ABSTRACT
Introduction The last chapter described the mixed success of various laws and regulations in preventing, pricking, or mitigating the severity of asset price bubbles. This chapter explores one of the few effective means of controlling bubbles, restricting credit. It explores how various financial regulations that govern credit and leverage may control the size and severity of asset price bubbles. Conversely, changes in these regulations, including deteriorating regulations, may exacerbate bubbles. Consider first the evidence: in experimental asset markets, restrictions on credit to investors have been shown to mitigate the severity of bubbles. More precisely, when inexperienced traders in these experimental markets could borrow funds to purchase shares, the magnitude of a bubble increased significantly. The ability to invest on credit drove asset prices much higher than fundamental values.1 These experiments demonstrate the effectiveness of credit restrictions in mitigating the severity of bubbles in a laboratory environment. These results led the economists conducting the experiments to rank regulations that restrict credit to investors as one of the most promising policy tools for addressing asset price bubbles.2
