Bubbles and Recursive Definitions

Determining if an economic bubble has happened in the past - such as the dot com bubble of the late 90s - is easy enough: simply examine the emperical data and you should find an unrealistic swelling followed by a sudden 'burst,' a dramatic drop-off in the economic vehicle's valuation. But how do you tell if you are currently in a bubble? Sure, you can point to past data, such as the vast swells in home prices, and say, "Ah-ha! This irrational rise in prices is proof enough that we are in a bubble," but how can you know for certain?

One thing neat about bubbles is that defining if you are in the midst of one can only be done rescursively. That is, one metric for determining if you are living through a bubble is... if people are talking about whether such a bubble exists or not. I don't think it really matters how the "we're in a bubble" vs. "we're not in a bubble" numbers work out - if there's sufficient discussion in the marketplace about the potential of a bubble, there's probably already one.

This sentiment was expressed more eloquently in The Wichita Eagle's Is It a Housing Bubble? Act as If It Was article, where the author wrote:

Ocean sailors have a rule about reducing sail when the wind picks up: "If you wonder whether it's time to reef, you already should have." Sure, the wind might ease, but calling it wrong can be fatal. Which brings us to the current debate about whether we're in a housing bubble: If you think we might be, better act as if we are. As I said in a recent column, if we could identify bubbles for sure, they'd never form. Surely, though, one sign of a bubble is that more and more people start debating whether one exists -- and these days, it's near impossible to pick up a financial publication that doesn't have a bubble story.

The article also includes some good data on rising home prices, definitely worth reading.