A Theory on Origin of Speculative Bubbles and Public Debt Accumulation

Abstract

I define a speculative bubble as the phenomenon in which zero expected return assets possess positive economic values. The limited liability principle matters in such a case. Individual investors prefer higher risk and higher return assets under limited liability, and they become incautious about the downside risk. Accordingly, even the zero expected return assets have a positive market value. However, we must note that some substantial amount of government subsidies should be introduced into the market to penetrate the limited liability principle. As circulating such assets implies the prevalence of economy-wide zero-sum game, if we presume the limited liability principle, additional provision of an official subsidy is unavoidable to finance the private positive gains. This finding implies that the precariousness of whether a speculative bubble emerges vitally depends on the fiscal discipline of a government. Whenever investors foresee a government’s forbearing policy, they invest in riskier zero-sum assets, and there emerges a more violent speculative bubble. In such a case, a huge amount of public debt is accumulated as a result of the government’s aids. I negate not only the Ricardian equivalence theorem under non-altruistic individuals but also the Lerner’s assertion that alleges the issuance of a public debt to be irrelevant to the future resource allocation. Therefore, speculative bubbles genetically distort the intergenerational resource allocation, and hence, intergenerational ethic on the macroeconomic policy should be urgently established.