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An economic bubble (also called a speculative bubble or a financial bubble) is a period when current asset prices greatly exceed their intrinsic valuation, being the valuation that the underlying long-term fundamentals justify. Bubbles can be caused by overly optimistic projections about the scale and sustainability of growth (e.g. dot-com bubble), and/or by the belief that intrinsic valuation is no longer relevant when making an investment (e.g. Tulip mania). They have appeared in most asset classes, including equities (e.g. Roaring Twenties),
commodities In economics, a commodity is an economic good, usually a resource, that has full or substantial fungibility: that is, the market treats instances of the good as equivalent or nearly so with no regard to who produced them. The price of a comm ...
(e.g. Uranium bubble), real estate (e.g. 2000s US housing bubble), and even esoteric assets (e.g.
Cryptocurrency bubble A cryptocurrency bubble is a phenomenon where the market increasingly considers the going price of cryptocurrency assets to be inflated against their hypothetical value. The history of cryptocurrency has been marked by several speculative bubble ...
). Bubbles usually form as a result of either excess liquidity in markets, and/or changed investor psychology. Large multi-asset bubbles (e.g. 1980s Japanese asset bubble and the 2020–21 Everything bubble), are attributed to central banking liquidity (e.g. overuse of the
Fed put The Greenspan put was a monetary policy response to financial crises that Alan Greenspan, former chair of the Federal Reserve, exercised beginning with the Black Monday (1987), crash of 1987. Successful in addressing various crises, it became c ...
). In the early stages of a bubble, many investors do not recognise the bubble for what it is. People notice the prices are going up and often think it is justified. Therefore bubbles are often conclusively identified only in retrospect, after the bubble has already popped and prices have crashed.


Origin of term

The term "bubble", in reference to financial crisis, originated in the 1711–1720 British
South Sea Bubble South is one of the cardinal directions or compass points. The direction is the opposite of north and is perpendicular to both east and west. Etymology The word ''south'' comes from Old English ''sūþ'', from earlier Proto-Germanic ''*sunþaz ...
, and originally referred to the companies themselves, and their inflated stock, rather than to the crisis itself. This was one of the earliest modern financial crises; other episodes were referred to as "manias", as in the Dutch tulip mania. The metaphor indicated that the prices of the stock were inflated and fragile – expanded based on nothing but air, and vulnerable to a sudden burst, as in fact occurred. Some later commentators have extended the metaphor to emphasize the suddenness, suggesting that economic bubbles end "All at once, and nothing first, / Just as bubbles do when they burst," though theories of financial crises such as debt deflation and the Financial Instability Hypothesis suggest instead that bubbles burst ''progressively,'' with the most vulnerable (most highly-
leveraged In finance, leverage (or gearing in the United Kingdom and Australia) is any technique involving borrowing funds to buy things, hoping that future profits will be many times more than the cost of borrowing. This technique is named after a lever ...
) assets failing first, and then the collapse spreading throughout the economy.


Types

There are different types of bubbles, with economists primarily interested in two major types of bubbles:


Equity bubble

An
equity Equity may refer to: Finance, accounting and ownership * Equity (finance), ownership of assets that have liabilities attached to them ** Stock, equity based on original contributions of cash or other value to a business ** Home equity, the dif ...
bubble is characterised by tangible investments and the unsustainable desire to satisfy a legitimate market in high demand. These kind of bubbles are characterised by easy liquidity, tangible and real assets, and an actual innovation that boosts confidence. Three instances of an equity bubble are the Tulip Mania,
Bitcoin Bitcoin ( abbreviation: BTC; sign: ₿) is a decentralized digital currency that can be transferred on the peer-to-peer bitcoin network. Bitcoin transactions are verified by network nodes through cryptography and recorded in a public distr ...
, and the dot-com bubble.


Debt bubble

A debt bubble is characterised by intangible or credit based investments with little ability to satisfy growing demand in a non-existent market. These bubbles are not backed by real assets and are based on frivolous lending in the hope of returning a profit or security. These bubbles usually end in debt deflation causing bank runs or a currency crisis when the government can no longer maintain the fiat currency. Examples are the Roaring Twenties stock market bubble (which caused the
Great Depression The Great Depression (19291939) was an economic shock that impacted most countries across the world. It was a period of economic depression that became evident after a major fall in stock prices in the United States. The economic contagio ...
) and the United States housing bubble (which caused the Great Recession).


Impact

The impact of economic bubbles is debated within and between schools of economic thought; they are not generally considered beneficial, but it is debated how harmful their formation and bursting is. Within
mainstream economics Mainstream economics is the body of knowledge, theories, and models of economics, as taught by universities worldwide, that are generally accepted by economists as a basis for discussion. Also known as orthodox economics, it can be contrasted to h ...
, many believe that bubbles cannot be identified in advance, cannot be prevented from forming, that attempts to "prick" the bubble may cause financial crisis, and that instead authorities should wait for bubbles to burst of their own accord, dealing with the aftermath via monetary policy and fiscal policy. Political economist Robert E. Wright argues that bubbles can be identified before the fact with high confidence. In addition, the crash which usually follows an economic bubble can destroy a large amount of wealth and cause continuing economic malaise; this view is particularly associated with the debt-deflation theory of
Irving Fisher Irving Fisher (February 27, 1867 – April 29, 1947) was an American economist, statistician, inventor, eugenicist and progressive social campaigner. He was one of the earliest American neoclassical economists, though his later work on debt def ...
, and elaborated within Post-Keynesian economics. A protracted period of low risk premiums can simply prolong the downturn in asset price deflation, as was the case of the
Great Depression The Great Depression (19291939) was an economic shock that impacted most countries across the world. It was a period of economic depression that became evident after a major fall in stock prices in the United States. The economic contagio ...
in the 1930s for much of the world and the 1990s for
Japan Japan ( ja, 日本, or , and formally , ''Nihonkoku'') is an island country in East Asia. It is situated in the northwest Pacific Ocean, and is bordered on the west by the Sea of Japan, while extending from the Sea of Okhotsk in the north ...
. Not only can the aftermath of a crash devastate the economy of a nation, but its effects can also reverberate beyond its borders.


Effect upon spending

Another important aspect of economic bubbles is their impact on spending habits. Market participants with overvalued assets tend to spend more because they "feel" richer (the wealth effect). Many observers quote the
housing market Housing market can refer to: * The economics of real-estate used for residential purposes; see Real estate economics. * Real estate business - buying, selling, or renting real estate (land, buildings, or housing). * The problem of assigning indivis ...
in the United Kingdom,
Australia Australia, officially the Commonwealth of Australia, is a Sovereign state, sovereign country comprising the mainland of the Australia (continent), Australian continent, the island of Tasmania, and numerous List of islands of Australia, sma ...
, New Zealand, Spain and parts of the United States in recent times, as an example of this effect. When the bubble inevitably bursts, those who hold on to these overvalued assets usually experience a feeling of reduced wealth and tend to cut discretionary spending at the same time, hindering economic growth or, worse, exacerbating the economic slowdown. In an economy with a central bank, the bank may therefore attempt to keep an eye on asset price appreciation and take measures to curb high levels of speculative activity in financial assets. This is usually done by increasing the interest rate (that is, the cost of borrowing money). Historically, this is not the only approach taken by central banks. It has been argued that they should stay out of it and let the bubble, if it is one, take its course.


Causes

It has also been variously suggested that bubbles may be rational, intrinsic, and contagious. To date, there is no widely accepted theory to explain their occurrence. Recent computer-generated agency models suggest excessive leverage could be a key factor in causing financial bubbles. Puzzlingly for some, bubbles occur even in highly predictable experimental markets, where uncertainty is eliminated and market participants should be able to calculate the intrinsic value of the assets simply by examining the expected stream of dividends. Nevertheless, bubbles have been observed repeatedly in experimental markets, even with participants such as business students, managers, and professional traders. Experimental bubbles have proven robust to a variety of conditions, including short-selling, margin buying, and insider trading. While there is no clear agreement on what causes bubbles, there is evidence to suggest that they are not caused by
bounded rationality Bounded rationality is the idea that rationality is limited when individuals make decisions, and under these limitations, rational individuals will select a decision that is satisfactory rather than optimal. Limitations include the difficulty of ...
or assumptions about the irrationality of others, as assumed by greater fool theory. It has also been shown that bubbles appear even when market participants are well capable of pricing assets correctly. Further, it has been shown that bubbles appear even when
speculation In finance, speculation is the purchase of an asset (a commodity, good (economics), goods, or real estate) with the hope that it will become more valuable shortly. (It can also refer to short sales in which the speculator hopes for a decline i ...
is not possible or when over-confidence is absent. More recent theories of asset bubble formation suggest that they are likely sociologically-driven events, thus explanations that merely involve fundamental factors or snippets of human behavior are incomplete at best. For instance, qualitative researchers
Preston Teeter Preston is a place name, surname and given name that may refer to: Places England *Preston, Lancashire, an urban settlement **The City of Preston, Lancashire, a borough and non-metropolitan district which contains the settlement **County Boro ...
and Jorgen Sandberg argue that market speculation is driven by culturally-situated narratives that are deeply embedded in and supported by the prevailing institutions of the time. They cite factors such as bubbles forming during periods of innovation, easy credit, loose regulations, and internationalized investment as reasons why narratives play such an influential role in the growth of asset bubbles.


Liquidity

One possible cause of bubbles is excessive monetary liquidity in the financial system, inducing lax or inappropriate standards of lending by the banks, which makes markets vulnerable to volatile asset price inflation caused by short-term, leveraged speculation. For example,
Axel A. Weber Axel Alfred Weber (born 8 March 1957) is a German economist, professor, and banker. He is currently a board member and chairman of Swiss investment bank and financial services company, UBS Group AG, and has announced his resignation effective 7 A ...
, the former president of the
Deutsche Bundesbank The Deutsche Bundesbank (), literally "German Federal Bank", is the central bank of the Federal Republic of Germany and as such part of the European System of Central Banks (ESCB). Due to its strength and former size, the Bundesbank is the most ...
, has argued that "The past has shown that an overly generous provision of liquidity in global financial markets in connection with a very low level of interest rates promotes the formation of asset-price bubbles." According to the explanation, excessive monetary liquidity (easy credit, large disposable incomes) potentially occurs while fractional reserve banks are implementing expansionary monetary policy (i.e. lowering of interest rates and flushing the financial system with money supply); this explanation may differ in certain details according to economic philosophy. Those who believe the money supply is controlled exogenously by a central bank may attribute an 'expansionary monetary policy' to that bank and (should one exist) a governing body or institution; others who believe that the money supply is created endogenously by the banking sector may attribute such a 'policy' to the behavior of the financial sector itself, and view the state as a passive or reactive factor. This may determine how central or relatively minor/inconsequential policies like
fractional reserve banking Fractional-reserve banking is the system of banking operating in almost all countries worldwide, under which banks that take deposits from the public are required to hold a proportion of their deposit liabilities in liquid assets as a reserve, ...
and the central bank's efforts to raise or lower short-term interest rates are to one's view on the creation, inflation and ultimate implosion of an economic bubble. Explanations focusing on interest rates tend to take on a common form, however: when interest rates are set excessively low (regardless of the mechanism by which that is accomplished) investors tend to avoid putting their capital into savings accounts. Instead, investors tend to leverage their capital by borrowing from banks and invest the leveraged capital in financial assets such as
stock In finance, stock (also capital stock) consists of all the shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which ownership of a company ...
s and real estate. Risky leveraged behavior like speculation and
Ponzi scheme A Ponzi scheme (, ) is a form of fraud that lures investors and pays profits to earlier investors with funds from more recent investors. Named after Italian businessman Charles Ponzi, the scheme leads victims to believe that profits are comin ...
s can lead to an increasingly fragile economy, and may also be part of what pushes asset prices artificially upward until the bubble pops. Simply put, economic bubbles often occur when too much money is chasing too few assets, causing both good assets and bad assets to appreciate excessively beyond their fundamentals to an unsustainable level. Once the bubble bursts, the fall in prices causes the collapse of unsustainable investment schemes (especially speculative and/or Ponzi investments, but not exclusively so), which leads to a crisis of consumer (and investor) confidence that may result in a financial panic and/or financial crisis. If there is a monetary authority like a central bank, it may take measures to soak up the liquidity in the financial system in an attempt to prevent a collapse of its currency. This may involve actions like bailouts of the financial system, but also others that reverse the trend of monetary accommodation, commonly termed forms of 'contractionary monetary policy'. These measures may include raising interest rates, which tends to make investors become more risk averse and thus avoid leveraged capital because the costs of borrowing may become too expensive. There may also be countermeasures taken pre-emptively during periods of strong economic growth, such as increasing capital reserve requirements and implementing regulation that checks and/or prevents processes leading to over-expansion and excessive leveraging of debt. Ideally, such countermeasures lessen the impact of a downturn by strengthening financial institutions while the economy is strong. Advocates of perspectives stressing the role of credit money in an economy often refer to (such) bubbles as "credit bubbles", and look at such measures of financial leverage as
debt-to-GDP ratio In economics, the debt-to-GDP ratio is the ratio between a country's government debt (measured in units of currency) and its gross domestic product (GDP) (measured in units of currency per year). While it is a "ratio", it is technically measured i ...
s to identify bubbles. Typically the collapse of any economic bubble results in an economic contraction termed (if less severe) a recession or (if more severe) a depression; what economic policies to follow in reaction to such a contraction is a hotly debated perennial topic of political economy.


Psychology


Greater fool theory

Greater fool theory states that bubbles are driven by the behavior of perennially optimistic market participants (the fools) who buy overvalued assets in anticipation of selling it to other speculators (the greater fools) at a much higher price. According to this explanation, the bubbles continue as long as the fools can find greater fools to pay up for the overvalued asset. The bubbles will end only when the greater fool becomes the greatest fool who pays the top price for the overvalued asset and can no longer find another buyer to pay for it at a higher price. This theory is popular among laity but has not yet been fully confirmed by empirical research.


Extrapolation

Extrapolation is projecting historical data into the future on the same basis; if prices have risen at a certain rate in the past, they will continue to rise at that rate forever. The argument is that investors tend to extrapolate past extraordinary returns on investment of certain assets into the future, causing them to overbid those risky assets in order to attempt to continue to capture those same rates of return. Overbidding on certain assets will at some point result in uneconomic rates of return for investors; only then the asset price deflation will begin. When investors feel that they are no longer well compensated for holding those risky assets, they will start to demand higher rates of return on their investments.


Herding

Another related explanation used in behavioral finance lies in herd behavior, the fact that investors tend to buy or sell in the direction of the market trend. This is sometimes helped by technical analysis that tries precisely to detect those trends and follow them, which creates a
self-fulfilling prophecy A self-fulfilling prophecy is a prediction that comes true at least in part as a result of a person's or group of persons' belief or expectation that said prediction would come true. This suggests that people's beliefs influence their actions. ...
. Investment managers, such as stock mutual fund managers, are compensated and retained in part due to their performance relative to peers. Taking a conservative or contrarian position as a bubble builds results in performance unfavorable to peers. This may cause customers to go elsewhere and can affect the investment manager's own employment or compensation. The typical short-term focus of U.S. equity markets exacerbates the risk for investment managers that do not participate during the building phase of a bubble, particularly one that builds over a longer period of time. In attempting to maximize returns for clients and maintain their employment, they may rationally participate in a bubble they believe to be forming, as the likely shorter-term benefits of doing so outweigh the likely longer-term risks.


Moral hazard

Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. A person's belief that they are responsible for the consequences of their own actions is an essential aspect of rational behavior. An investor must balance the possibility of making a return on their investment with the risk of making a loss – the risk-return relationship. A moral hazard can occur when this relationship is interfered with, often via government policy. A recent example is the Troubled Asset Relief Program (TARP), signed into law by U.S. President
George W. Bush George Walker Bush (born July 6, 1946) is an American politician who served as the 43rd president of the United States from 2001 to 2009. A member of the Republican Party, Bush family, and son of the 41st president George H. W. Bush, he ...
on 3 October 2008 to provide a government bailout for many financial and non-financial institutions who speculated in high-risk financial instruments during the housing boom condemned by a 2005 story in '' The Economist'' titled "The worldwide rise in house prices is the biggest bubble in history". A historical example was intervention by the Dutch Parliament during the great Tulip Mania of 1637. Other causes of perceived insulation from risk may derive from a given entity's predominance in a market relative to other players, and not from state intervention or market regulation. A firm – or several large firms acting in concert (see cartel,
oligopoly An oligopoly (from Greek ὀλίγος, ''oligos'' "few" and πωλεῖν, ''polein'' "to sell") is a market structure in which a market or industry is dominated by a small number of large sellers or producers. Oligopolies often result from ...
and collusion) – with very large holdings and capital reserves could instigate a market bubble by investing heavily in a given asset, creating a relative scarcity which drives up that asset's price. Because of the signaling power of the large firm or group of colluding firms, the firm's smaller competitors will follow suit, similarly investing in the asset due to its price gains. However, in relation to the party instigating the bubble, these smaller competitors are insufficiently leveraged to withstand a similarly rapid decline in the asset's price. When the large firm, cartel or ''de facto'' collusive body perceives a maximal peak has been reached in the traded asset's price, it can then proceed to rapidly sell or "dump" its holdings of this asset on the market, precipitating a price decline that forces its competitors into insolvency, bankruptcy or foreclosure. The large firm or cartel – which has intentionally leveraged itself to withstand the price decline it engineered – can then acquire the capital of its failing or devalued competitors at a low price as well as capture a greater market share (e.g., via a merger or acquisition which expands the dominant firm's distribution chain). If the bubble-instigating party is itself a lending institution, it can combine its knowledge of its borrowers' leveraging positions with publicly available information on their stock holdings, and strategically shield or expose them to default.


Other

Some regard bubbles as related to inflation and thus believe that the causes of inflation are also the causes of bubbles. Others take the view that there is a "fundamental value" to an asset, and that bubbles represent a rise over that fundamental value, which must eventually return to that fundamental value. There are chaotic theories of bubbles which assert that bubbles come from particular "critical" states in the market based on the communication of economic factors. Finally, others regard bubbles as necessary consequences of irrationally valuing assets solely based upon their returns in the recent past without resorting to a rigorous analysis based on their underlying "fundamentals".


Stages

According to the economist Charles P. Kindleberger, the basic structure of a speculative bubble can be divided into five phases: * Substitution: increase in the value of an asset * Takeoff: speculative purchases (buy now to sell in the future at a higher price and obtain a profit) * Exuberance: a state of unsustainable euphoria. * Critical stage: begin to shorten the buyers, some begin to sell. * Pop (crash): prices plummet


Identification

Economic or asset price bubbles are often characterized by one or more of the following: # Unusual changes in single measures, or relationships among measures (e.g., ratios) relative to their historical levels. For example, in the housing bubble of the 2000s, the housing prices were unusually high relative to income. For stocks, the
price to earnings ratio A price is the (usually not negative) quantity of payment or compensation given by one party to another in return for goods or services. In some situations, the price of production has a different name. If the product is a "good" in the c ...
provides a measure of stock prices relative to corporate earnings; higher readings indicate investors are paying more for each dollar of earnings. # Elevated usage of debt (leverage) to purchase assets, such as purchasing stocks on margin or homes with a lower down payment. # Higher risk lending and borrowing behavior, such as originating loans to borrowers with lower credit quality scores (e.g., subprime borrowers), combined with adjustable rate mortgages and "interest-only" loans. # Rationalizing borrowing, lending, and purchase decisions based on expected future price increases rather than the ability of the borrower to repay. # Rationalizing asset prices by increasingly weaker arguments, such as "this time it's different" or "housing prices only go up." # A high presence of marketing or media coverage related to the asset. # Incentives that place the consequences of bad behavior by one economic actor upon another, such as the origination of mortgages to those with limited ability to repay because the mortgage could be sold or securitized, moving the consequences from the originator to the investor. # International trade (
current account Current account or Current Account may refer to: * Current account (balance of payments), a country's balance of trade, net of factor income and cash transfers * Current account (banking) A transaction account, also called a checking account, ch ...
) imbalances, resulting in an excess of savings over investments, increasing the volatility of capital flow among countries. For example, the flow of savings from Asia to the U.S. was one of the drivers of the 2000s housing bubble. # A lower interest rate environment, which encourages lending and borrowing.


Notable asset bubbles


Commodities

* Tulip mania (Dutch) (1634–1637) * Comic book speculation bubble (1985-1993) * Silver Thursday 1980 * Uranium bubble of 2007 *
Cryptocurrency bubble A cryptocurrency bubble is a phenomenon where the market increasingly considers the going price of cryptocurrency assets to be inflated against their hypothetical value. The history of cryptocurrency has been marked by several speculative bubble ...
(2016–2017, 2021–)


Equities


Private securities

* South Sea Company (British) (1720) * Mississippi Company (France) (1720) * Canal Mania (UK) (1790s–1810s) *
Railway Mania Railway Mania was an instance of a stock market bubble in the United Kingdom of Great Britain and Ireland in the 1840s. It followed a common pattern: as the price of railway shares increased, speculators invested more money, which further incre ...
(UK) (1840s)


Quoted securities

* Roaring Twenties stock-market bubble (US) (1921–1929) * Poseidon bubble (Australia) (1969–1970) * Chinese stock bubble of 2007 (2003–2007) * Dot-com bubble (US) (1996–2000)


Real estate

* Florida building bubble (US) (1922–1926) * 2000s Property bubbles: ** Australian property bubble **
Indian property bubble The Indian real estate sector is collapsing due to increasing costs of financing. Real estate projects in India take a long time to complete due to a complicated regulatory mechanism. Several of India's publicly traded real estate firms are in ...
** Irish property bubble ** New Zealand property bubble ** Spanish property bubble ** Romanian property bubble ** United States housing bubble (US) (2002–2006)


Debt

*
Corporate debt bubble The corporate debt bubble is the large increase in corporate bonds, excluding that of financial institutions, following the financial crisis of 2007–08. Global corporate debt rose from 84% of gross world product in 2009 to 92% in 2019, or about $ ...
(2010–)


Multi-asset/Broad-based

*
Japanese asset price bubble The was an economic bubble in Japan from 1986 to 1991 in which real estate and stock market prices were greatly inflated. In early 1992, this price bubble burst and Japan's economy stagnated. The bubble was characterized by rapid acceleration ...
(1986–1991) *
1997 Asian financial crisis The Asian financial crisis was a period of financial crisis that gripped much of East Asia and Southeast Asia beginning in July 1997 and raised fears of a worldwide economic meltdown due to financial contagion. However, the recovery in 1998–1 ...
(1997) * Everything bubble (2020–2021)


Notable periods post asset bubbles

*
Panic of 1837 The Panic of 1837 was a financial crisis in the United States that touched off a major depression, which lasted until the mid-1840s. Profits, prices, and wages went down, westward expansion was stalled, unemployment went up, and pessimism abound ...
*
Great Depression The Great Depression (19291939) was an economic shock that impacted most countries across the world. It was a period of economic depression that became evident after a major fall in stock prices in the United States. The economic contagio ...
(1929–1934) * Lost Decade (Japan) (1990–2013) * Early 2000s recession (2002–2003) * Great Recession (2008–2012)


See also


References


Further reading

*


External links


When Bubbles Burst, World Economic Outlook
(PDF), International Monetary Fund, April 2003. {{DEFAULTSORT:Economic Bubble Business cycle Business failures Financial crises