Economic Bubble

The Basic Idea

The term “bubble” is used to describe the rapid inflation of market value, which is typically followed by an equally rapid decline in value – which may be referred to as a “bubble burst.”1 This happens when the price of a good surpasses its intrinsic value. While some bubbles may be identified as they occur, or even predicted beforehand, they are often only identified after the fact.2

There are five stages of a financial bubble.3 The first is displacement, the stage which gives rise to the bubble. Here, investors take note of something new and exciting, such as low interest rates or a novel technology. The second stage is the boom, in which steadily climbing prices suddenly skyrocket upward, attracting media attention and new investors alike. Third is euphoria, a blissful stage in which prices continue to climb and people are swept up in the belief that no matter how high the prices get, someone will always be willing to buy. Fourth comes profit-taking. In this stage, some people predict that the bubble is about to burst – a tricky prediction to make with accuracy – and begin to sell. The fifth and final stage is panic. Relatively self-explanatory, this stage consists of sharply declining prices sharply and panicking investors selling as quickly as possible.

 

At the root of all financial bubbles is a good idea carried to excess.

– Seth Klarman, American investor

History

Throughout history, there have been several instances identified as financial bubbles. The Dutch Tulip Bubble, or Tulipmania, is regarded as the first major financial bubble, dates back to the 17th century.4 In the late 1500s and early 1600s, tulips were regarded as a sign of affluence. A rare type of tulip, which flowered in a striped, multicolored pattern, rather than the usual solid coloration, was particularly coveted. The high demand for this rare variety of tulip bulb caused the market value of tulips to soar.5 Between the end of 1636 and early 1637, the price of tulips increased by twenty times its original value.6 Like every financial bubble, this one inevitably burst and prices fell drastically – according to some records, they dropped by as much as 99%.7 Tulipmania did not have devastating effects for the Dutch economy, but many people lost their fortunes when the bubble burst.8 In order to allay some of the panic, contract holders were permitted by the Dutch government to end their contracts for 10% of their value.9

Since the Dutch Tulip Bubble of the 17th century, many other financial bubbles have been recorded. Another famous instance comes from the early 1700s, when the British government granted the South Sea Company a monopoly on trade with South America’s Spanish colonies. As the East India Trading Company had been a raging success, investors were keen to purchase shares in the South Sea Company. This enthusiasm resulted in a bubble which ultimately burst, leaving serious financial fallout in its wake.10 The economic expansion and stock market bubble of the 1920s is cited as a causal factor behind the Great Depression, a period of serious economic crisis.11 More recently, the US Housing Bubble, in which real estate’s market value skyrocketed, gave way to a devastating financial crisis that began in 2008.12

In his 1986 book, Stabilizing an Unstable Economy, economist Hyman P. Minsky identified the five stages to a credit cycle – displacement, boom, euphoria, profit-taking, and panic. These five stages are also applicable to financial bubbles and offer important insight into the mechanisms that underlie this financial phenomenon.13

Consequences

As seen in the historical examples, financial bubbles can have serious consequences for entire economies. At their most extreme, they may lead to recessions. These instances demonstrate how excessive greed and extravagance are unsustainable. The lavish lifestyle associated with the Roaring Twenties preceded the disastrous stock market crash that catalyzed the Great Depression.14

A key problem with financial bubbles is that they are not always identified until after they burst. At this point, it is too late for preventative measures. The hope is that, by spreading information on this topic, investors will become more in tune with the cautionary signs and do away with the suspension of disbelief that allows market prices to soar to dangerously high levels.15 The case studies of past bubbles contain valuable lessons that investors can use to inform their decision-making and, hopefully, avoid the pitfalls of the past.

Controversies

Bubbles are a controversial topic in and of themselves – whether they even exist is hotly debated. Some economists argue that these fluctuations in a good’s market value occur with such regularity that it is the norm.16 The study of bubbles is made challenging by the fact that they are often only identified retrospectively, and hindsight is 20/20.

Case Study

Housing bubble

One of the most famous instances of a financial bubble is that of the US Housing Bubble in the early 2000s. This bubble’s burst led to the price of real estate crashing, causing millions of foreclosures and an economic crisis that came to be known as the Great Recession.17

The housing bubble resulted from another bubble, known as the dotcom bubble. During the nineties, the rising popularity of the Internet led the value of several dotcom companies to skyrocket as soon as they went public. When this bubble inevitably burst, it resulted in a minor recession.18 Around the same time, events of 9/11 unfolded, leaving people scared and uncertain. In order to mitigate the damage caused by the dotcom bubble bursting and ease the uncertainty resulting from the attack on the World Trade Center, the American government reduced real estate interest rates and implemented policies to encourage people to buy homes.

At the same time, investors in the dotcom turned their sights to the housing market.19 All of this culminated in the market value of real estate reaching astronomical heights. Interest rates continued to drop and lending requirements became increasingly lenient. People began flipping houses – buying them and reselling them for profit – at alarming rates. At the same time, the stock market was recovering from the recession that resulted from the dotcom bubble’s burst.

This recovery caused interest rates to increase again around 2006. When real estate prices became so high that investors were unwilling to buy houses, the demand dropped off sharply, causing the market value to decrease quickly. Of course, this resulted in rapid sales of mortgage-backed securities, or the shares of a loan on a house bought by investors. The price of a home decreased by 19% in two years, causing millions of people the need to foreclose their houses. 20

Related TDL Content

Robert Shiller

Shiller, a Nobel Prize winning economist, is known for challenging many of the widely accepted assumptions of economic theory. In particular, he stressed the notion that humans are often irrational, which goes against the model of humans as rational agents. Some of his work has focused on the analysis of financial bubbles, specifically the dotcom bubble of the 1990s and the real estate bubble of the early 2000s. His analysis of the former is presented in his book Irrational Exuberance, originally published in 2000.

Optimism Bias

This cognitive bias describes our tendency to overestimate the likelihood of good things happening to us and underestimating the likelihood that bad things will happen to us. This article uses the concept of financial bubbles, particularly the real estate bubble and the financial crisis that followed, as an example to illustrate this bias and the consequences it can have.

Sources

  1. Kenton, W. (2020). Bubble Definition. Investopedia. https://www.investopedia.com/terms/b/bubble.asp
  2. Picardo, E. (2020). Asset Bubbles Through History: The 5 Biggest. Investopedia. https://www.investopedia.com/articles/personal-finance/062315/five-largest-asset-bubbles-history.asp
  3. Segal, T. (2020). 5 Stages Of A Bubble. Investopedia. https://www.investopedia.com/articles/stocks/10/5-steps-of-a-bubble.asp
  4. See 3
  5. Hayes, A. (2019). Dutch Tulip Bulb Market Bubble Definition. Investopedia. https://www.investopedia.com/terms/d/dutch_tulip_bulb_market_bubble.asp
  6. See 2
  7. See 2
  8. See 5
  9. See 1
  10. See 2
  11. How Do Asset Bubbles Cause Recessions? Investopedia. https://www.investopedia.com/articles/investing/082515/how-do-asset-bubbles-cause-recessions.asp
  12. See 2
  13. See 1
  14. See 11
  15. 11
  16. See 1
  17. Housing Bubble Definition. Investopedia. https://www.investopedia.com/terms/h/housing_bubble.asp
  18. See 2
  19. See 17
  20. See 17

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