Information about Economic Bubble

An economic bubble (sometimes referred to as a "speculative bubble", a "market bubble", a "price bubble", a "financial bubble", or a "speculative mania") is “trade in high volumes at prices that are considerably at variance from intrinsic values”.^[1] The intrinsic value is a theoretical calculation that aims at reflecting the fair value by taking into account hypotheses of future returns and risks.

The cause of bubbles remains a challenge to economic theory. While many explanations have been suggested, it has been recently shown that bubbles appear even without uncertainty ^[2], speculation^[3], or bounded rationality ^[4]. Most recently, it has been suggested that bubbles might ultimately be caused by processes of price coordination ^[5] or institutionalization ^[6]. Because it is often difficult to observe intrinsic values in real-life markets, bubbles are often identified only in retrospect, when a sudden drop in prices appear. Such drop is known as a crash or a bubble burst. Both the boom and the bust phases of the bubble are examples of a positive feedback mechanism, in contrast to the negative feedback mechanism that determines the equilibrium price under normal market circumstances. Prices in an economic bubble can fluctuate chaotically, and become impossible to predict from supply and demand alone.

Economic bubbles are generally considered to have a negative impact on the economy because they tend to cause misallocation of resources into non-optimal uses. In addition, the crash which usually follows an economic bubble can destroy a large amount of wealth and cause continuing economic malaise. A protracted period of low risk premiums can simply prolong the downturn in asset price deflation as was the case of the Great Depression in the 1930s for much of the world and the 1990s for Japan. Not only can the aftermath of a crash devastate the economy of a nation, but its effects can also reverberate beyond its borders.

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 in the United Kingdom, Australia, 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 poorness and tend to cut discretionary spending at the same time, hindering economic growth or, worse, exacerbating the economic slowdown. Therefore, it is imperative for the central bank to keep its eyes 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).

When the bubble occurs in equity markets, it is called a stock market bubble. It is usually very difficult to differentiate a stock market bubble from an ordinary bull market except in hindsight.

Causes

The cause of bubbles remains a puzzle. While it has been suggested that bubbles may be rational ^[7], intrinsic ^[8], and contagious ^[9], there is no widely accepted theory to explain their occurrence.

Puzzlingly, 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 ^[10]. Nevertheless, bubbles have been observed repeatedly in experimental markets, even with sophisticated 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 ^[11].

While it is not clear what causes bubbles, there is evidence to suggest that they are not caused by bounded rationality or assumptions about the irrationality of others, as assumed by greater fool's theory. It has also been shown that bubbles appear even when market participants are well-capable of pricing assets correctly ^[12]. Further, it has been shown that bubbles appear even when speculation is not possible ^[13] or when over-confidence is absent ^[14].

Popular among laymen but recently discredited by empirical research ^{[15] [16]}, greater fool's theory portrays bubbles as driven by the behavior of a perennially optimistic market participants (the fools) who buy overvalued assets in anticipation of selling it to other rapacious speculators (the greater fools) at a much higher price. According to this unsupported 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.

Others argue that the cause of bubbles is excessive monetary liquidity in the financial system. However, this explanation cannot be complete, because bubbles appear even in experimental markets that are carefully controlled ^[17]. According to the explanation, excessive monetary liquidity (easy credit, large disposable incomes) potentially occurs while central banks are implementing expansionary monetary policy (i.e. lowering of interest rates and flushing the financial system with money supply). When interest rates are going down, 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 equities and real estate. 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. The bubbles will burst only when the central bank reverses its monetary accommodation policy and soaks up the liquidity in the financial system. The removal of monetary accommodation policy is commonly known as a contractionary monetary policy. When the central bank raises interest rates, investors tend to become risk averse and thus avoid leveraged capital because the costs of borrowing may become too expensive.

Another insufficient explanation is that economic bubbles are mainly driven by the greed and irrational exuberance of overly bullish investors. They argue 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. This in return may reflect as shortage of skilled labour causing a vicious circle since young skilled workers tend to go abroad for better financial opportunities due to a halt in the industry. The economic downtime however stagnates once a dedicated pool of workers is allocated but this obviously comes at the cost of high service rates. Australia from the last three years has been facing such a problem. Although it is a stable economy, young skilled labor follows a trend to go up to the United Kingdom and other European countries on work visas. This creates a demand and supply gap chain which is then fulfilled by allowing immigration into the country on a suitable basis. The issue is readily addressed as a 'Floating Economic Bubble' which strains the economy for that particular time but eventually phases out. During the period, the Australian Government takes appropriate measures to avoid the outsourcing of any business and therefore implements strict control over labour shortage both in the skilled and highly skilled fields. Since this phenomenon creates a high assumed charge over exact prices and rates, a 'Constant Economic Bubble' may emerge as happened in 2004 when National Australia Bank lost A$360 million resulting from foreign currency trades undertaken by 4 option traders.

Due to this phenomenon, 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".

Examples

Examples of economic bubbles include:

• Tulip mania (top 1637)
• The South Sea Company (1720)
• Mississippi Company (1720)
• English Channels Bubble
• Railroads Bubble
• the Victorian land boom of the 1880s; see http://www.dailyreckoning.com/Featured/TheLandBoomers.html
• Florida speculative building bubble (1926)
• The Nifty Fifty American stocks of the late 1960s and early 1970s
• Poseidon bubble (1970)
• Sports cards in the 1980s and early 1990s
• TY Beanie Babies (1996)
• The Dot-com bubble (circa 1995–2001)
• Australian economy bubblehttp://www.wsws.org/articles/2004/sep2004/hous-s27.shtml
• Japanese asset price bubble (1980s)
• Real estate bubble
• British property bubble (as of 2006)
• Irish property bubble (as of 2006)
• United States housing bubble (as of 2007)
• (The former Florida swampland real estate bubble)
• Spanish property bubble (as of 2006)
• California property bubble (as of 2006)
• Panic of 1837
• China stock bubble (as of 2006)
• Great Depression

^[18]

Other goods which have produced bubbles include postage stamps and coin collecting.

See also

• Fictitious capital
• Real estate bubble
• Speculation
• Stock market bubble
• Business cycle

References

External links

• Discussion of the recent stock market bubble
• Discussion of the US housing bubble and conflicting opinions.
• The compelling Real DJIA, 1924-now
• The 3 Fed Chair warnings, Real DJIA
• When Bubbles Burst (PDF), World Economic Outlook, International Monetary Fund, April 2003.