Learning from the past allows us to understand the present moment better and make educated guesses about the near future. This is particularly true in the field of economics. Understanding the large picture in economics requires a firm grasp of the nitty-gritty principles and industries that make up the economy. It may be challenging to track and interpret economic trends, but doing so is necessary to understand the economy as a whole comprehensively.
In this article, we will discuss what an economic bubble is? the role it plays, the benefits it has, the reason behind it, as well as some significant cases from the history of the economy.
What is a Bubble?
A bubble is a kind of economic cycle defined by the fast escalation of market value, notably in the price of assets. This quick increase in market value is a characteristic of a bubble. In simpler terms, a bubble is an unexpected market price rise.
For investors who have gambled on the bubble's growth, the outcome is sometimes devastating when a swift deflation follows this market inflation; this contradicting scenario is known as a collapse or bubble bust.
A number of different variables may cause the construction of a bubble; however, there is one thing that all of these elements have in common: an excessive amount of money competing for an insufficient amount of assets.
Types of Bubbles
Theoretically, there might be an unlimited amount of asset bubbles. After all, a speculation craze may develop over anything, from meme stocks like Gamestop and AMC to cryptocurrency markets like Bitcoin and Dogecoin to home prices and tulip bulbs. Even tulip bulbs could experience a bubble. On the other hand, asset bubbles may often be divided into the following four broad categories:
1. Stock Market Bubble
The phenomenon known as a stock market bubble occurs when the prices of a firm's shares of stock do not accurately represent the fundamental situation of the company, because of this, the stock prices are inflated and cannot be justified by the company's real operations or financial success. As a result, there is a gap between the actual economy and the financial economy, which may be the result of market investors' excessive optimism, herd mentality, or another such factor.
The stock market, ETFs, or a particular area or market sector, such as Internet-based businesses, which fueled the dot-com boom of the late 1990s, may all be affected by these bubbles.
2. Asset Market Bubble
Even if assets aren't stocks, they can cause an economic bubble. The phenomenon known as an asset bubble takes place when the price of an asset, such as real estate, or gold, skyrockets in a relatively short amount of time for no reason. When many investors buy into a particular asset class, such as real estate, the demand for it and its price go up. Irrational exuberance, the phenomenon in which everyone appears to pick up a certain asset without necessarily having a valid cause, is a clear indication of a bubble.
When there is a bubble in the market, investors continue to inflate the cost of an asset much beyond any actual or stable value. At some point in the future, the bubble will "bust" due to a drop in demand and prices. The result of this is often a reduction in spending by businesses and households and a possible slowdown in economic activity.
3. Credit Bubble Market
Understanding the possible issues associated with credit overuse is crucial as the world economy changes. A credit bubble, often known as a debt bubble, may have a significantly negative effect on individual borrowers and financial institutions.
A credit bubble occurs when there is a sudden demand for various types of credit, including personal loans, government bonds, and debentures. This has resulted in the creation of a "bubble" in the market, in which individuals borrow more money than they are capable of repaying, which has the potential to cause a significant fall in the market.
This rise in credit demand has also been fueled by banks, financial institutions, and other lenders that have simplified their loan requirements so that customers may more easily get credit. The danger here is that if these people cannot pay back their loans, then lenders might suffer huge losses, resulting in market volatility and possibly the potential of a market collapse.
4. Commodity Bubble Market
Commodities are a vital component of the global economy; therefore, it is crucial to know what commodities are before investing in the commodity bubble. A fundamental good utilized in commercial transactions and interchangeable with other items of the same sort is referred to as a commodity. Most of the time, commodities are used as inputs in manufacturing various other items and services. Therefore, a raw material used in the production of completed items is often referred to as a commodity.
Commodities markets have seen substantial price growth and increased volatility in recent years. This phenomenon is now more often referred to as "commodity bubbles." When the price of a commodity increases sharply and in a way that cannot be maintained for an extended period, this phenomenon is known as a "commodity bubble," followed by a decline to the level at which it was first traded.
Recent instances of these bubbles may be observed in the oil markets, where prices increased dramatically in 2008 but collapsed heavily during the global financial crisis. These inflated prices are often the result of speculative behavior on the part of investors who assume that increased demand will result in perpetual price increases.
Stages of Economic Bubble
Researchers have discovered that there is a technique to detect bubbles before they burst, which involves doing an in-depth study of the data that comes before it. Experts can discover trends that signal when a bubble might be formed by looking at the market's growth stage just before a collapse, because of this insight, investors may be able to take precautionary measures or even sell off their holdings before it's too late.
These are the stages of an economic bubble
Investors are typically driven to new paradigms in today's market because of the possibility of large profits. This phenomenon is referred to as displacement, and it may occur due to various factors, such as the buzz around exciting new technology or historically low loan rates. Unfortunately, conditions like this may lead to the formation of a bubble, which ultimately results in market collapse.
The drop in the federal funds rate from 6.5% in July 2000 to 1.2% in June 2003 is a brilliant example of displacement. This reduction had achieved over three years.
During the Boom stage, there is an increase in the number of new investors who are looking to earn profits by capitalizing on the good momentum that the market is experiencing. When there are more investments, there is more competition, which makes prices go up because of high demand. This is what causes a bubble in the market.
The massive media coverage, enormous amounts of attention, and big promises all contribute to what is known as the "Fear of Missing Out" (FOMO). Numerous individuals enter the market for the sole purpose of speculating because they are motivated by the fear of missing out a once in a lifetime opportunity. Boom stages may be extremely rewarding if handled properly; nevertheless, they are also very unpredictable and, as a result, should be treated with care by professional traders who know how bubbles function to prevent failures that might be very expensive.
When markets approach the euphoric phase, prices often begin to skyrocket. When investors have an extremely optimistic outlook on the potential returns of a company or asset, such optimism may lead to a valuation that is several times higher than what the asset or company is worth. This is a typical indication of an economic bubble, which almost always results in a collapse once the market faces reality and prices fall significantly.
According to the Greater Fool Theory, regardless of how high prices rise, someone will always be ready to pay more. This theory has been associated with "market euphoria," a state in which companies and investors act irrationally out of pure excitement rather than logic. The Greater Fool Theory may come true when individuals buy assets at inflated prices because they believe they will benefit from them. Such irrational behavior can hurt the economy in a big way because it means that a lot of people aren't thinking about long-term returns and are instead buying something with the hope of selling it soon for more money. Ultimately, this theory leads to unsustainable growth cycles that cause big losses for investors who hold on too long when the bubble bursts.
4. Profit Taking
When the market indicates that it may have reached the "pinnacle" of its current cycle, investors may engage in "profit taking," selling assets at high prices. Profit-taking is sometimes seen as a sign of an economic bubble, as investors aim to profit on any potential price gain before the market turns.
Asset values can see a sharp decline when a profit occurs since this might trigger a chain reaction. This is because investors are no longer prepared to hold onto their investments because they fear an even bigger decline in value due to the warning indicators that have been seen in the economy. This quick selling-off leads to a fall in demand for specific stocks or other financial instruments, decreasing pricing and causing losses for those who hadn't sold out earlier and were still holding on to their investments.
When anxiety comes in, investors often seek safe havens and try for rapid returns, which may lead to panic selling. This selling flood may cause a market bubble, which economists call the "panic stage." if investors start selling in fear, it might trigger a chain reaction as more and more people want to get out before it's too late. Selloffs that occur during the panic phase of the market are particularly risky because they have the potential to set off a chain reaction that results in more widespread losses across the board in all market segments. When investors' trust begins to decline, many choose to take out their investments rather than risk more losses.
Top Examples of Economic Bubble
1. The Tulip Mania (1637)
It would seem ridiculous to imagine that a single flower could bring down a whole economy, yet that is exactly what occurred in Holland in the early 1600s. A shortage of tulips caused the Dutch Tulip Craze. The trading in tulip bulbs began unintentionally. A botanist traveled to Constantinople to pick up tulip bulbs, which he planted in his garden for research. After that, some neighbors stole the bulbs and started selling them on the black market. As a luxury item, the rich started to collect some of these rarer types. The price of tulip bulbs skyrocketed as their popularity grew.
Investors started purchasing tulip bulbs because they were under the impression that they might later sell them for a profit. Although the bulbs were first only handled by individuals in the trade, middle-class and lower-class families started taking out loans or mortgaging their houses to purchase bulbs because they believed they could profit from them. During the hipe of the tulip mania, bulbs were sold for hundreds of dollars each and were bought and sold many times daily.
When people started to doubt that prices could stay where they were, they started selling off their holdings. Panic set in, which resulted in a massive selloff and price collapse, which put many new investors out of business.
2. The Great Depression (1929)
When it comes to economic downturns or recessions, the Great Depression is universally recognized as the worst and longest in modern times. It began in America. After then, it started having an influence that could be felt across the globe's economies.
The day when the stock market in the United States experienced a collapse, which occurred on October 24, 1929, and is remembered as "Black Thursday" in the annals of American history, is recognized as the beginning of the Great Depression.
Investors on Wall Street were set into a state of panic as a direct consequence of the effect of the stock market collapse, which led to the loss of about $30 billion from the stock market. As a direct consequence, several other significant financial firms, including banks, went bankrupt.
It is believed that over 5,000 financial institutions failed directly due to the crisis. One of these financial institutions was Boden-Kredit Anstalt, which at the time was considered to be the most significant bank in all of Austria.
There was a huge decrease in the amount of money spent by consumers and investments, which resulted in a considerable reduction in the number of goods produced by industries and the termination of workers in those industries.
Most scholars and economists agree that the 1929 stock market collapse was not the main reason for the Great Depression. Other causes, particularly the Fed's inactivity and subsequent overreaction, also led to the Great Depression. Both President Hoover and President Roosevelt tried, via various programs enacted by their respective administrations, to reduce the severity of the effects of the Great Depression.
3. Black Monday (1987)
The fall of the stock market that occurred in 1929 was not the last one that investors would have to suffer in the following decades, despite the lessons learned from the Great Depression and the measures made by the government to control the financial industry.
On October 19, 1987, the economy saw yet another significant decline. On this day, stock markets all across the globe collapsed, but the event did not occur all at once. On "Black Monday," the United States stock market recorded its largest one-day percentage decline.
The Dow Jones Industrial Average (DJIA) saw a decline that was just more than 22 percent. The greatest one-day decrease in the DJIA during the 1929 stock market collapse was just over 12%, which is a little over half of the decline on Black Monday in 1987. The S&P 500 Index saw a comparable decrease of 20.4% over this period.
4. Asian Financial Crisis
The devaluation of currencies and the burst of the hot money bubble led to the Asian Financial Crisis. It began in Thailand in July 1997 and quickly spread across East and Southeast Asia. In many East and Southeast Asian nations, the financial crisis severely impacted the value of the country's currency, the stock markets, and other asset prices.
On July 2, 1997, the Thai government could not purchase any more foreign money since they had nothing left. After the government realized it could no longer maintain its exchange rate, it was forced to float the Thai baht currency, which had previously been pegged to the value of the United States dollar, because of this, there was an instantaneous drop in the value of the baht compared to other currencies.
Some people attribute the origins of the Asian Financial Crisis to speculative bubbles that formed in Thailand, Malaysia, and Indonesia, as well as to shifts in monetary policy in the United States that made that country a more appealing investment destination. Because Indonesia and South Korea were the two nations that were hit the worst by the crisis, the International Monetary Fund was forced to intervene in an effort to find a solution to the problem. The devaluation of currencies also had a significant impact on Hong Kong, Malaysia, Laos, and the Philippines. These four countries absorbed a significant portion of the burden.
Whatever the case, there was too much credit available, so when prices started to fall, investors and companies with too much debt couldn't pay their bills, and yet another speculative bubble burst.
5. Mississippi Bubble (1716)
John Law and his Bank Générale were largely responsible for the economic devastation in 1716 due to the Mississippi Bubble. Law was permitted to put his economic ideas into reality by the bank, giving him the authority to create notes. His ideas were ahead of his time, but in the end, they brought about a catastrophic downturn in the economic situation in France.
Through his efforts, he monopolized the tobacco products market in France and the trading of enslaved Africans. In 1719, Law decided to change the name of his business to the "Compagnie des Indes."
Soon after, he exerted great influence over a major portion of the nation's commerce with other countries. The value of Law's company's shares skyrocketed as he continued to create and distribute an increasing number of banknotes. It started at five hundred lives and reached a high of eighteen thousand lives, but shortly after, investors attempted to convert their notes into coins, which led to the bubble's bursting and a subsequent fall of the stock market in 1720.
6. Dot-Com Bubble (1995)
The spike in stock markets that came to be known as the "dot-com bubble" was mostly fueled by investments made in businesses based on the internet and other forms of technology. It developed as a result of the widespread practice of speculative investment as well as the excessive amount of venture money that was invested in newly established businesses. In the 1990s, investors began pouring money into internet startup companies with the explicit goal that these companies would eventually be profitable.
With the advent of commercial internet use and other technological advancements, new businesses in the Internet and technology industry boosted the stock market beginning in 1995. Following that, a bubble was developed as a result of easy access to capital and easy access to money.
When the market reached its highest point, investor confidence began to decline, and investors began to worry that this would result in a decline of around 10% in the stock market. Companies with millions of dollars in market capitalization started to lose value. They ended up being worthless, and by the end of the year 2001, the majority of dot-com companies had been liquidated.
7. U.S. Housing Bubble or Credit Crises
In recent memory, one of the most economically debilitating disasters to strike the United States was the financial crisis of 2008. Large financial institutions gave homeowners money and created a series of dangerous investments, including mortgage-backed securities, which led to massive losses and the financial crisis.
These loans made it possible for individuals who, in the past, would not have been able to qualify for mortgages owing to their poor credit ratings or lack of income to purchase houses and become homeowners.
This financial collapse could be seen as the result of bad decisions, but it also shows how important it is to have rules in place to protect markets and investors from similar problems in the future.
Millions of people in the United States lost their jobs. They struggled to make ends meet as businesses all around them filed for bankruptcy as a direct result of the irresponsible actions taken by large banks in the United States during this period. This reckless behavior triggered a global economic recession. Even with government bailouts and economic recovery packages, it took many individuals years to get back on their feet after the crisis.
The fact that economic bubbles have occurred throughout human history demonstrates that there is always the possibility that a bubble may arise as a result of the behavior of humans. Over the course of many centuries, several bubbles of varying types have arisen in various industries, including the stock and real estate markets. A bubble happens when the price of an asset goes up more than what its real value can support. This creates an artificial demand in the market, which causes prices to crash when the bubble bursts. The field of behavioral economics has emerged as an important resource for understanding the mysteries behind the formation of bubbles in the first place.
When studying how people behave economically, behavioral economics considers psychological factors, including beliefs, perceptions, and biases, among other things. It has been used to justify the behavior of investors who buy assets that have little or no intrinsic worth but which they then speculate on to unsustainable heights. This helps economists figure out why certain economic trends happen and how investors can make better decisions about where to put their money.
Having said that, bubbles can bring rewards in the short term when they are handled well. Before making any choices, investors should always ensure that they have done sufficient research and have a solid understanding of the market in which they are investing.