Surreal illustration of a bubble-filled cityscape representing financial risk.

Are Asset Bubbles Inevitable? A New Economic Theorem Explained

Beau Callahan in Business & Economy December 2025 • 4 min read.

"Discover the 'Bubble Necessity Theorem' and how it challenges traditional economic views on asset prices and market stability."

In the world of finance, the term "asset bubble" often conjures images of instability and impending economic doom. These bubbles occur when the price of an asset, be it stocks, real estate, or even tulips in historical examples, far exceeds its intrinsic or fundamental value. Conventional economic thought has long held that such bubbles are anomalies, either impossible in rational markets or, at best, fragile and easily corrected deviations from equilibrium.

However, a recent groundbreaking paper accepted for publication in the Journal of Political Economy is turning this conventional wisdom on its head. The paper introduces the "Bubble Necessity Theorem," a provocative theory suggesting that, under certain plausible conditions, asset bubbles are not just possible, but fundamentally necessary for economic equilibrium. This challenges the long-held belief that markets will self-correct and always reflect true value.

This isn't just an academic debate. If bubbles are indeed a necessary component of how economies function, it has profound implications for how we understand and manage financial markets. It would mean that regulators and investors alike must accept and adapt to the reality of bubbles, rather than simply trying to prevent them from forming.

What the Bubble Necessity Theorem Says

Surreal illustration of a bubble-filled cityscape representing financial risk.

At its core, the Bubble Necessity Theorem states that in economies characterized by specific conditions, all equilibrium states must exhibit asset bubbles. The key conditions that give rise to this necessity are:

These factors create an environment where the theoretical, bubble-free price of assets cannot be sustained in equilibrium. The theorem highlights that bubbles aren't random occurrences but arise systematically from underlying economic structures.

Faster long-run economic growth (G) than dividend growth (Ga): The overall economy is expanding more rapidly than the returns from specific assets (dividends).
Counterfactual long-run autarky interest rate (R) below dividend growth (Ga): If the economy were isolated (autarky), the natural interest rate would be lower than the growth rate of dividends.
Strong Savings Motives: The economic agents wants/ needs to save more.

The theorem isn't about predicting when bubbles will occur but rather identifies the structural preconditions that make them unavoidable. It suggests that bubbles are a symptom of deeper economic forces at play.

What Does This Mean for You?

While the Bubble Necessity Theorem may seem abstract, it has practical implications for investors, policymakers, and anyone trying to understand the financial landscape. For investors, it suggests a need to be more aware of the potential for bubbles and to incorporate bubble risk into investment strategies. This might mean diversifying portfolios, being wary of assets with extremely high valuations, and understanding the macroeconomic conditions that could fuel bubble formation. For policymakers, the theorem implies that preventing bubbles entirely may be unrealistic or even counterproductive. Instead, the focus may need to shift toward managing the impact of bubbles, mitigating their potential for causing widespread economic damage. This could involve measures such as macroprudential regulation, which aims to limit excessive risk-taking in the financial system, and policies that promote greater financial literacy and responsible investment behavior.

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Everything You Need To Know

What is the 'Bubble Necessity Theorem' and how does it challenge traditional economic thought?

The 'Bubble Necessity Theorem' proposes that asset bubbles are not anomalies, but rather a necessary component for economic equilibrium under certain conditions. This directly challenges the conventional view that bubbles are deviations from true asset value and that markets will self-correct. The theorem suggests that bubbles arise systematically from underlying economic structures, specifically when faster long-run economic growth (G) exists compared to dividend growth (Ga), a counterfactual long-run autarky interest rate (R) is below dividend growth (Ga), and strong savings motives are present. This perspective shifts the focus from bubble prevention to bubble management.

What are the key conditions that, according to the 'Bubble Necessity Theorem', make asset bubbles unavoidable?

The 'Bubble Necessity Theorem' identifies three key conditions that make asset bubbles unavoidable. First, faster long-run economic growth (G) than dividend growth (Ga) must exist. Second, the counterfactual long-run autarky interest rate (R) must be below dividend growth (Ga). Third, there must be strong savings motives among economic agents. These factors create an environment where the bubble-free price of assets cannot be sustained in equilibrium, thus leading to the formation of bubbles.

How does the 'Bubble Necessity Theorem' impact investors?

For investors, the 'Bubble Necessity Theorem' underscores the need to acknowledge and incorporate bubble risk into their investment strategies. This includes diversifying portfolios to mitigate risks, being cautious of assets with extremely high valuations that might be inflated by a bubble, and understanding the underlying macroeconomic conditions that could fuel bubble formation. This new perspective suggests a shift from a strategy focused on avoiding bubbles, to a more proactive approach of managing and adapting to the inherent presence of bubbles in the market.

What are the implications of the 'Bubble Necessity Theorem' for policymakers and regulators?

The 'Bubble Necessity Theorem' suggests that preventing bubbles entirely may be unrealistic or even counterproductive. Policymakers and regulators should shift their focus towards managing the impact of bubbles, rather than simply trying to prevent them. This could involve the implementation of macroprudential regulation, which aims to limit excessive risk-taking in the financial system, and policies that promote greater financial literacy and encourage responsible investment behavior. The theorem implies a need for proactive strategies to mitigate the potential economic damage caused by bubbles.

How does the 'Bubble Necessity Theorem' explain the occurrence of asset bubbles, using specific examples?

The 'Bubble Necessity Theorem' doesn't explicitly predict specific bubbles but offers a framework for understanding why they occur based on underlying economic conditions. For instance, if long-run economic growth (G) outpaces dividend growth (Ga), and savings motives are strong, assets may become overvalued as investors seek higher returns, thus forming a bubble. This is exacerbated if the counterfactual long-run autarky interest rate (R) is lower than dividend growth (Ga). It highlights that bubbles aren't random occurrences, using stocks and real estate as examples, but arise systematically from underlying economic structures, driven by the interplay of these factors.