Noah Smith on the Gennaioli and Shleifer theory of the great recession

Gennaioli and Shleifer explain these patterns by turning to their own preferred theory of human irrationality — the theory of extrapolative expectations. Basically, this theory holds that when asset prices rise — home values, stocks and so on — without a break, investors start to believe that this trend represents a new normal. They pile into the asset, pumping up the price even more, and seeming to confirm the idea that the trend will never end. But when the extrapolators’ money runs out, reality sets in and a crash ensues. Gennaioli, Shleifer, and their coauthors have been only one of several teams of researchers to investigate this idea and its implications in recent years.

When extrapolative expectations are combined with an inherently fragile financial system, a predictable cycle of booms and busts is the result. At some point during good economic times, irrational exuberance takes hold, pushing stock prices, house values, or both into the stratosphere. When they inevitably come down, banks collapse, taking the rest of the economy with them.

Here is his full Bloomberg column.  Here slides from the authors.

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