Rational Exuberance: Overinvestment as an Optimal Adaptive Control

It is widely believed that major technological innovations inevitably spark speculative fever, resulting in wasteful overinvestment. This paper presents a general equilibrium model of investment in a new industry, whose production function is not known in advance. In the context of the model, overinvestment is actually socially optimal as the most efficient way to learn about the new technology. The model thus provides an explanation for the perceived linkage between innovation and apparent irrationality, even though no irrationality is at work. Further, the initial overinvestment is accompanied in the model by apparently inflated prices and apparently negative expected excess returns in the shares of the new industry, all of which are also fully rational. This suggests a new explanation for observed patterns of stock returns in emerging industries.