing that investors make decisions because of social and behavioral factors rather than through rational, self-interested calculations).
136. See SHLEIFER, supra note 35, at 154-55.
137. Id. at 155-56. Again, economists consider price-trend-information noise rather than information about the fundamental value of the asset.
138. For a model of this feedback loop, see id. at 158-68.
139. See Barberis & Thaler, supra note 55, at 1058-59.
140. See, e.g., Powers et al., supra note 13.
141. See Barberis & Thaler, supra note 55, at 1058-59.
142. Hedging by buying or selling substitute stocks cannot completely remove this risk given the rarity of perfect substitutes. Id.;
143. SHLEIFER, supra note 35, at 14.
144. In addition, substitute stocks may themselves be mispriced, which is more likely in periods of systematic mispricing, such as bubbles. Barberis & Thaler, supra note 55, at 1058 n.4.
145. No substitutes exist for stocks or bonds as a whole, making arbitrage against market-wide mispricing impossible. SHLEIFER, supra note 35, at 13.
146. Andrei Shleifer describes the huge losses that would have threatened an arbitrageur attempting to sell short during the apparent stock-market-wide overvaluation of the late 1990s. Id. at 15-16.
147. J. Bradford De Long et al., Noise Trader Risk in Financial Markets, 98 J. POL. ECON. 703, 705 (1990).
148. See SHLEIFER, supra note 35, at 15-16 (describing the noise-trader risk faced by arbitrageurs attacking apparent overvaluation during the technology bubble).
149. Arbitrageurs enjoy neither unlimited resources nor infinite time horizons. Shleifer & Vishny, supra note 12, at 38-43.
150. Most arbitrageurs have short horizons because they are managing the money of other investors; this creates a classic agency problem. If an arbitrageur loses considerable money in the short-run trading against noise, investors and creditors may view this as a sign of the arbitrageur's incompetence and threaten to withdraw funds or loans, forcing the arbitrageur to liquidate positions prematurely. Id. Arbitrageurs may be unable to outlast noise traders; economists have shown that, contrary to the assumptions of the EMH, noise traders can persist in financial markets for extended periods.
151. See generally De Long & Shleifer, supra note 88 (arguing that the overconfidence bias leads noise traders to remain in the market despite a risk of severe losses).
152. The risks arbitrageurs face in betting against irrational investors are not just theoretical. The Tiger Fund-perhaps the most prominent fund that refused to bet against technology stocks in the late 1990s by refusing to invest in them-suffered heavy losses and was forced to close in March 2000, mere months before the peak of the NASDAQ. Markus K. Brunnermeier & Stefan Nagel, Hedge Funds and the Technology Bubble, 59 J. FIN. 2013, 2030-32 (2004).
153. Furthermore, even if a market crash wipes out noise traders, a new
154. Other arbitrageurs may not similarly trade against noise because of different information. See Dilip Abreu & Markus K. Brunnermeier, Synchronization Risk and Delayed Arbitrage, 66 J. FIN. ECON. 341, 343 (2002) (labeling this risk of collective action failure as "synchronization risk").
155. Coordinated action is limited by the threat of defection and legal constraints. See id.
156. SHLEIFER, supra note 35, at 169, 172.
157. See Brunnermeier & Nagel, supra note 103, at 2014-16.
158. SHLEIFER, supra note 35, at 169-75.
159. Id. at 169-75.
160. Lynn A. Stout, Why the Law Hates Speculators, 48 DUKE L.J. 701, 755-62 (1999) (describing this set of models).
161. Brunnermeier, Bubbles, supra note 19.
162. Id.
163. Barberis & Thaler, supra note 55, at 1061-64;
164. SHILLER, supra note 15, at 179-80.
165. The prices of certain mutual funds have occasionally risen far above the net asset value of the fund, even after adjusting for tax and other considerations. This means that investors are paying more for shares in a fund than they would pay if they purchased the proportionate share of the stocks in that fund's portfolio. See De Long & Shleifer, supra note 88, at 697 (recognizing that this phenomenon existed in the late 1920s).
166. This anomaly occurs when a given security is traded on two different markets, but the prices in those markets diverge over an extended period of time. See Barberis & Thaler, supra note 55, at 1061-63 (explaining the twin-share anomaly and noting how arbitrageurs theoretically could exploit it).
167. After 3Com sold five percent of its shares of Palm in an initial public offering, Palm's stock price paradoxically rose above the implicit price of its parent, 3Com. This implied that, apart from its shareholdings in Palm, 3Com had a negative value. Owen A. Lamont & Richard H. Thaler, Can the Market Add and Subtract?: Mispricing in Tech Stock Carve-Outs, 111 J. POL. ECON. 227, 230-31 (2003) (documenting multiple examples of this anomaly).
168. During the recent technology-stock boom, researchers noted that shares of companies with ".com" in their name sold in public offerings for significantly higher prices statistically than those of comparable companies. Also, market news about certain companies would irrationally affect me prices of different companies with similar names or stock-market-ticker symbols. Yaron Brooks & Robert J. Hendershott, Hype and Internet Stocks, J. INVESTING, Summer 2001, at 53;
169. Michael J. Cooper et al., A Rose.com by Any Other Name, 56 J. FIN. 2371, 2371-72 (2001).
170. Malcolm Baker & Jeffrey Wurgler, Investor Sentiment in the Stock Market, J. ECON. PERSP., Spring 2007, at 129, 129 (defining sentiment as "belief about future cash flows and investment risks that is not justified by the facts at hand").
171. See Robert J. Shiller, From Efficient Markets Theory to Behavioral Finance, J. ECON. PERSP., Winter 2003, at 83, 101-02.
172. See, e.g., Malkiel, supra note 53.
173. E.g., id.
174. See, e.g., Robert J. Shiller, Measuring Bubble Expectations and Investor Confidence (Nat'l Bureau of Econ. Research, Working Paper No. 7008, 1999).
175. Robert S. Chirinko, Comments on: "Stocks as Money ..." and "Bubble Psychology," in ASSET-PRICE BUBBLES, supra note 18, at 231, 234-35 ("While reading the behavioral finance literature, one gets the feeling of being in a well-stocked supermarket with a multitude of psychological tendencies waiting to be plucked from the shelf to explain the NASDAQ decline and other financial market outcomes. . . . With a surplus of explanations, it is difficult to know how to evaluate and discriminate among behavioral theories.").
176. The hot-hand fallacy translates a phenomenon from the sports world where coaches and athletes believe that an individual's shooting streak will continue, despite the statistical evidence that the shooter is enjoying a streak of luck and his or her performance will revert to its long-term mean. Thomas Gilovich et al., The HotHand in Basketball: On the Misperception of Random Sequences, 17 COGNITIVE PSYCHOL. 295 (1985). The hot-hand fallacy could lead to investors bidding up assets based on the erroneous belief that rising prices indicate a streak of their personal investing skill rather than chance or the development of a positive-feedback loop.
177. This fallacy refers to a common mistake that one random event can affect or be used to predict another random event. The canonical example is the erroneous belief that if a coin is flipped four times and lands "heads" each of those times, it has a greater than fifty percent probability of landing "tails" on the next flip. Amos Tversky & Daniel Kahnemann, Belief in the Law of Small Numbers, 76 PSYCHOL. BULL. 105, 106 (1971). In asset prices, the gambler's fallacy might lead an investor to conclude that a lucky streak of rising prices is about to end and cause him or her to sell, thus short-circuiting a positive-feedback loop.
178. Gregory La Blanc & Jeffrey J. Rachlinski, In Praise of Investor Irrationality, in THE LAW AND ECONOMICS OF IRRATIONAL BEHAVIOR, supra note 83, at 542, 556.
179. Conservatism describes mistakes in calculating probability due to the overweighting of base-rate probabilities and the underweighting of sample probabilities. Ward Edwards, Conservatism in Human Information Processing, in FORMAL REPRESENTATION OF HUMAN JUDGMENT 17, 17-18 (Benjamin Kleinmutz ed., 1968).
180. See Meltzer, supra note 47, at 28.
181. See, e.g., SHLEIFER, supra note 35, at 169-74;
182. Weihong Huang & Richard H. Day, Chaotically Switching Bear and Bull Markets: The Derivation of Stock Market Distributions from Behavioral Rules, in NONLINEAR DYNAMICS AND EVOLUTIONARY ECONOMICS, supra note 24, at 169, 169-81 (modeling stock-market cycles as nonlinear results of the interaction of noise traders, investors trading on fundamental information, and market makers).
183. This explanation would benefit greatly from further precision regarding the profiles of the investors who fall in each category and from an investigation into whether stocks become increasingly concentrated in the hands of noise traders. See Meltzer, supra note 47, at 26-28 (critiquing irrational-bubble models for failing to answer these questions).
184. In both explanations, further research is required to understand the mechanics of the tipping point between bubble and crash.
185. Gregory Mitchell argues that behavioral-law-and-economics scholarship has been impeded by its focus on "behavioral tendencies" and its failure to articulate the "boundary conditions" for those tendencies. Gregory Mitchell, Tendencies versus Boundaries: Levels of Generality in Behavioral Law and Economics, 56 VAND. L. REV. 1781 (2003).
186. The difficulty in linking behavioral biases to mispricings (a "bottom-up approach") has led other economists to take a "top-down approach" and use clear statistical evidence of investor sentiment to identify types of securities more likely to suffer from sentiment. See, e.g., Baker & Wurgler, supra note 117, at 130.
187. See, e.g., Gunduz Caginalp et al., Overreactions, Momentum, Liquidity, and Price Bubbles in Laboratory and Field Asset Markets, 1 J. PSYCHOL. & FIN. MARKETS 24 (2000);
188. King et al., supra note 24, at 183; Porter & Smith, supra note 23, at 111;
189. Vernon L. Smith et al., Bubbles, Crashes, and Endogenous Expectations in Experimental Spot Asset Markets, 56 ECONOMETRICA 1119 (1988).
190. E.g., Caginalp et al., supra note 131 (using experimental-asset-market results to create a "momentum model" explaining trader behavior).
191. See, e.g., Caginalp et al., supra note 131, at 24;
192. King et al., supra note 24, at 183;
193. Porter & Smith, supra note 23, at 111;
194. Smith et al., supra note 131, at 56.
195. See supra note 23 and accompanying text.
196. See Caginalp et al., supra note 131, at 24-25;
197. David P. Porter & Vernon L. Smith, Futures Contracting and Dividend Uncertainty in Experimental Asset Markets, 68 J. BUS. 509, 509-10 (1995);
198. Smith et al., supra note 131, at 1124.
199. Caginalp et al., supra note 131, at 26;
200. King et al., supra note 24, at 199200;
201. Porter & Smith, supra note 23, at 121-22;
202. Smith et al., supra note 131, at 1148-50.
203. See Caginalp et al., supra note 131, at 26-32 (surveying experiments where bubbles occurred despite various changes in experimental market conditions).
204. For samples of experiments testing for the occurrence of bubbles under various economic conditions and policies, see King et al., supra note 24, at 185-200;
205. Vivian Lei et al., Non-speculative Bubbles in Experimental Asset Markets: Lack of Common Knowledge of Rationality vs. Actual Irrationality, 69 ECONOMETRICA 831 (2001);
206. Smith et al., supra note 131.
207. Real estate, by definition, cannot be moved from one location to another, which, in turn, influences the other economic properties of real estate discussed in this Section. MICHAEL BALL ET AL., THE ECONOMICS OF COMMERCIAL PROPERTY MARKETS 273 (1998) ("Partly because the investment is heterogeneous and immobile, no central trading market, equivalent to the stock market, has developed for property.").
208. Securities and the companies that issue them can terminate, but, barring cataclysm, land cannot be destroyed and buildings tend to have long lives. THOMAS W. SHAFER, REAL ESTATE AND ECONOMICS 29-30 (1975) ("The possibility of the marketmaking necessary adjustments in the short run to take advantage of temporary and short-lived demand is reduced by the long life of real estate assets.").
209. The uniqueness of each piece of real estate generates information costs for purchasers, complicates pricing, and limits the availability of substitutes. BALL ET AL., supra note 138, at 273.
210. Real estate represents not only an investment good that can be leased or sold for a return, but also a consumption good used for work or living space; and investors often purchase a real-estate asset for both investment and consumption functions. Id. at 14.
211. See supra note 138.
212. Immobility means that supply of real estate in one physical location cannot be moved to meet greater demand in another area; people and businesses must move to real estate, which involves high transaction costs. See SHAFER, supra note 139, at 2930.
213. Durability means that the stock of housing cannot contract easily in periods of lower demand, creating the potential for gluts. See id. at 29.
214. Heterogeneity contributes to higher information costs and information asymmetries. See BALL ET AL., supra note 138, at 273-74.
215. Heterogeneity also makes hedging difficult by limiting the availability of close substitutes and increasing the transaction costs of purchasing real estate. Id. at 273.
216. The high transaction costs of purchasing and selling real estate slow market corrections. In turn, the high costs of development delays the entry of new real-estate stock to meet demand. Id. at 15.
217. Finally, the dual use of real estate for investment and consumption often leads individuals to "overinvest" in real estate by investing more money in a particular asset than can be recouped when selling the asset in the market. See Jan K. Brueckner, Consumption and Investment Motives and the Portfolio Choices of Homeowners, 15 J. REAL EST. FIN. & ECON. 159 (1997) (evaluating evidence of overinvestment due to the consumption value of real estate).
218. E.g., Markus K. Brunnermeier & Christian Julliard, Money Illusion and Housing Frenzies, REV. FIN. STUD, (forthcoming 2007), available at http://www.princeton.edu/-markus/ research/papers/money_illusion_housing_frenzies. pdf;
219. Robert J. Shiller, Historic Turning Points in Real Estate (Crowles Found., Discussion Paper No. 1610, 2007), available at http://cowles.econ.yale.edu/P/cd/d16a/d1610.pdf);
220. Grace Wong, The Anatomy of a Housing Bubble: Overconfidence, Media and Politics (Feb. 2007) (unpublished manuscript, available at http://real.wharton.upenn.edu/~wongg/research/bubble.pdf).
221. Man Cho, House Price Dynamics: A Survey of Theoretical and Empirical Issues, 7 J. HOUSING RES. 145 (1996);
222. Dean H. Gatzlaff & Dogan Tirtiroglu, Real Estate Market Efficiency: Issues and Evidence, 3 J. REAL EST. LITERATURE 157 (1995).
223. But, due to the innovations of economists, it is also now possible to invest in real-estate futures contracts sold on the Chicago Mercantile Exchange. These futures contracts allow property owners and investors to hedge against potential increases or decreases in property values in various regional markets. Economists also believe that by providing information to investors on expectations of long-run price trends these futures may also signal when real estate is overpriced and thus deter the formation of bubbles. Noam Scheiber, The Pork-Bellies Approach to Housing, N.Y. TIMES MAG., Sep. 10, 2006, at 90.
224. Karl E. Case & Robert J. Shiller, The Behavior of Home Buyers in Boom and Post-Boom Markets, NEW ENG. ECON. REV., Nov.-Dec. 1988, at 29, 44-45.
225. Karl E. Case & Robert J. Shiller, Is There a Bubble in the Housing Market?, 2 BROOKINGS PAPERS ECON. ACTIVITY 299 (2003).
226. See SHILLER supra note 15, at 222-23.
227. See infra notes 296-97 and accompanying text.
228. Compare Ben S. Bernanke & Mark Gertier, Should Central Banks Respond to Movements in Asset Prices, AM. ECON. REV., May 2001, at 253 (arguing that monetary policy should not be used to prick asset-price bubbles),
229. with Stephen G. Cecchetti et al., Asset Prices in a Flexible Inflation Targeting Framework, in ASSET-PRICE BUBBLES, supra note 18, at 427, 438-41 (arguing that monetary policy can and should respond to "asset price misalignments").
230. One controversial exception is the theory that asset-price bubbles might be spurred by investor anticipation of fluctuations in interest rates due to inconsistent and changing monetary policy (labeled "process switching"). Robert P. Flood & Robert J. Hodrick, Asset Price Volatility, Bubbles and Process Switching, in SPECULATIVE BUBBLES, SPECULATIVE ATTACKS, AND POLICY SWITCHING 135, 136 (Robert P. Flood & Peter M. Garber eds., 1994). In many macroeconomic models that examine the effects of interest rates on asset-price bubbles, asset-price bubbles are exogenous and their formation need not be explained.
231. See, e.g., Ben Bernanke & Mark Gertler, Monetary Policy and Asset Price Volatility 7, 15-25 (Nat'l Bureau of Econ. Research, Working Paper No. 7559, 2000).
232. Several theories may explain the link between interest rates and bubbles. First, lower interest rates may fuel speculation through provision of cheap credit to investors purchasing assets, and rising interest rates make borrowing these funds too expensive. See Stephen Malpezzi & Susan M. Wachter, The Role of Speculation in Real Estate Cycles, 13 J. REAL EST. LITERATURE 143 (2005).
233. But this theory is problematic, as lower costs of borrowing could stimulate investing in assets without necessarily causing prices to deviate from fundamental value. This necessitates consideration of alternative theories. A second theory is that lower interest rates may cause investors to suffer from "money illusion," or the mistaken belief that assets purchased with credit are cheaper in real terms. See Brunnermeier & Julliard, supra note 144, at 1-3;
234. Eldar Shafir et al., Money Illusion, 112 Q. J. ECON. 341 (1997). The first and second theories can be synthesized into a third theory. Even if lower costs of borrowing stimulate asset prices without deviating from fundamental value, the price boom may encourage noise traders to chase a price trend, perhaps in the mistaken belief that the boom stems from a transformational change in fundamental value.
235. Some scholars who have advocated disclosure as an antidote for bubbles subscribe to the theory that bubbles stem from the heterogeneous expectations of investors; disclosure could mitigate the incidence and severity of bubbles by encouraging investors to form common expectations of future asset prices. Gabaldon, supra note 9, at 283-84;
236. Stout, supra note 18, at 695-97. By contrast, a few scholars have recommended tailoring securities-disclosure requirements to take into account behavioral and emotional responses to information by investors.
237. See, e.g., Huang, supra note 83, at 518-22.
238. Nicholas L. Georgakopoulos, Why Should Disclosure Rules Subsidize Informed Traders, 16 INT'L REV. L. & ECON. 417, 424 (1996) (arguing that disclosure may cause noise traders to reconsider beliefs).
239. Some scholars take an alternative approach and argue that disclosure reduces the effect of noise traders by increasing the number and influence of "informational traders." Id.;
240. Zohar Goshen & Gideon Parchomovsky, The Essential Role of Securities Regulation, 55 DUKE L.J. 711, 739 (2006). Other scholars have used the findings of behavioral finance to argue that mandatory disclosure promotes noise trading.
241. E.g., Paul G. Mahoney, Is There a Cure for " Excessive" Trading?, 81 VA. L. REV. 713, 743 (1995).
242. Kroszner, supra note 18, at 8-12. In this same article, Kroszner also argues that Bush administration proposals to alter the Employee Retirement Income Security Act would serve these same goals by giving employers greater flexibility to sponsor investment advice for employees and clarifying the employer's legal liability in doing so.
243. Id. at 8-10.
244. De Bondt, supra note 86, at 212;
245. Gabaldon, supra note 9, at 280-83;
246. cf. Lawrence A. Cunningham, Behavioral Finance and Investor Governance, 59 WASH. & LEE L. REV. 767, 788-96 (2002) (proposing investor-education programs to remedy investor behavioral biases).
247. ROBERT J. SHILLER, MACRO MARKETS: CREATING INSTITUTIONS FOR MANAGING SOCIETY'S LARGEST ECONOMIC RISKS 204-05 (1993).
248. Stephen Choi has argued for an investor-licensing regime that would classify investors according to their informational resources and provide more securities law protection to those investors with less information. Stephen Choi, Regulating Investors Not Issuers: A Market-Based Proposal, 88 CAL. L. REV. 279 (2000).
249. Choi summarizes the scheme: "much like a pilot's license, investors would need an investment license to deal with particular types of capital market participants." Id. at 283.
250. Choi compares his proposal to the existing securities-law regime of exemptions to issuer registration that attempts to tailor information requirements according to the sophistication of investors. Id. at 305-07;
251. see also Gabaldon, supra note 9, at 279, 282-83 (considering restricting access of investors to markets or investor licensing schemes to combat investor speculation).
252. See supra note 11.
253. See Gabaldon, supra note 9, at 283 (advocating reverse circuit breakers for this reason);
254. SHILLER, supra note 15, at 225-26 (describing this rationale but questioning the effectiveness of circuit breakers).
255. Rule 144A of the Securities Act of 1933 allows private resale of securities to "qualified institutional buyers." 17 C.F.R. § 230.144A (2007).
256. Rules 505 and 506 of Regulation D of the Securities Act of 1933 do not require disclosure to "accredited investors" and do not count these investors toward the limit on the number of purchasers in their respective exemptions. Id. §§ 230.505-.506.
257. Regulation D defines "accredited investors" as certain institutions and individuals whose net worth exceeds certain thresholds. Id. § 230.501(a).
258. Under an exemption in Rule 506, issuers may still sell securities to investors that are not accredited, see supra note 162, provided that these nonaccredited investors meet certain sophistication standards.
259. C.F.R. § 230.506(b)(2)(ii).
260. 15 U.S.C. § 80a-3(c)(7) (2000).
261. William W. Bratton, Hedge Funds and Governance Targets, 95 GEO. L.J. 1375, 1382 n.33 (2007).
262. Arthur E. Wilmarth, Jr., The Transformation of the U.S. Financial Services Industry, 1975-2000: Competition, Consolidation, and Increased Risks, 2002 U. ILL. L. REV. 215, 333 n.488.
263. This logic of tailoring disclosure to meet the needs of investors for protection was adopted by the Supreme Court in SEC v. Ralston Purina Co., 346 U.S. 119, 124-25 (1953) (determining whether a securities offering was a "public offering," and thus not entitled to the private-offering exemption from registration requirements, by looking to the sophistication of the investors).
264. Interpreting exemptions with an eye towards matching investors with risk accords with the way many in the federal-securities bar interpret Ralston Purina. See supra note 167;
265. Federal Regulation of Securities Committee, Am. Bar Ass'n, Section 4(2) and Statutory Law, 31 BUS. LAW. 485, 491-95 (1975) (arguing that one factor in interpreting Ralston Purina and applying the private-placement exemption from federal securities laws should be the purchaser's risk-bearing ability). However, the mere fact that securities are registered with the SEC and are sold with increased disclosure does not guarantee that they are less risky than securities sold pursuant to an exemption. This tiering effect is reinforced by other securities laws that require securities intermediaries to take into account the specific circumstances of individual clients in providing advice and facilitating investments. The suitability requirements imposed on broker-dealers by the National Association of Securities Dealers represents the most prominent example of this type of rule.
266. See Daniel G. Schmedlen, Jr., Broker-Dealer Sales Practice in Derivatives Transactions: A Survey and Evaluation of Suitability Requirements, 52 WASH. & LEE L. REV. 1441, 1456 (1995) (analyzing National Association of Securities Dealers suitability requirements in the context of derivative sales);
267. National Association of Securities Dealers, Rules of the Association, Rule 2310 (2007), available at http:// finra.complinet.com/finra/index. html ("Recommendations to Customers (Suitability)").
268. C. Thomas Paschall, U.S. Capital Gains Taxes: Arbitrary Holding Periods, Debatable Tax Rates, 73 S. CAL. L. REV. 843, 861-64 (2000) (arguing that legislators in the United States and Europe intended that holding periods for capitalgains taxes would discourage speculation).
269. Comment, Short-Swing Profits and the Ten Percent Rule, 9 STAN. L. REV. 582, 586 (1957) (noting that Congress intended section 16(b) of the Securities Exchange Act to discourage insider speculation).
270. Barboza & Bradsher, supra note 2.
271. See supra note 16 and accompanying text.
272. E.g., Powers et al., supra note 13, at 264-70 (arguing for removal of the uptick rule and other legal restrictions on short sales);
273. Lynn A. Stout, Why the Law Hates Speculators: Regulation and Private Ordering in the Market for OTC Derivatives, 48 DUKE L.J. 701, 761-62 (1999) (noting that easing restrictions on short sales may be a remedy for bubbles but may also increase market volatility).
274. See supra note 15 and accompanying text. At the same time, however, the SEC did place additional restrictions on "naked" short selling, that is, when the investor does not own and has not borrowed the securities it is selling short.
275. For a detailed account of this controversy, with emphasis on the approach of the Central Bank of Japan during the real-estate bubble in that country during the late 1980's, see Geoffrey P. Miller, The Role of a Central Bank in a Bubble Economy, 18 CARDOZO L. REV. 1053 (1996).
276. See also Kevin J. Lansing, Should the Fed React to the Stock Market, FRBSF ECON. LETTER (Fed. Res. Bank of S.F., Nov. 14, 2003).
277. E.g., Karmel, supra note 9, at 948.
278. The Federal Reserve sets margin requirements, see, e.g., 12 C.F.R. § 220 (2007),
279. which the SEC has authority to enforce, 15 U.S.C § 78(g) (2000).
280. 15 U.S.C. § 78b(3);
281. JERRY W. MARKHAM & THOMAS LEE HAZEN, BROKER-DEALER OPERATIONS UNDER SECURITIES AND COMMODITIES LAW §§ 3.01-.02 (2001). Professors Markham and Hazen note that the Federal Reserve has reset margin rates twenty-five times in history "to squelch speculation in the case of increases or to ease access to the market during downturns" and that "most actively traded stock is today subject to a margin requirement of fifty percent."
282. MARKHAM & HAZEN, supra, § 3.01-.02.
283. See Karmel, supra note 9, at 948. Paralleling the margin regulations, federal commodities law authorizes regulators to impose position limits on investors in commodity exchanges, and the authorizing statute likewise recites the objective of curbing harmful speculation.
284. U.S.C. § 6a.
285. See supra Part II.A.
286. Proving the negative, for example, that an asset bubble has been prevented, presents particular challenges.
287. Porter & Smith, supra note 23, at 111.
288. Smith et al., supra note 131, at 1125-28.
289. Smith, supra note 33, at 923-35.
290. Hoffman & Spitzer, supra note 30, at 991.
291. Id.
292. Vernon L. Smith, Experimental Economics: Induced Value Theory, AM. ECON. REV., MAY 1976, at 274, 274-77.
293. See, e.g., Colin F. Camerer & Robin M. Hogarth, The Effects of Financial Incentives in Experiments: A Review and Capital-Labor-Production Framework, 19 J. RISK & UNCERTAINTY 7 (1999) (analyzing seventy-four experimental studies to determine whether incentive levels or monetary versus nonmonetary payoffs improved subject performance).
294. Even early reactions among legal scholars reflected this concern. See, e.g., Stewart E. Sterk, Neighbors in American Land Law, 87 COLUM. L. REV. 55, 73 n.69 (1987) (critiquing whether experiments used to support Coase Theorem are valid given the small stakes involved).
295. E.g., Camerer & Hogarth, supra note 187.
296. Ralph Hertwig & Andreas Ortmann, Experimental Practices in Economics: A Methodological Challenge for Psychologists?, 24 BEHAVIORAL & BRAIN SCIS. 383, 401 (2001).
297. As one example, proponents of behavioral law and economics have referenced various experiments in which subjects traded coffee mugs as evidence of the "endowment effect" (the propensity for individuals to place a higher value on objects they already own than on objects they do not). See, e.g., Jolis et al., supra note 86, at 1483
298. (citing Daniel Kahneman, et al., Experimental Tests of the Endowment Effect and the Coase Theorem, 98 J. POL. ECON. 1325, 1329-42 (1990)).
299. This reliance of behavioral economics on fairly basic experiments, many with nonmonetary payoffs, may explain persistent criticism of behavioral law and economics. See, e.g., Richard A. Posner, Rational Choice, Behavioral Economics, and the Law, 50 STAN. L. REV. 1551, 1565-67 (1998) (critiquing conclusions drawn by the authors above from coffeemug experiments).
300. Hoffman & Spitzer, supra note 30, at 992-93.
301. Id.
302. Id. at 993.
303. For the basic formulation of this protocol, see Smith et al., supra note 131, at 1122-25. This Section describes the general parameters of the experiments conducted by Smith and colleagues. When other experimental asset markets that had different parameters are considered in Part III.C, differences from this general design are noted.
304. See supra notes 134-35 and accompanying text.
305. Smith et al., supra note 131, at 1122-25.
306. In most of Smith's experiments there were fifteen trading periods. See, e.g., King et al., supra note 24, at 183.
307. Generally, the trading period lasted a maximum of four minutes. Smith et al., supra note 131, at 1124.
308. King et al., supra note 24, at 184;
309. Smith et al., supra note 131, at 1122-25.
310. See supra note 132 and accompanying text.
311. See Caginalp et al., supra note 131, at 26-32 (describing changes to the experimental environment to make experiments match attributes of real markets).
312. Traders were given copies of previous studies of experimental asset markets that showed prices exceeded fundamental value. E.g., King et al., supra note 24, at 190-94.
313. Multiple experiments were rerun with at least some traders having participated in earlier experiment iterations. See, e.g., King et al., supra note 24, at 186-200;
314. Smith et al., supra note 131, at 1133-36.
315. Porter & Smith, supra note 23, at 120.
316. Criticisms of the validity of early experiments that used undergraduate economics students as traders were addressed by later experiments that used smallbusiness people, corporate executives, and stock-market dealers as subjects. Caginalp et al., supra note 131, at 28.
317. Compare Smith et al., supra note 131, at 1124 (using unequal endowments of cash and assets),
318. with King et al., supra note 24, at 189 ("buyers [tend] to be those subjects with endowments large in cash and small in shares; the reverse holds for sellers.").
319. King et al., supra note 24, at 190.
320. Vivian Lei et al., Asset Bubbles and Rationality: Additional Evidence from Capital Gains Tax Experiments 1-2 (Cal. Inst. of Tech., Working Paper No. 1137, June 2002), available at http://www.hss.caltech.edu/SSPapers/ wp1137.pdf.
321. King et al., supra note 24, at 194-95.
322. Lei et al., supra note 137, at 834.
323. King et al., supra note 24, at 186-88.
324. Id. at 188-89.
325. Caginalp et al., supra note 131, at 26.
326. Camerer & Hogarth, supra note 187, at 36 ("Because it is generally difficult to impose losses or punishments on subjects for bureaucratic reasonsuniversity committees that approve protocols involving human subjects strongly object to it-we do not know how earning money and losing money differ.").
327. Behavioral-economics literature often recites the "loss- aversion" bias (i.e., that individuals are willing to take on less risk that would lead to losses than risk that would lead to the same amount of gains). See, e.g., Daniel Kahneman et al., Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias, J. ECON. PERSP., Winter 1991, at 193;
328. Robert A. Prentice & Jonathan J. Koehler, A Normality Bias in Legal Decision Making, 88 CORNELL L. REV. 583, 601-02 (2003).
329. James S. Ang & Thomas Schwarz, Risk Aversion and Information Structure: An Experimental Study of Price Variability in the Securities Markets, 40 J. FIN. 825, 830-31 (1985).
330. Nevertheless, the Ang and Schwarz experiments in which traders invested with their own money did not feature the full set of controls-including all of the controls that mimic the various antibubble laws-that the experiments following the Smith protocol did. See supra note 216. The potential for skewed results in the Smith protocol experiments-because subjects were "playing with house money"-argues for rerunning the Ang and Schwarz experiments with controls that mimic more antibubble laws.
331. Smith et al., supra note 131, at 1133 (noting this potential flaw).
332. See supra note 204.
333. Caginalp et al., supra note 131, at 26.
334. King et al., supra note 24, at 196-97.
335. Other experiment-based asset-market research supports the hypothesis that short horizons promote bubble formation. See Shinichi Hirota & Shyam Sunder, Price Bubbles Sans Dividend Anchors: Evidence from Laboratory Stock Markets, 31 J. ECON. DYNAMICS & CONTROL 1875 (2007).
336. Some scholars have raised a related criticism, namely that Smith's design predetermined a crash by setting fundamental values to decline to zero. These scholars found that when fundamental value was held constant prices of securities traded close to fundamental value. Dean Johnson & Patrick Joyce, Bubbles and Crashes Revisited (Oct. 2006) (unpublished manuscript, available at http://www.gate.cnrs.fr/seminaires/2006_2007/Joyce.pdf). But this research does not appear to have been replicated. Other studies of experimental asset markets with a flat fundamental value showed recurring bubbles.
337. E.g., Charles Noussair et al., Price Bubbles in Laboratory Asset Markets with Constant Fundamental Values, 4 EXPERIMENTAL ECON. 87 (2001);
338. AJ Bostian et al., Price Bubbles in Asset Market Experiments with a Flat Fundamental Value (Aug. 30, 2005) (unpublished manuscript, available at http://www.atl-res.com/finance/conference_pdf/HoltFinal. pdf).
339. For example, traders in these virtual markets could not have enjoyed any consumption value from the securities being traded, but real-estate investors often do place such a value on their properties. Supra note 141.
340. Porter and Smith phrase the conclusion: "Public information in intrinsic dividend (or net asset) value is not sufficient to induce common expectations and trading at fundamental value." Porter & Smith, supra note 23, at 114.
341. Fundamental value equaled (1) the probability of a dividend multiplied by (2) the amount of a possible dividend multiplied by (3) the number of trading periods remaining in the experiment. see King et al., supra note 24, at 183.
342. Supra notes 134-35 and accompanying text.
343. Because the value of experimental asset markets lies in large part on having known fundamental values and thus being able to identify bubbles with certainty, it would be logically problematic to test whether experiment subjects operating in an environment of true uncertainty would be more or less likely to create bubbles. Again, using risk as a proxy for uncertainty may be unavoidable in this area of economics, but it also limits the validity of research.
344. William R. White, What Have We Learned from Recent Financial Crises and Policy Responses?, in GLOBAL FINANCIAL CRISES: LESSONS FROM RECENT EVENTS 177 (Joseph R. Bisignano et al. eds., 2000). These findings mesh with broader studies that have found a connection between investor-protection laws and the depth of a nation's securities markets.
345. SHLEIFER, supra note 35, at 191-92 (surveying studies showing a correlation between nations' investor-protection regimes and success in developing well-functioning and deep securities markets).
346. See, e.g., STEPHAN HAGGARD, THE POLITICAL ECONOMY OF THE ASIAN FINANCIAL CRISIS 19 (2000);
347. Robert Chote, Financial Crises: The Lessons of Asia, in FINANCIAL CRISES AND ASIA 1, 10 (1998).
348. Troy A. Paredes, Blinded by the Light: Information Overload and its Consequences for Securities Regulation, 81 WASH. U. L.Q. 417, 441 (2003).
349. Jeffrey Carmichael & Neil Esho, Asset-Price Bubbles and Prudential Regulation, in ASSET-PRICE BUBBLES, supra note 18, at 481, 491.
350. See SHILLER, supra note 15, at 96-132 (describing how popular perceptions during stock market expansions that "the future is brighter or less uncertain than it was in the past" can lead to asset-price bubbles).
351. The warning by Federal Reserve Chairman Greenspan in 1996 that the stock market was "irrationally exuberant" represents a recent example of such a failed attempt. KINDLEBERGER, supra note 37, at 7.
352. For historical surveys of the futility of official warnings that a bubble may be occurring (in part, because of contrary statements by other officials), see id. at 91-94;
353. CHANCELLOR, supra note 56, at 151, 230-31.
354. Daniela Deane, Higher Prices, Tougher Choices, WASH. POST, Mar. 23, 2005, at H1.
355. Porter & Smith, supra note 23, at 120. Experimenters first conducted a series of two-period training sequences in which traders could enter into futures contracts in period one and the contracts would mature in period two. This taught traders "that a futures contract is equivalent to a cash contract in the period in which it expires, and should trade at the same price."
356. Caginalp et al., supra note 131, at 30. In the actual experimental markets with fifteen trading periods, traders could enter into spot and futures contracts for the first eight periods, with futures contracts expiring in period eight. After the eighth period, traders could only enter into spot contracts.
357. Caginalp et al., supra note 131, at 30.
358. Porter & Smith, supra note 23, at 120;
359. see also Charles Noussair & Steven Tucker, Futures Markets and Bubble Formation in Experimental Asset Markets, 11 PAC. ECON. REV. 167 (2006).
360. Supra notes 147 and 157 and accompanying text. This finding meshes with the heterogeneous-expecations model of bubbles.
361. Smith et al., supra note 131, at 1130-31.
362. King et al., supra note 24, at 196-97.
363. Id.
364. Caginalp et al., supra note 131, at 28-29.
365. Undergraduate economics students produced dramatic bubbles in trading. Id.
366. King et al., supra note 24, at 190-93.
367. But, if the percentage of traders who lacked experience in the experimental asset markets and were not informed of the studies is too high, bubbles formed as "experienced" and "informed" traders did not have sufficient resources to undercut bubble prices through short selling. Id. at 193-94.
368. Supra note 192 and accompanying text.
369. Caginalp et al., supra note 131, at 26;
370. Smith et al., supra note 131, at 1133-36.
371. See King et al., supra note 24, at 188-200.
372. KINDLEBERGER, supra note 37, at 13 ("[S]ome time must elapse after one speculative mania that ends in crisis before investors have recovered sufficiently from their losses and disillusionment to be willing to take a flyer again.");
373. see also SHILLER, supra note 15, at 96-117 (surveying episodes of "new era economic thinking" in the United States in the twentieth century, which occurs "in pulses.")
374. For an accessible account of this theory, see Greg Ip & Jon E. Hilsenrath, Debt Bomb, WALL ST. J., Aug. 7, 2007, at A1.
375. Some economists believe that currency crises in China are having this effect on markets in other countries. Id. Economists have also studied the reverse problem of crashes in one market having cross-border effects through stock-market and other economic interlinkages.
376. See, e.g., Michael D. Bordo & Antu Panini Murshid, Globalization and Changing Patterns in Crisis Transmission, in ASSET-PRICE BUBBLES, supra note 18, at 309, 309-22.
377. Economists have created "overlapping-generations" models to study the potential effects of new investors entering markets. See, e.g., Jean Tirole, Asset-Price Bubbles and Overlapping Generations, 53 ECONOMETRICA 1071 (1985) (concluding that new generations of investors overlapping with older generations allow bubbles to form). If new generations enter asset markets more quickly, the chastening effect of assetbubble crashes may have a shorter duration.
378. Supra note 222 and accompanying text.
379. Supra notes 162-64 and accompanying text.
380. See, e.g., SHLEIFER, supra note 35, at 172.
381. E.g., La Blanc & Rachlinkski, supra note 125, at 570-74.
382. Shyam Sunder, Experiment Asset Markets: A Survey, in THE HANDBOOK OF EXPERIMENTAL ECONOMICS 445, 489 (John H. Kagel & Alvin E. Roth Sunder eds., 1995) (summarizing one set of studies).
383. Supra notes 88-91.
384. King et al., supra note 24, at 190. One experiment charged an exchange fee of $0.20 on each transaction, split equally between buyer and seller. To give a sense of the reasonableness of this tax, the intrinsic value of one share started at $3.50 at the beginning of the experiment and declined linearly to zero at the end of fifteen trading periods. Assuming turnover of six-times total shares, $0.20 represents an average cost of $1.20 per share.
385. See id.
386. Id.
387. Id. The tax did have the expected effect of reducing turnover by experienced traders.
388. Id.
389. Lei et al., supra note 209, at 2, 4.
390. SHILLER, supra note 15, at 227;
391. see also James R. Repetti, The Use of Tax Law to Stabilize the Stock Market: The Efficacy of Holding Period Requirements, 8 VA. TAX. REV. 591, 627-30 (1989) (arguing that holding-period requirements of long-term-capital-gains-tax preferences and short-sale restrictions are not justified as ways to deter speculation and may reinforce irrational investing and mispricing). Other tax rules might help address mispricing during a bubble, but further study is needed.
392. Richard Roll, Price Volatility, International Market Links, and Their Implications for Regulatory Policies, 3 J. FIN. SERVS. RES. 211, 238 (1989).
393. SHILLER, supra note 15, at 227.
394. For one early salvo in this debate, see Andrei Shleifer, Do Demand Curves for Stocks Slope Down?, 41 J. FIN 579 (1986).
395. See supra note 257 and accompanying text.
396. King et al., supra note 24, at 194-95. The price band used in the experiment was plus or minus thirty-two cents (which equaled twice the expected dividend for any period).
397. Id. at 195.
398. Id. at 195. The experimenters posited that the circuit breaker "accentuates the severity of bubbles because traders perceive that their downside risk is limited by the 32 or 48 cent bounds on price declines in each period."
399. Id. Only when the experiment was rerun with traders "experienced" with previous experimental iterations, did prices track fundamental value. But, this was the same result as in baseline experiments comparing inexperienced and experienced traders without a circuit breaker, which suggests that it is the experience of past bubbles and crashes, not circuit breakers, that prevents mispricings.
400. Id.;
401. see also Lucy F. Ackert et al., An Experimental Study of Circuit Breakers: the Effects of Mandated Market Closures and Temporary Halts on Market Behavior, 4 J. FIN. MARKETS 185 (2001) ("[The] presence of a circuit breaker rule does not affect the magnitude of the absolute deviation in price from fundamental value . . . .").
402. SHILLER, supra note 15, at 226.
403. Lei et al., supra note 137, at 841-45.
404. Id.
405. One experiment placed three graduate students who had read earlier experimental asset studies (labeled "insiders") in a market with six to nine undergraduates who had not read the studies ("outsiders"). Insiders and outsiders had the same share endowments, but insiders could sell two shares borrowed from
406. experimenters. Each of these shares had to be repurchased and repaid to the experimenters or a penalty of one-half the initial dividend value would be imposed on each share not repaid. It is unclear what the initial share endowment was. Caginalp et al., supra note 131, at 27.
407. King et al., supra note 24, at 186-88. When short-sale experiments were rerun to give traders experience, bubble magnitude decreased. However, as with the circuit-breaker experiments, it appears as if experience, not short sales, was the primary factor mitigating mispricings.
408. See id. at 188-89, 199.
409. The insiders were the graduate students who were informed of past experimental-asset-market research and had the capability of selling short, as described above in note 263.
410. Caginalp et al., supra note 131, at 27-28.
411. See Sunder, supra note 255, at 448 (surveying other experimental asset markets that tested for effects of short selling).
412. Conclusions on the limited effectiveness of short selling in reducing bubbles could be made more robust by rerunning these experiments and changing the parameters to further decrease the costs of short selling. For example, the experiment could be rerun with the following parameters varied: (1) increasing the number of shares the short sellers could borrow (it is difficult to interpret the results of the initial survey because, while the number of shares that could be borrowed (two) is known, the share endowments of each trader is not disclosed); (2) decreasing the penalty for not repaying shares borrowed; (3) increasing the proportion of traders that could sell short compared to the total number of traders; (4) increasing the time horizon of the short sellers.
413. The ability to purchase substitute securities allows arbitrageurs to mitigate risk and is therefore critical to fully effective arbitrage. SHLEIFER, supra note 35, at 3-4.
414. See supra notes 98-104 and accompanying text.
415. King et al., supra note 24, at 188-89. The results are more mixed in experiments in which traders could both buy on margin and sell shares short.
416. Id. Allowing traders to gain experience by repeating the margin-buying experiments forced prices to closely track fundamentals, but, again, this result did not significantly differ from the baseline, which bolsters the inference that experience with bubbles and crashes was the key determinant in reducing mispricing.
417. Id.
418. Id. at 199.
419. See supra Part II.E.
420. E.g., 12 C.F.R. § 220 (2007).
421. See OFFICE OF TECH. ASSESSMENT, U.S. CONG., ELECTRONIC BULLS AND BEARS: U.S. SECURITIES MARKETS AND INFORMATION TECHNOLOGY 86 (1990);
422. BD. OF GOVERNORS OF THE FED. RESERVE SYS., A REVIEW AND EVALUATION OF FEDERAL MARGIN REGULATIONS 44-50, 85-91 (1984);
423. Stephen Figlewski, Margins and Market Integrity: Margin Setting for Stock Index Futures and Options, 4 J. FUTURES MARKETS 385 (1984).
424. Regulation T, the principal margin regulation, only covers extensions of credit by brokers and dealers. 12 C.F.R. §§ 2201-.130.
425. Stout, supra note 173, at 730-31.
426. For an extended discussion of the inefficient allocation of resources that bubbles can cause in emerging markets, see Carlos Massad, Capital Flows in Chile: Changes and Policies in the 1990s, in FINANCIAL GLOBALIZATION AND THE EMERGING ECONOMIES 219, 219-223 (José Antonio Ocampo et al. eds., 2000).
427. Kahan, supra note 21, at 988.
428. Overpriced shares allow companies to raise capital for unprofitable projects (and underpriced shares may deny funding for profitable projects). Id. at 1005-06.
429. Market liquidity may suffer if investors are risk averse to losses from inaccurate prices. Id. at 1017. In its worst form, this liquidity reduction manifests itself as a crisis in investor confidence and can precipitate a liquidity crunch (discussed in greater detail below).
430. See infra notes 288-89 and accompanying text. A liquidity crunch can lead to further inaccuracies in stock prices.
431. See Kahan, supra note 21, at 992.
432. Inaccurate stock prices may increase stock volatility, and risk-averse investors may not be able to hedge this risk through diversification. Kahan, supra note 21, at 1025-28.
433. Mispricings may create perverse incentives for managers to take actions that raise the stock prices of their company even when those actions would lower the company's fundamental values. Id. at 1028-34. Kahan also summarizes the circumstances in which mispricings may skew the market for corporate control, lead to inefficient terms in contracts between shareholders and managers, and lead to inefficient capital budgeting by companies.
434. Id. at 1034-41.
435. Id. at 990-92.
436. KINDLEBERGER, supra note 37, at 73-90 (surveying historical swindles in stock and other financial markets during bubbles);
437. Erik F. Gerding, The Next Epidemic: Bubbles and the Growth and Decay of Securities Regulation, 38 CONN. L. REV. 393, 405-13 (2006).
438. Marc A. Weiss, The Politics of Real Estate Cycles, 20 BUS. & ECON. HIST. 127, 128 (1991), available at http://www.h-net.org/~business/bhcweb/publications/BEHprint/v020/p0127- p0135.pdf (stating that the excesses of real-estate bubbles may include outright business fraud).
439. Gerding, supra note 293, at 424-41.
440. Tamar Frankel, Regulation and Investors' Trust in the Securities Markets, 68 BROOK. L. REV. 439, 447-48 (2002);
441. Lynn A. Stout, The Investor Confidence Game, 68 BROOK. L. REV. 407, 411-12 (2002).
442. E.g., Michael D. Bordo & Olivier Jeanne, Boom-Busts in Asset Prices, Economic Instability, and Monetary Policy 11 (Nat'l Bureau of Econ. Research, Working Paper No. 8966, 2002), available athttp://www. nber.org/papers/W8966.pdf.
443. Vikas Bajaj et al., Central Banks Intervene to Calm Volatile Markets, N.Y. TIMES, Aug. 11, 2007, at Al.
444. Ben Bernanke & Mark Gertler, Monetary Policy and Asset Price Volatility 29 (Nat'l Bureau of Econ. Research, Working Paper No. 8966, 2000), a vailable at http://www.nber.org/papers/W7559.pdf.
445. E.g., Paul Krugman, Dutch Tulips and Emerging Markets, FOREIGN AFFAIRS, July-Aug. 1995, at 28.
446. DIDIER SORNETTE, WHY STOCK MARKETS CRASH: CRITICAL EVENTS IN COMPLEX FINANCIAL SYSTEMS 309-13 (2003)
447. Id. at 310.
448. Supra note 148 and accompanying text.
449. For a survey of the historical and cultural effects of the bursting of asset-price bubbles, see CHANCELLOR, supra note 56.
450. See Stuart Banner, What Causes New Securities Regulation?: 300 Years of Evidence, 75 WASH U. L.Q. 849, 850 (1997).
451. Compare Joseph A. Grundfest, Punctuated Equilibria in the Evolution of United States Securities Regulation, 8 STAN. J.L. BUS. & FIN. 1 (2002),
452. with Gerding, supra note 293, at 423-24.
453. For a description of the cycle of the politics of regulation during the rise and fall of real-estate booms, see Weiss, supra note 294, and Larry E. Ribstein, Bubble Laws, 40 HOUS. L. REV. 77, 79-83 (2003).
454. See Miller, supra note 175, at 1055.
455. See supra Part II.A.4, C. 1.
456. Supra notes 297-302 and accompanying text.
457. See Miller, supra note 175, at 1055.
458. La Blanc & Rachlinski, supra note 125, at 565-78.
459. Id. at 567-70.
460. Id. at 568.
461. See supra Part II.B.2.b.
462. La Blanc & Rachlinski, supra note 125, at 565-67.
463. Supra note 11 and accompanying text.
464. Gabaldon, supra note 9.
465. For an article critical of attempts to cure excessive speculation, see Mahoney, supra note 154. For an article that highlights the tradeoffs in securities law between serving investors with short-term horizons and those with long-term horizons, see Steven L. Schwarcz, Temporal Perspectives: Resolving the Conflict Between Current and Future Investors, 89 MINN. L. REV. 1044 (2005).
466. SHLEIFER, supra note 35, at 97-102 (describing the benefits of arbitrage).
467. La Blanc & Rachlinski, supra note 125, at 570-74.
468. See supra note 73 and accompanying text.
469. La Blanc & Rachlinski, supra note 125, at 575-76.
470. Powers et al., supra note 13, at 246-49 (outlining potential benefits of short sale restrictions).
471. Emily Chasan, Analysts Fear Shorting Effect, GLOBE & MAIL (Toronto) Aug. 10, 2007, at B12. Given the recency of this repeal, conclusions on its effects remain premature.
472. For an accessible articulation of this argument, see DANIEL GROSS, POP!: WHY BUBBLES ARE GREAT FOR THE ECONOMY (2007).
473. Although many definitions in the economic literature, including those found in experimental-asset-market research, might consider any departure from fundamental value a bubble, this Article, like the experimental-asset-market research it cites, does not consider small deviations of price from fundamental value to be a bubble.
474. E.g., Charles Bram Cadsby et al., Pooling, Separating, and Semiseparating Equilibria in Financial Markets: Some Experimental Evidence, 3 REV. FIN. STUD. 315 (1990);
475. Robert Forsythe et al., Cheap Talk, Fraud, and Adverse Selection in Financial Markets: Some Experimental Evidence, 12 REV. FIN. STUD. 481 (1999);
476. Jayant R. Kale & Thomas H. Noe, Unconditional and Conditional Takeover Offers: Experimental Evidence, 10 REV. FIN. STUD. 735 (1997);
477. Robert Libby et al., Experimental Research in Financial Accounting, 27 ACCT. ORG. & SOC'Y 775 (2002).
478. Kahan, supra note 21.
479. Supra Part III.C.4.
480. See supra notes 282-83 and accompanying text.
481. See supra notes 284-85 and accompanying text.
482. Miller, supra note 175, at 1053-55.
483. Id.
484. Id.
485. One interesting question is whether bankruptcy laws that reduce the protections of debtors from creditors may overstimulate lending and, in turn, leveraged purchases of assets. For example, what impact did the recent Bankruptcy Abuse Prevention and Consumer Protection Act, Pub. L. No. 109-8, 119 Stat. 23 (codified under Title 11 of the U.S. Code), have on lending from financial institutions to individuals investing in homes? Did that law contribute to the recent subprime-mortgage crisis?
486. Members of Congress reacted to the potential threat of a credit crunch posed by the subprime-mortgage-lending crisis. For example, Senator Schumer arguedfor easing the regulations restricting the levels of mortgages that Freddie Mac and Fannie Mae may purchase (and ultimately securitize) to inject liquidity into the primemortgage market. Eric Dash, Fannie Mae's Offer to Help Ease Credit Squeeze Is Rejected, as Critics Complain of Opportunism, N.Y. TIMES, Aug. 11, 2007, at C1 (reporting that the regulator of Freddie Mac and Fannie Mae rejected this proposal).
487. Carmichael & Esho, supra note 232, at 481 (discussing interaction of financial institution regulation and asset-price bubbles);
488. SHILLER, supra note 15, at 220-22 (analyzing Social Security reform in light of recurring asset-price bubbles).
489. Lei et al., supra note 137.
490. For a compelling argument on the way theory, experimental research, and empirical inquiry should work together, see Smith, supra note 33, at 923-34.
491. Professor Athey, for example, has created models for decision making under conditions of uncertainty that show how individuals value and react to increased information. Susan Athey, Monotone Comparative Statics Under Uncertainty, 117 Q.J. ECON. 187 (2002).
492. See supra note 29 and accompanying text.