One of the key lessons of the Global Financial Crisis is the important role of bubbles in financial markets, and their influence on the economy as a whole. But at the same time, the GFC revealed just how little we know about what causes bubbles and how they can be prevented. Among the economists hoping to change this is Dr Nikos Nikiforakis (pictured during an interview). This University of Melbourne economist uses laboratory experiments to unlock the market forces behind the bubbles.

Volunteers participate in Dr Nikiforakis’ experiments in the University of Melbourne Experimental Economics Laboratory, a $900,000 facility funded under a joint venture with the Victorian Government and facilitated by the Economic Design Network. Using controlled experiments, Dr Nikiforakis is able to test the conventional theories regarding how and why bubbles emerge. The experiment sets up an asset market where participants can trade over a number of periods. In order to create an environment as close as possible to a real market, the participants are paid real money for the “assets” they possess at the end of the experiment.

This relatively simple set up can reveal a lot of information about behaviour in asset markets. In the experiment, the fundamental value of the asset is known by everyone in the market because the participants are told the monetary value that the assets will have at the end of the game. But according to Dr Nikiforakis, repeated experiments show that participants are still willing to buy and sell above the fundamental price for a certain number of periods. Even without the uncertainty present in real financial markets, the price of an asset can spiral much higher than its fundamental value. Dr Nikiforakis suggests that participants may be simply following the herd, or may believe they can outsmart the market by buying low and selling their assets high before the bubble inevitably bursts. Though Dr Nikiforakis says there is evidence that participants learn over time with multiple repeated experiments, changing small details or introducing uncertainty can make the bubble reappear.

Equally exciting from a policy perspective is the opportunity to test methods of preventing bubbles from forming, or at least ways to reduce the factors that contribute to them. Once again, this is an area where theories are plentiful but are costly and risky to test in real markets. But Dr Nikiforakis says that the controlled environment of the Experimental Economics Laboratory allows economists to “test mechanisms that are more likely to prevent bubbles forming”. Given the current economic situation, developing such techniques is more important than ever, and the role of Experimental Economics is likely to be crucial. This is what makes the work of Dr Nikiforakis so relevant today – for theorists and policymakers alike.