A wonderful blog post by Jeff Ely about how people are working on constructing Economic models which could explain how optimistic investors could inflate a bubble. First, why this is a problem
Alp Simsek asks whether the presence of optimistic traders can inflate the price of assets, say housing prices. It seems obvious, but remember that investment in housing is leveraged using collateralized loans where the house itself is the collateral. If the optimists are borrowing from the “realists” to buy houses at overinflated prices, and they are offering up the house as collateral, then surely the realists aren’t willing to lend?
How the market works
Suppose that you are a realist and you are making a loan to me to purchase a house. A year later we will see whether housing prices have gone up or down. If they go up, I will pay off the loan and realize a profit. If they go down I will default on the loan. A key idea is to understand that the loan effectively makes us partners in the purchase of the house. I own it on the upside (and I pay you back your loan) and you own it on the downside. We pay for the house together too: you contribute the loan amount and I contribute the down pament.
The equilibrium price of the house will be determined by how much we, as partners, are willing to pay. I am an optimist and I would like to pay a lot for it, but I am financially constrained so my contribution to the total price is some fixed amount, my down payment. Thus, our total willingness to pay is determined by how much you are willing to pay to enter this partnership.
This means that it is the "realistic" lender who determines the market price which the asset goes for. However, assume the lender and the borrower agree on the likelihood of default, but the borrower is more optimistic as to what the house would be worth if the borrower did not default. In that case, the borrower would be willing to give up some of that upside in order to get the lender to participate. And the promise of that potential upside makes the deal more attractive for the lender as well, and makes him more willing to lend.
Lots to think about in this.