Why do asset bubbles occur




















Other prices in the economy are rising to normalize the relative prices of the bubble assets, dampening and no new money is entering the economy to fuel more bubble price rise, both of which also dampen expectations of future bubble price appreciation. Bubble prices begin to fall back toward those implied by market fundamentals. The central bank or other monetary authority may at this point try to continue inflating the bubble by injecting more new money, and repeat the above described process, or after a sustained period of monetary injections and bubble inflation it may cut back on injecting new money to tamp down consumer price and wage inflation.

Sometimes a real economic shock, such as a spike in oil prices, helps trigger a cut back in monetary injections. When the flow of new money stops, or even slows substantially, this can cause the asset bubble to burst. This sends prices falling precipitously and wreaks havoc for latecomers to the game, most of whom lose a large percentage of their investments. The bursting of the bubble is also the final realization of the Cantillon Effect, as not just a change in relative prices on paper during the rise of the bubble, but a large scale transfer of real wealth and income from the late comers to the early recipients of the newly created money who started the bubble.

This redistribution of wealth and income from late investors to the early recipients of newly created money and credit who got in on the ground floor is what makes the formation and collapse of asset price bubbles very much like a pyramid or Ponzi scheme. When this process is driven by money in its modern form of a fiat currency mostly made of fractional reserve credit created by the central bank and the banking system, then the bursting of the bubble not only induces losses to the then current holders of the bubble assets, but it can also lead to a process of debt deflation that spread beyond those exposed directly to the bubble assets but to all other debtors as well.

This means that any sufficiently large bubble can crash the entire economy into recession under the right monetary conditions. The biggest asset bubbles in recent history have been followed by deep recessions. The reverse is equally true: the largest and most high-profile economic crises in the U.

While the correlation between asset bubbles and recessions is irrefutable, economists debate the strength of the cause-and-effect relationship. Some economists even dispute the existence of bubbles at all, and argue that large real economic shocks randomly knock the economy into recession from time to time, independent of financial factors, that price bubbles and crashes are simply the optimal market response to changing real fundamentals.

Broader agreement exists, however, that the bursting of an asset bubble has played at least some role in each of the following economic recessions. The s began with a deep but short recession that gave way to a prolonged period of economic expansion. Lavish wealth, the kind depicted in F. The bubble started when the Fed eased credit requirements and lowered interest rates in the second half of through , hoping to spur borrowing, increase the money supply, and stimulate the economy.

It worked, but too well. Consumers and businesses began taking on more debt than ever. Steady expansion of the supply of money and credit through the 's fueled a massive bubble in stock prices. Widespread adoption of the telephone and the shift from a majority rural to a majority urban population increased the appeal of more sophisticated savings and investment strategies like stock ownership compared traditionally popular savings accounts and life insurance policies.

The excess of the s was fun while it lasted but far from sustainable. By , cracks began to appear in the facade. The problem was debt had fueled too much of the decade's extravagance. The investors, the general public, and the banks eventually became skeptical that the continuous extension of new credit could go on forever, and began to cut back to protect themselves from the eventual speculative losses.

Savvy investors, the ones tuned in to the idea the good times were about to end, began profit-taking. They locked in their gains, anticipating a coming market decline. Before too long, a massive sell-off took hold. People and businesses began withdrawing their money at such a rate that the banks didn't have the available capital to meet the requests. Debt deflation set in despite Fed attempts to reinflate.

The rapidly worsening situation culminated with the crash of , which witnessed the insolvency of several large banks due to bank runs. The crash touched off The Great Depression , still known as the worst economic crisis in modern American history. While the official years of the Depression were from to , the economy did not regain footing on a long-term basis until World War II ended in In the year , the words Internet, Web and online did not even exist in the common lexicon.

By , they dominated the economy. The Nasdaq index, which tracks mostly tech-based stocks, hovered below at the beginning of the s. By the turn of the century, it had soared past 5, In , the Fed began easing monetary policy in order to support the government bailout of the holders of Mexican bonds in response to the Mexican debt crisis.

The new liquid credit that the Fed added to the economy began to flow into the emerging tech sector. As the Fed dropped interest rates starting in , the Nasdaq began to really take off, Netscape launched its IPO, and the dot-com bubble began. The hype of new technologies can attract the flow of new money investment that leads to a bubble.

The Internet changed the way the world lives and does business. Many robust companies launched during the dot-com bubble , such as Google, Yahoo, and Amazon. Dwarfing the number of these companies, however, was the number of fly-by-night companies with no long-term vision, no innovation and often no product at all. Because investors were swept up in dot-com mania, these companies still attracted millions of investment dollars, many even managing to go public without ever releasing a product to the market.

As wage and consumer price pressures mounted amid a flood of liquidity meant to combat the underwhelming effects of the Y2K bug , the Fed began cutting back money supply growth and raising interest rates in early This pulled the run out from under the Fed fueled mania of the tech boom. A Nasdaq sell-off in March marked the end of the dot-com bubble.

The recession that followed was relatively shallow for the broader economy but devastating for the tech industry. The Bay Area in California, home to tech-heavy Silicon Valley, saw unemployment rates reach their highest levels in decades. Many factors coalesced to produce the s real estate bubble. The biggest were monetary expansion leading to low interest rates and significantly relaxed lending standards. The Fed dropped its target interest rate to successive historic lows from to mid and the M2 money supply grew an average of 6.

Government policies that try to shape economic trends are almost bound to guide the growth of bubbles in the presence of the expansion of money and credit.

As house fever spread like a drought-fueled conflagration, lenders, particularly those in the high-risk arena known as subprime, began competing with each other on who could relax standards the most and attract the riskiest buyers.

However, there is a compelling argument that the gold bubble is real and that the "everything is different now" philosophy won't be any more true with today's gold prices than it was with past Internet stock and housing prices. Historically, gold prices have largely been flat or grown incrementally. Uncertainty tends to make gold appear to be a safe, inflation -protected store of long-term value. Any number of factors, from easy money to irrational exuberance to speculation to policy-driven market distortions , may have a hand in the inflation and bursting of bubbles.

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The Keynesian Perspective. The Bottom Line. Key Takeaways A bubble is an economic cycle that is characterized by the rapid escalation of market value, particularly in the price of assets. This steep price rise is typically followed by a rapid decrease in value, or a contraction, when the bubble is burst. Bubbles are usually only identified and studied in retrospect, after a massive drop in prices occurs.

The cause of bubbles is disputed by economists; some economists even disagree that bubbles occur at all. Here we look at two of these perspectives. Compare Accounts. Following the boom phase, a stage of euphoria occurs. This is when investors start throwing caution to the wind and become increasingly speculative. Valuations may reach extreme levels that are disproportionate to the stock fundamentals.

Finally, a bust occurs. This is the bursting of the economic bubble, resulting in sharp declines in the valuations. As the prices fall, investors panic and sell their holdings, causing the prices to fall even more. A bubble occurs when the price of a financial asset like a stock, bond, real estate, or commodity increases at a rapid pace without underlying fundamentals to support the increase. The price spike of a financial asset attracts opportunistic speculators and investors to jump in.

They then drive the price up even higher, which leads to further price increases and speculation that are unsupported by market fundamentals.

Inexperienced investors may not recognize the signs of an economic bubble. Instead, they notice the price spike in the financial asset and believe that they can profit from the rising prices. Then there is a flood of investment dollars into the asset, which drives the price up to unsustainable levels and creates the financial bubble.

The founder of Keynesian theory, John Maynard Keynes was an English economist whose theories largely shaped the economic approach today. Under the Keynesian theory, the government is encouraged to play a large and active economic role.

As a result, Western economies today are characterized by huge central governments that carry massive debt, and Western governments largely follow the principles of Keynesian economics. The Federal Reserve is responsible for establishing interest rates in an effort to control the economy and the financial market.

When the interest rates are low, people are encouraged to borrow and to spend. Consumer demand for a product or an asset may outweigh the aggregate supply, driving inflation. There are several causes of demand-pull inflation , including the following:. When there is too much money in an economic system that has too few goods, the prices will go up.

If there is a supply shortage of an asset class that is in high demand in a financial market, the prices may dramatically increase.

The increase may spur other investors to get in to purchase securities in the asset class, eventually leading to the valuations to increase far higher than the intrinsic value of the financial assets contained within the class. This can lead to a financial bubble , which will eventually burst. Several factors can cause the bursting of an economic bubble. The demand for assets can eventually become exhausted.

This can lead to a downward shift that pressures prices in a descending spiral. There can also be a slowdown in another area of the economy. This can shift the overall demand curve in a downward direction, causing prices to plummet.

In the short-term , financial bubbles can be devastating. However, Hyman Minsky viewed the bursting of economic bubbles as more of a feature of the market rather than a failure of it. In the long-term, the bursting of a bubble may lead to new technology, new infrastructure, and improvements in the overall economy.

Three of the largest bubbles in history demonstrate how bubbles work and what their aftermath can be. The first of these three examples occurred in Holland in the s. The Dutch Tulip Bubble is an example of an asset bubble where the prices of tulips soared by 20 times in the three-month period from Nov.

By May , the bubble burst, and the price plummeted by 99 percent. Another example of a financial bubble was the South Sea Company bubble, which happened in The British government promised the South Sea Company that it would have a monopoly on all of the trade with the South American Spanish colonies.

The directors of the company spread tall tales about the riches in South America, leading to investors snapping up shares. The burst of the bubble led to a severe economic downturn. A more modern example of a stock market bubble is the Dot-Com Bubble of the late s. Hundreds of internet companies were valued in the multi-billion range as soon as they completed their initial public offerings.

However, these valuations were not supported by the intrinsic value of the companies or their fundamentals. This led to the Nasdaq index soaring to over 5, by By , it had dropped by 80 percent and plunged the economy into a recession and bear market. The key to investing during a bubble is to identify the phases so that you can recognize that a bubble is forming.

The earliest phase is when there is a new development or technology that has market promise. Smart money investors who are able to spot when an asset price bubble is beginning to form may get in early before widespread media coverage drives up prices further.



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