What is an economic bubble? What are its causes and effects? What are some of the notable examples of this phenomenon in history?
An economic bubble is a phenomenon characterized by rapid increases in the price of assets followed by a contraction or deflation and the possible collapse of relevant markets. Hence, by this definition alone, it is an economic cycle.
Bubbles form in different types of assets such as stock markets, securities, and housing markets, as well as in business industries and sectors and economies. Take note that the phenomenon is also called asset bubble, speculative bubble, speculative mania, balloon, and market or financial bubble, among others.
There are also two types of economic bubble: equity bubble and debt bubble. An equity bubble involves high demands for tangible investments involving tangible or real assets from a legitimate market. Meanwhile, a debt bubble involves intangible or credit-based investments with minimal capability to meet growing demand in a nonexistent market
Causes and Effects of Economic Bubble
Investor behavior is the primary and general driving force behind economic bubbles. However, it is also important to highlight the fact that there is no clear agreement on what specifically causes this phenomenon.
Nonetheless, the five stages in a typical credit cycle identified by economist Hyman P. Minsky in his work on financial instability remains pretty consistent with the boom and bust patterns in bubbles. Take note of the following stages:
1. Displacement: Investors start to notice a new paradigm or more specifically, a new product or technology, or new low interest rates.
2. Boom: Prices of a particular asset start to rise at first because of a high demand for a limited supply driven by more investors entering the market.
3. Euphoria: More and more investors try to enter the market while disregarding risks because of a positive perception toward the involved asset.
4. Profit Taking: Several investors begin to cash out after realizing that the value of the asset is not really worth that much.
5. Panic: Prices of the asset suddenly plummets as more investors start to liquidate, and the availability of supply outnumbers present demand.
The review study of S. Girdzijauskas highlighted other theories or hypotheses explaining the reason behind or causes of an economic bubble. One assumption asserts that bubbles are related to inflation. Thus, the factors causing inflation could also be the same factors that cause bubbles to occur.
Another assumption is that there is a basic fundamental value to every asset, and the bubbles represent an increase or rise over that fundamental value. There are also chaotic theories arguing that the phenomenon comes from certain critical states on the market that originate from the communication of economic players.
Nevertheless, the multifaceted effects of economic bubbles can be generally understood by observing the situations transpiring in the five stages of the credit cycle identified by Minsky. For example, both the profit-taking and panic stages result in massive liquidation or perhaps, defaults that in turn, leads to deflation of asset prices.
The extent of the effects of a collapsed bubble depends on the socioeconomic influence of the involved asset. For example, the housing bubble in the U.S. resulted in the subprime mortgage crisis that further resulted in the pervasive 2007-2008 Financial Crisis that affected not only the American economy but also the entire global economy.
Notable Examples of Bubbles in History
The emergence and collapse of bubbles are regarded as a recurrent feature of modern economic history. The first recorded example of this phenomenon dated back in the 1600s during the tulip mania in The Netherlands. Below are the notable examples of economic bubble in history:
1. Tulip Mania of the 1600s
Tulips were valuable commodities in The Netherlands during the Dutch Golden Age. The trading of tulip bulbs started during the late 1590s when Dutch botanist Carolus Clusius brought the plant from the Ottoman Empire and planted them for his scientific research. The plant caught the fancy of the Dutch, and it became a hot commodity across the country, with some rare varieties becoming luxury goods.
Demands for tulips increased. The rare varieties commanded astronomical prices. The growing Dutch middle class bought them as a status symbol. French merchants fueled further the demand. Investors took notice, and they began buying tulips from local growers for eventual reselling.
Note that it took years for the plant to mature. Current supply could not keep up with the demand. However, traders found a way to sell nonexistent tulips through unregulated futures exchange in which the plant was essentially sold and bought through future contracts with no actual delivery timeline. Futures trading fueled speculative pricing further.
Prices dramatically shoot up between 1636 and 1637. A bulb from a rare variety amounted to an upscale residential property in Holland. However, they eventually collapsed in February 1637 as both buyers and investors began to realize that the value of tulips and the futures contracts were excessively and unreasonably high.
2. The Dot-Com Bubble
The years that spanned from 1994 to 2000 marked the emergence of the Internet and web-based companies. In the United States, there was excessive speculation with investors betting on the current and future viability of numerous companies ranging from online shops to communication and technologies companies.
Investors were right for a certain reason. The introduction of the web browser in 1993 made the World Wide Web possible and accessible. From 1990 to 1997, ownership of computers in American households increased from 15 percent to 35 percent. Computers became a necessity rather than a luxury. The Information Age was born around this time.
The public acceptance of computers and the Internet fueled the creation of Internet-related companies. Investors were eager to invest in any dot-com company at any valuation, especially if it had one of the Internet-related prefixes in its trade name. Note that investors range from venture capitalists to personal investors who engaged in full-time day trading.
But several problems confronted dot-com companies. Most of them incurred net operating losses because they spent heavily on marketing and advertising, not toward their consumers but their investors. Some tech companies, including telecommunications providers, fast-tracked their spending to provide next-generation Internet services and communication technology.
Nevertheless, the dot-com era marked the pervasiveness of a growth-over-profits mentality. In addition, many of these companies were focusing on attracting investors rather than introducing significant products or generating profits. Easy capital was widely accessible. However, panic eventually ensued as the market peaked. Easy capital started to dry up in 2000, and companies with millions in market capitalization became worthless in a very short amount of time.
3. The U.S. Housing Bubble
Another notable example of economic bubble in recent history was the U.S. housing bubble of 2002 to 2006 that resulted in the subprime mortgage crisis that collapsed the U.S. housing market and resulted further in the 2007-2008 Financial Crisis.
The bubble was driven by numerous factors. Among these factors was the collection of laws that made housing available to low-income Americans through subsidies and lowering of interest rates via monetary policy. Other factors include subprime mortgage, predatory lending, and other banking practices that centered on relaxing standards to make mortgages more accessible.
Banks were encouraging the public to avail mortgages because they were earning from these loans. Essentially, they were securitizing these mortgages and selling them to investors. These securities are called mortgage-backed securities or MBS. Investors deemed these a low-risk and high-return investment. Thus, demand for MBS increased, and as a response, banks made housing loans easily accessible.
On the other hand, a sizeable portion of American gave in to banks. Some of them secured mortgages to buy their own houses. Others bought properties through loans in hopes that they could sell them in the future at a higher price. However, while the properties appreciated, the income of American households did not increase significantly.
Other homeowners were also unable to pay their mortgages. The positive performance of the stock market resulted in the rise in interest rates. Essentially, homeowners could not afford their mortgages as their low introductory-rate mortgages reverted to regular interest rates. Foreclosures ensued. The banking system collapsed. Eventually, the American financial market collapsed with a series of bankruptcies of companies involved in MBS investments.
FURTHER READINGS AND REFERENCES
- Financial Crisis Inquiry Commission. 2011. The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial Economic Crisis in the United States. ISBN: 978-0-16-087727-8. Available via PDF
- Girdzijauskas, S., Štreimikienė, D., Čepinskis, J., Moskaliova, V., Jurkonytė, E., and Mackevičius, R. 2009. “Formation of Economic Bubbles: Causes and Possible Preventions.” Technological and Economic Development of Economy. 15(2): 267-280. DOI: 10.3846/1392-8619.2009.15.267-280
- The Economist. 2013, October 4. “Economic History: Was Tulipmania Irrational?” The Economist. Available online
- Wang, Z. 2007. “Technological Innovation and Market Turbulence: The Dot-Com Experience.” Review of Economic Dynamics. 10(1): 78-105. DOI: 10.1016/j.red.2006.10.001