Economic bubble
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An economic bubble (also called a speculative bubble, asset bubble, or simply financial bubble) is a period when current asset prices greatly exceed their intrinsic valuation, being the valuation that the underlying long-term fundamentals justify. Bubbles can be caused by overly optimistic projections about the scale and sustainability of growth (e.g. dot-com bubble), and/or by the belief that intrinsic valuation is no longer relevant when making an investment (e.g. Tulip mania). They have appeared in most asset classes, including stocks (e.g. Roaring Twenties), commodities (e.g. 2007 uranium bubble), real estate (e.g. 2000s US housing bubble), and even esoteric assets (e.g. cryptocurrency bubble). Bubbles usually form as a result of either excess liquidity in markets, and/or changed investor psychology. Large multi-asset bubbles (e.g. 1980s Japanese asset bubble and the 2020–21 Everything bubble) are attributed to central banking liquidity (e.g. overuse of the Fed put).[citation needed]
In the early stages of a bubble, many investors do not recognise the bubble for what it is, often thinking that the increase in asset prices is justified. Therefore, bubbles are often conclusively identified only in retrospect, after the bubble has already "popped" (or "burst") and prices have crashed.[1]
Origin of term
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The term "bubble", in reference to financial crisis, originated in the 1711–1720 British South Sea Bubble, and originally referred to the companies themselves, and their inflated stock, rather than to the crisis itself. This was one of the earliest modern financial crises; other episodes were referred to as "manias", as in the Dutch tulip mania. The metaphor indicated that the prices of the stock were inflated and fragile – expanded based on nothing but air, and vulnerable to a sudden burst, as in fact occurred.
Some later commentators have extended the metaphor to emphasize the suddenness, suggesting that economic bubbles end "All at once, and nothing first, / Just as bubbles do when they burst,"[2] though theories of financial crises such as debt deflation and the Financial Instability Hypothesis suggest instead that bubbles burst progressively, with the most vulnerable (most highly-leveraged) assets failing first, and then the collapse spreading throughout the economy.[3][4]
Types
[edit]There are different types of bubbles,[5] with economists primarily interested in two major types of bubbles: The equity bubble and the debt bubble.
Equity bubble
[edit]An equity bubble[5] is characterised by tangible investments and the unsustainable desire to satisfy a legitimate market in high demand. These kind of bubbles are characterised by easy liquidity, tangible and real assets, and an actual innovation that boosts confidence. The injection of funds into the business cycle is capable of accelerating the innovation process and propelling faster productivity growth.[6][7][8] Examples of an equity bubble are the Tulip Mania, the cryptocurrency bubble, the dot-com bubble, and the Roaring Twenties[9] .
Debt bubble
[edit]A debt bubble[5] is characterised by intangible or credit based investments with little ability to satisfy growing demand in a non-existent market. These bubbles are not backed by real assets and are based on frivolous lending in the hope of returning a profit or security. These bubbles usually end in debt deflation causing bank runs or a currency crisis when the government can no longer maintain the fiat currency. Examples are the Roaring Twenties stock market bubble (which caused the Great Depression) and the United States housing bubble (which caused the Great Recession).
Impact
[edit]The impact of economic bubbles is debated within and between schools of economic thought; they are not generally considered beneficial, but it is debated how harmful their formation and bursting is.
Within mainstream economics, many[who?] believe that bubbles cannot be identified in advance, cannot be prevented from forming, that attempts to "prick" the bubble may cause financial crisis, and that instead authorities should wait for bubbles to burst of their own accord, dealing with the aftermath via monetary policy and fiscal policy.[citation needed]
Political economist Robert E. Wright argues that bubbles can be identified before the fact with high confidence.[10]
In addition, the crash which usually follows an economic bubble can destroy a large amount of wealth and cause continuing economic malaise; this view is particularly associated with the debt-deflation theory of Irving Fisher, and elaborated within Post-Keynesian economics.
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.
Effect upon spending
[edit]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