Alex Tabarrok addresses the age-old question:
On the way up, bubbles encourage excessive investment in the bubble sector. On the way down a bursting bubble can create wealth shocks, liquidity shortages, and balance-sheet death-spirals. For both of these reasons, it would be good to be able to identify and pop bubbles. Identifying bubbles isn't easy, however, because, especially when interest rates are low, prices can increase rapidly with small, rational changes in investor expectations. But the difficulty of identifying bubbles is reasonably well known. What I think may be less appreciated is that bubbles are hard to pop even when you know that they exist.
Daniel Indiviglio joins the discussion:
Alan Greenspan is widely blamed for exacerbating the housing bubble, after leaving interest rates too low for too long. The poor guy just can't win: either he's raising rates too quickly (popping the internet bubble) or keeping them too low for too long (creating the real estate bubble). One possible solution to this could be for the Fed to only use monetary policy to control inflation and never attempt to affect business cycles. Yet, that probably would not fly politically, which is one of the problems in having a quasi-public central bank.
But either way, I'm not sure it matters. I asserted before that investors tend to be too emotional, and that helps to make bubbles worse. That's partially true, but the flip side is that investing in the asset of the day during a bubble is wholly rational. If you don't, you will fail to reap the returns that everyone else will enjoy.
[...] Unfortunately, this is a problem that I'm not sure can be solved. You would have to essentially discourage that rational behavior. One possibility would be forcing long-term investment only. Then investors would certainly be less apt to take part in inflating a bubble, since they can't count on getting out before the crash. I just worry that such a policy would do more harm to the market through creating inefficiency than good though only allowing smaller bubbles.
(Photo by Richard Heeks. Find the rest of his series here.)