Economic bubble

An economic bubble (sometimes referred to as a speculative bubble, a market bubble, a price bubble, a financial bubble, a speculative mania or a balloon) is “trade in high volumes at prices that are considerably at variance with intrinsic values”.[1][2] (Another way to describe it is: trade in products or assets with inflated values.)

While some economists deny that bubbles occur,[3] the cause of bubbles remains a challenge to those who are convinced that asset prices often deviate strongly from intrinsic values.

While many explanations have been suggested, it has been recently shown that bubbles appear even without uncertainty,[4] speculation,[5] or bounded rationality.[6] It has also been suggested that bubbles might ultimately be caused by processes of price coordination[7] or emerging social norms.[6] Because it is often difficult to observe intrinsic values in real-life markets, bubbles are often conclusively identified only in retrospect, when a sudden drop in prices appears. Such a 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 erratically, and become impossible to predict from supply and demand alone.

Contents

Origin of term

A card from the South Sea Bubble.

The term "bubble", in reference to financial crises, 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,"[8] 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-levered) assets failing first, and then the collapse spreading throughout the economy.

Impact

The impact of economic bubbles is debated within and between schools of economic thought; they are not generally considered beneficial, but it's debated how harmful their formation and bursting is.

Within mainstream economics, many believe that bubbles cannot be identified in advance, cannot be prevented from forming, that attempts to "prick" the bubble cause financial crises, and that instead authorities should wait for bubbles to burst of their own accord, dealing with the aftermath via monetary policy and fiscal policy.

Within Austrian economics, 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; this forms the basis of Austrian business cycle theory.

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.

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, New Zealand, 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 reduced wealth and tend to cut discretionary spending at the same time, hindering economic growth or, worse, exacerbating the economic slowdown. In an economy with a central bank, the bank may therefore attempt to keep an eye 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) (Historically, this is not the only approach taken by central banks. It has been argued [9] that they should stay out of it and let the bubble, if it is one, take its course.)

Possible causes

In the seventies excess monetary expansion after the U.S. came off the gold standard (August 1971) created massive commodities bubbles. These bubbles only ended when the U.S. Central Bank (Federal Reserve) finally reigned in the excess money, raising federal funds interest rates to over 14%. The commodities bubble popped and prices of oil and gold, for instance, came down to their proper levels. Similarly, low interest rate policies by the U.S. Federal Reserve in the 2001-2004 created housing and commodities bubbles. These bubbles once again popped as soon as fed funds rates were raised to natural levels.

It has also been variously suggested that bubbles may be rational,[10] intrinsic,[11] and contagious.[12] To date, there is no widely accepted theory to explain their occurrence. Recent computer-generated agency models suggest excessive leverage could be a key factor in causing financial bubbles.[13]

Puzzlingly for some, 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.[4] Nevertheless, bubbles have been observed repeatedly in experimental markets, even with 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.[1]

While there is no clear agreement on 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 theory. It has also been shown that bubbles appear even when market participants are well-capable of pricing assets correctly.[6] Further, it has been shown that bubbles appear even when speculation is not possible[5] or when over-confidence is absent.[6]

Austrians believe that market participants´ decisions are blurred by the wrong price signals given by artificially low interest rates, which explains why many of these are "fooled" during an asset bubble (they call this the cluster of errors).

Liquidity

One possible cause of bubbles is excessive monetary liquidity in the financial system, inducing lax or inappropriate lending standards by the banks, which asset markets are then caused to be vulnerable to volatile hyperinflation caused by short-term, leveraged speculation.[13] For example, Axel A. Weber, the president of the Deutsche Bundesbank, has argued that "The past has shown that an overly generous provision of liquidity in global financial markets in connection with a very low level of interest rates promotes the formation of asset-price bubbles."[14] According to the explanation, excessive monetary liquidity (easy credit, large disposable incomes) potentially occurs while fractional reserve 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. Once the bubble bursts the central bank will be forced to reverse its monetary accommodation policy and soak up the liquidity in the financial system or risk a collapse of its currency. 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 approach would be to increase capital reserve requirements during periods of strong economic growth. This would both reduce the chance of entering over-expansion while also lessening the impact of a downturn by strengthening financial institutions while the economy is strong.

Advocates of this perspective refer to (such) bubbles as "credit bubbles," and look at such measures of financial leverage as debt to GDP ratios to identify bubbles.

Social psychology factors

Greater fool theory

Popular among laymen but not fully confirmed by empirical research,[5][6] greater fool 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 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.

Extrapolation

Extrapolation is projecting historical data into the future on the same basis; if prices have risen at a certain rate in the past, they will continue to rise at that rate forever. The argument is 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.

Herding

Another related explanation used in behavioral finance lies in herd behavior, the fact that investors tend to buy or sell in the direction of the market trend. This is sometimes helped by technical analysis that tries precisely to detect those trends and follow them, which creates a self-fulfilling prophecy.

Investment managers, such as stock mutual fund managers, are compensated and retained in part due to their performance relative to peers. Taking a conservative or contrarian position as a bubble builds results in performance unfavorable to peers. This may cause customers to go elsewhere and can affect the investment manager's own employment or compensation. The typical short-term focus of U.S. equity markets exacerbates the risk for investment managers that do not participate during the building phase of a bubble, particularly one that builds over a longer period of time. In attempting to maximize returns for clients and maintain their employment, they may rationally participate in a bubble they believe to be forming, as the risks of not doing so outweigh the benefits.[15]

Moral hazard

Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. A person's belief that they are responsible for the consequences of their own actions is an essential aspect of rational behaviour. An investor must balance the possibility of making a return on their investment with the risk of making a loss - the risk-return relationship. A moral hazard can occur when this relationship is interfered with, often via government policy. A recent example is the Troubled Asset Relief Program (TARP) which provided a Government bailout for many financial and non-financial institutions who speculated in high-risk financial instruments during the housing boom and suffered losses due to the corresponding drop in housing prices. An historical example was intervention by the Dutch Parliament during the great Tulip Mania of 1637.

Other possible causes

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".

Net Result of a Bubble: The one true constant with all bubbles is that they create excess demand and production. Once the bubble deflates, which it always does, a contraction or consolidation has to occur to alleviate the excess. Two perfect examples are the Dot Com Bubble and the current Housing Bubble. In both cases there were huge consolidations, bankruptcies, and deterioration of asset values.

Examples of bubbles and purported bubbles

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

Examples of aftermaths of bubbles

See also

References

  1. ↑ 1.0 1.1 King, Ronald R.; Smith, Vernon L.; Williams, Arlington W. and van Boening, Mark V. (1993). "The Robustness of Bubbles and Crashes in Experimental Stock Markets". In R. H. Day and P. Chen. Nonlinear Dynamics and Evolutionary Economics. New York: Oxford University Press. ISBN 0195078594. 
  2. ↑ Lahart, Justin (2008-05-16). "Bernanke's Bubble Laboratory, Princeton Protégés of Fed Chief Study the Economics of Manias". The Wall Street Journal: p. A1. http://online.wsj.com/article/SB121089412378097011.html. 
  3. ↑ Garber, Peter (2001). Famous First Bubbles: The Fundamentals of Early Manias. Cambridge, MA: MIT Press. ISBN 0262571536. 
  4. ↑ 4.0 4.1 Smith, Vernon L.; Suchanek, Gerry L.; Williams, Arlington W. (1988). "Bubbles, Crashes, and Endogenous Expectations in Experimental Spot Asset Markets". Econometrica 56: 1119–1151. 
  5. ↑ 5.0 5.1 5.2 Lei, Vivian; Noussair, Charles N.; Plott, Charles R. (2001). "Nonspeculative Bubbles in Experimental Asset Markets: Lack of Common Knowledge of Rationality Vs. Actual Irrationality". Econometrica 69: 831. 
  6. ↑ 6.0 6.1 6.2 6.3 6.4 Levine, Sheen S.; Zajac, Edward J. (2007-06-27). The Institutional Nature of Price Bubbles. http://ssrn.com/abstract=960178. 
  7. ↑ Hommes, Cars; Sonnemans, Joep; Tuinstra, Jan; Velden, Henk van de (2005). "Coordination of Expectations in Asset Pricing Experiments". Review of Financial Studies 18: 955–980. 
  8. ↑ Quote from The Deacon's Masterpiece or The One-Hoss Shay, by Oliver Wendell Holmes, Sr.
  9. ↑ http://www.gold-eagle.com/editorials/cscb001.html
  10. ↑ Garber, Peter M. (1990). "Famous First Bubbles". The Journal of Economic Perspectives 4: 35–54. 
  11. ↑ Froot, Kenneth A.; Obstfeld, Maurice (1991). "Intrinsic Bubbles: The Case of Stock Prices". American Economic Review 81: 1189–1214. 
  12. ↑ Topol, Richard (1991). "Bubbles and Volatility of Stock Prices: Effect of Mimetic Contagion". The Economic Journal 101: 786–800. 
  13. ↑ 13.0 13.1 Buchanan, Mark (2008-07-19). "Why economic theory is out of whack". New Scientist. http://forum.globalhousepricecrash.com/index.php?act=attach&type=post&id=4127. Retrieved 15 December 2008. 
  14. ↑ Weber Says ECB Has Used Room to Cut Interest Rates
  15. ↑ Blodget-The Atlantic-Why Wall St. Always Blows It
  16. ↑ "Historical Rhodium Charts". Kitco. http://www.kitco.com/charts/historicalrhodium.html. Retrieved 2010-02-19. 

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