Job Market Paper
The traditional approach to financial theory assumes that any profitable speculation in financial markets will have stabilizing effects on prices. Speculation could only be destabilizing if investors, on average, bought high and sold low. Since this strategy would be unprofitable, speculation should dampen fluctuations as “arbitrageurs” bet against speculative bubbles. Despite the large body of theoretical and empirical work in favor of the idea that speculation has destabilizing effects on asset prices, the “traditional view” has still been used to argue that bank lending for the speculative purchase of assets will reduce price volatility. In this paper, I argue that financial intermediaries play a role in perpetuating periods of overvaluation through the extension of credit used for speculation. Using a Markov-switching vector autoregressive model with time-varying transition probabilities, I show that the expected duration of a “bull market” is dependent on the portfolio decisions of financial and nonfinancial sectors. As such, when the banking system lends against collateral, which is itself the object of speculation, asset price bubbles can persist, even when a growing share of investors believe that assets are overvalued.