Several other approaches of potential relevance to bubbles have also emerged during the many years of research and controversy surrounding the EMH/CAPM. These appear in the literature with colorful bubble adjectives such as “rational,” “exploding,” “intrinsic,” “churning,” and “collapsing,” though most begin with the neoclassical assumptions of financial theory.

As shall be seen, substantial theoretical assumptions and econometric contortions are needed to fit “bubbles” into a conventional rational valuation–model framework. One such crucial assumption in traditional models takes the existence of arbitrage and the law of one price (LOOP) as a given feature. This law – which need not apply intertemporally and/or if buyers have less than perfect information – says that in efficient markets all identical goods must have one price and, if not, sellers and buyers will cause convergence toward such a price.

Rational expectations

Muth (1961) was the first to explicitly propose a rational expectations hypothesis (REH) approach, which then gained publicity in the 1970s and 1980s as a potentially useful way to model expectations of future events. According to the approach – which was largely contra to the Keynesian macroeconomic analyses that had developed in the 1930s – the outcome of an economic event depends partly upon what people expect to happen. The larger importance, however, as Mehrling (2005, p. 210) observes, is that “[T]he hypothesis of rational expectations was for macroeconomics what the hypothesis of efficient markets was for finance … rational expectations thus undermined existing models.”