Economic bubble
The phrase economic bubble first appeared in the 1711 to 1720 British South Sea Bubble. This financial crisis involved inflated stock prices for a specific company rather than the crisis itself. The metaphor described how stock values were expanded based on nothing but air. These prices remained fragile and vulnerable to sudden bursts, as they eventually did. Other historical episodes used different terms like manias. The Dutch tulip mania serves as one such example from that era. Later commentators extended the metaphor to emphasize the suddenness of these events. Oliver Wendell Holmes Sr wrote about bubbles ending all at once without warning. Some theories suggest instead that bubbles burst progressively over time. The most highly-leveraged assets fail first before the collapse spreads throughout the economy. Over decades the term evolved to describe any situation where asset prices detach from fundamental value.
Economists primarily distinguish between two major types of bubbles: equity bubbles and debt bubbles. An equity bubble features tangible investments and an unsustainable desire to satisfy legitimate market demand. These bubbles involve easy liquidity and real assets alongside actual innovation boosting confidence. Examples include the Tulip Mania, the cryptocurrency bubble, the dot-com bubble, and the Roaring Twenties. A debt bubble involves intangible or credit-based investments with little ability to satisfy growing demand in non-existent markets. These bubbles are not backed by real assets and rely on frivolous lending hoping for profit or security. They usually end in debt deflation causing bank runs or currency crises when governments can no longer maintain fiat currency. Examples include the Roaring Twenties stock market bubble which caused the Great Depression and the United States housing bubble which caused the Great Recession. Many practical cases combine elements of both types starting with real investment opportunities later amplified by excessive credit. Debt bubbles tend to have more severe systemic consequences because they directly affect banking systems.
The bursting of a bubble is usually followed by rapid price declines leading to significant financial losses. Broader economic disruption often follows these crashes as seen during the Great Depression in the 1930s. Protracted periods of low risk premiums can prolong downturns in asset price deflation. The effects reverberate beyond national borders affecting global economies. Market participants holding overvalued assets tend to spend more because they feel richer. This phenomenon known as the wealth effect appears in housing markets across the United Kingdom, Australia, New Zealand, Spain, and parts of the United States. When the bubble bursts those who hold these assets experience reduced wealth feelings. They cut discretionary spending hindering economic growth or exacerbating slowdowns. Authorities may attempt to curb speculative activity through interest rate increases. Historically some argue central banks should stay out of it letting bubbles take their course. Despite risks bubbles can temporarily stimulate investment leaving lasting benefits after bursting.
Investor George Soros influenced by Karl Popper promoted reflexivity in economics publicly in his 1987 book The Alchemy of Finance. He regards insights from applying this principle as major factors in his financial career success. Reflexivity contradicts general equilibrium theory which stipulates markets move toward equilibrium correcting random noise. In equilibrium theory long-run prices reflect underlying fundamentals unaffected by current prices. Reflexivity asserts that prices influence fundamentals changing expectations thus influencing prices again. This self-reinforcing pattern drives markets toward disequilibrium until sentiment reverses into negative cycles explaining boom and bust patterns. Soros cites procyclical lending where banks ease standards for real estate loans when prices rise then raise them when falling. Property price inflation becomes a reflexive phenomenon since house prices depend on sums banks advance determined by property value estimates. For decades little sign existed of acceptance in mainstream circles but interest increased following the 2008 crash. Academic journals and economists like Larry Summers, Joe Stiglitz, and Paul Volker discussed these theories. Eugene Fama expressed skepticism arguing conventional rhetoric proposes no testable propositions or ways to measure bubbles.
Greater fool theory states bubbles are driven by optimistic market participants buying overvalued assets anticipating selling to speculators at higher prices. Bubbles continue as long as fools find greater fools willing to pay up. They end only when the greatest fool pays the top price unable to find another buyer. Extrapolation involves projecting historical data into the future assuming past rates will continue forever. Investors tend to extrapolate extraordinary returns causing them to overbid risky assets attempting to capture same rates. Uneconomic rates eventually result leading to asset price deflation when investors feel poorly compensated. Herding behavior describes how investors buy or sell in direction of market trends often helped by technical analysis creating self-fulfilling prophecies. Investment managers face employment risks if taking conservative positions during bubble building phases. Their typical short-term focus exacerbates risk for those not participating in bubble formation. Moral hazard occurs when parties insulated from risk behave differently than fully exposed counterparts. The Troubled Asset Relief Program signed the 3rd of October 2008 provided government bailouts for institutions speculating in high-risk instruments. Historical examples include Dutch Parliament intervention during the great Tulip Mania of 1637.
Excessive monetary liquidity induces lax lending standards making markets vulnerable to volatile asset price inflation. Axel A. Weber former president of Deutsche Bundesbank argued overly generous global financial liquidity promotes asset-price bubbles. Expansionary monetary policy lowers interest rates and flushes systems with money supply. When interest rates set excessively low investors avoid savings accounts leveraging capital instead. They borrow from banks investing leveraged capital in company shares and real estate. Risky leveraged behavior like speculation and Ponzi schemes pushes prices artificially upward until popping. Economic bubbles occur when too much money chases too few assets causing appreciation beyond fundamentals. Once bursting causes collapse of unsustainable investment schemes leading to crisis of consumer confidence. Central banks may take measures to soak up liquidity preventing currency collapse through bailouts or contractionary policies. Raising interest rates makes investors more risk averse avoiding leveraged capital due to borrowing costs. Countermeasures taken pre-emptively strengthen financial institutions while economy remains strong. Advocates referencing credit money refer to such bubbles as credit bubbles using debt-to-GDP ratios to identify them.
Notable historical examples range from Tulip Mania (1634, 1637) to the 2008 housing crisis and cryptocurrency fluctuations. The South Sea Company bubble occurred in Britain during 1720 alongside the Mississippi Company in France. Canal Mania affected the UK between the 1790s and 1810s while Railway Mania struck in the 1840s. The Roaring Twenties stock-market bubble spanned 1921 to 1929 before crashing into the Great Depression. Florida building bubble existed from 1922 to 1926 followed by the Japanese asset price bubble from 1986 to 1991. Silver Thursday happened on the 27th of March 1980 involving silver prices. Uranium bubble emerged in 2007 while cryptocurrency speculation bubbled between 2016, 2017 and again from 2021 onward. Comic book speculation bubble ran from 1985 to 1993 affecting collectible markets. Chinese stock bubble of 2007 lasted from 2003 to 2007 impacting Asian markets. Australian property bubble, Irish property bubble, New Zealand property bubble, Spanish property bubble, and Romanian property bubble all contributed to global instability. The Everything bubble appeared between 2020 and 2021 reflecting broad-based multi-asset inflation.
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Common questions
When did the phrase economic bubble first appear?
The phrase economic bubble first appeared during the 1711 to 1720 British South Sea Bubble. This financial crisis involved inflated stock prices for a specific company rather than the crisis itself.
What are the two major types of bubbles economists distinguish?
Economists primarily distinguish between equity bubbles and debt bubbles. An equity bubble features tangible investments while a debt bubble involves intangible or credit-based investments with little ability to satisfy growing demand in non-existent markets.
Who wrote about bubbles ending all at once without warning?
Oliver Wendell Holmes Sr wrote about bubbles ending all at once without warning. Some theories suggest instead that bubbles burst progressively over time as the most highly-leveraged assets fail first before the collapse spreads throughout the economy.
Which historical examples include the Dutch tulip mania and the Great Depression?
Notable historical examples range from Tulip Mania (1634, 1637) to the 2008 housing crisis and cryptocurrency fluctuations. The Roaring Twenties stock-market bubble spanned 1921 to 1929 before crashing into the Great Depression.
How did investor George Soros influence economic theory regarding reflexivity?
Investor George Soros promoted reflexivity in economics publicly in his 1987 book The Alchemy of Finance. He regards insights from applying this principle as major factors in his financial career success and asserts that prices influence fundamentals changing expectations thus influencing prices again.