The Common Sense Investor

What is an economic bubble?

An economic bubble is the commonly used term for an economic cycle that is characterized by a rapid expansion followed by a contraction, often times in a dramatic fashion.

The concept of “bubbles†are also posited as a theory which holds that security prices will always rise above their real value and will continue to do so until prices drop and the bubble bursts.

While some bubbles happen naturally as a part of the economic cycle, some also occur as a result of investor exuberance and serve as correctives. These typically happen in securities, stock markets, real estate and various other business sectors because of certain changes in the way key players conduct business. The popping of a bubble can often have significant economic repercussions.

The results of economic bubbles vary depending on the situation. It can be a substantial change as evidenced by the economic bubble economy of Japan in the 1980s that resulted in banks becoming partially deregulated. It can also result in an economic paradigm shift, as evidenced by the dotcom boom in the late 1990’s and early 2000s. During the dotcom boom people frenetically bought tech stocks even at high prices, firmly believing that they can sell these high-priced stocks at even higher prices until confidence was lost on these stocks and a large market correction, or a crash, occurred. Bubbles that happen in equities markets and economies tend to cause resources to be transferred to areas of fast growth. At the end of the cycle of a bubble, the resources are then moved again, causing prices to suddenly deflate.

What causes economic bubbles?

The exact cause of economic bubbles has been disputed by many economists. Some experts think that bubbles are related to inflation and therefore believe that the factors which cause inflation could also be the same factors that cause bubbles to occur. Other experts are of the opinion that there is a basic fundamental value to every asset and the bubbles represent an increase or rise over that fundamental value. This rising movement must eventually return to that fundamental value, which is its natural state.

There are also chaotic theories regarding the formation of bubbles. These theories maintain that bubbles come from certain critical states in the market that originate from the communication of economic players. Still a few others see bubbles as a necessary effect of unreasonably valuing assets based solely on their returns in the recent past without really thinking from a macro perspective or regard for economic fundamentals.

There are some economists who also theorize that a bubble is an imbalance in the way people perceive opportunities, because they try to chase the prices of assets instead of making purchases based on the intrinsic value of the assets (this could also be called a speculator’s mentality). It is also maintained that bubbles are a manifestation of the basic tenet that a market is very efficient in the long-term but not very efficient in the short-term.

Short-term economic bubbles (less than 10 years), which should be viewed as mistakes or artificial situations, tend to result in a natural correction of the economic imbalance. Less is known about long-term bubbles which could prove to be much more devastating to an economy. Long-term bubbles could result from a systematic misperception of the value of certain goods and services as well as long-term manipulation of financial records and lending practices by powerful governments and corporations. Rather than ushering in a recession, the correction of a long-term bubble has the potential of marking the beginning of a long period of depression.

What is a stock market bubble?

A stock market bubble in the financial markets is a term that applies to a self propagating rise or increase in the share prices of stocks in a particular industry or sector. The term “stock market bubble†can only be used with any certainty in retrospect when share prices have since fallen drastically or crashed. A bubble happens when speculators notice the swift rise in value of stocks and then decide to buy more of the same stocks as a way of anticipating further rises rather than because the shares have been undervalued. This buying spree results in many companies’ shares becoming grossly overvalued creating a widening discrepancy between the share price and the actual value of the stocks. When the bubble bursts the share prices will fall very swiftly and dramatically, with the falling prices trying to seek the fundamental value of the stocks. This can actually result in many companies going out of business.

One of the most recent examples of a stock market bubble happened during the dotcom boom of the late 1990s and early 2000, when tech stocks became the subject of a buying frenzy, and when the bubble burst the effects were devastating in that many companies had to close down.

What is a Real Estate Bubble?

A real estate bubble happens when the prices of housing rise at a rapid pace. In a regular market, prices would rise along with the rate of inflation or the increase in average incomes. At some point, when the prices are already too high the bubble would burst and housing prices would come tumbling down. This would consequently result in the housing market to collapse. This would often be followed by a recession in the area. This is different from a real estate boom in that the cycle must usually run its course and a marker correction happens at a more gradual pace with prices eventually settling down to more realistic and levels.

There are a lot of speculations and arguments among experts about real estate bubbles and a real estate boom. But either way, the rising cost of housing is compelling people to take on risky debts. A fall in interest rates can actually fuel a real estate bubble (or a boom). This makes higher priced houses more within reach of people and this could make homebuyers be more willing to take out second or third mortgages, variable rate loans, loan terms that are longer than 30 years, mortgages that far exceed the actual value of the home as well as interest-only loans. These moves can place homebuyers at a high financial risk position because their moves are actually giving more legs to the bubble.

How can economic bubbles be prevented?

When it comes to preventing economic bubbles that have an effect on international finance (those that can affect a country’s economy), a classical solution is always propagated by some. This is the idea of having an international lender of last resort who will lend money or resources when no one else will and will also alleviate the situation with its moves, thus preventing people and various monetary institutions from panicking and suddenly unloading their investments. A number of economists have identified the International Monetary Fund (IMF) as a good international lender of last resort because of its primary role in the international monetary system but, unfortunately, the IMF does not have the resources and institutional commitment to assume this role.

In the 1990s, the United States performed the role of lender of last resort, usually with the aid of other countries and international organizations. But it remains unclear how long one country can perform this crucial role without exhausting its own resources.

As it is occurrences of international investment bubbles (like the one that happened in Mexico in 1994-95, or the Asian financial crisis of 1997-98) will still likely happen with no clear solutions in place.

Suggested Books on Economic Bubbles

Stock Markets, Speculative Bubbles and Economic Growth
by Mathias Binswanger

Rational Bubbles: Theoretical Basis, Economic Relevance, and Empirical Evidence With a Special Emphasis on the German Stock Market
by Matthias Salge

Economic Uncertainty, Instabilities And Asset Bubbles: Selected Essays
by A. G. Malliaris

Economic Complexity: Chaos, Sunspots, Bubbles, and Nonlinearity
by William A. Barnett (Series Editor), John Geweke (Editor), Karl Shell (Editor)

The Stock Market: Bubbles, Volatility, and Chaos
by G.P. Dwyer (Editor), R.W. Hafer (Editor)

Bleeding Bull: The Stock Market Bubble and the American Middle Class
by Vladimir Sarkoff

How to Profit from the Coming Real Estate Bust: Money-Making Strategies for the End of the Housing Bubble
by John Rubino

The Coming Crash in the Housing Market: 10 Things You Can Do Now to Protect Your Most Valuable Investment
by John R. Talbott

Just What I Said: Bloomberg Economics Columnist Takes on Bonds, Banks, Budgets, And Bubbles
by Caroline Baum

Further Reading Material on Economic Bubbles

Investor Dictionary Entry on Economic Bubbles

Wikipedia Entry on Economic Bubbles

The Stock Market Bubble Debate

Breaking The Real Estate Bubble Myth