To begin with, an economic bubble is also called an asset bubble. However, the commonly used term is the economic bubble. Therefore, an economic bubble is the trade in an asset at a price that strongly exceeds its intrinsic value. This normally happens in a situation where the asset’s price appear to be based on implausible and inconsistent views about the future.
We should not confuse economic bubble with inflation. Whereas an economic bubble deals with only assets, inflation deals with all goods and services, including assets. In the era of economic bubble, the assets concerned either increase or appreciate in value, based on the prevailing economic circumstances.
The first economic bubble in history was recorded in the Netherlands in the mid 1630s. It is really difficult to observe the intrinsic values in assets in the real-life markets. In view of that, bubbles are mostly identified only in retrospect, once there is a sudden drop in the asset’s price. This sudden drop in the asset’s price is termed a crash or a bubble burst.
Some economists argue against bubbles. They are of the view that the causes of bubbles remain disputed in the sense that assets prices often deviate strongly from their intrinsic values. Many explanations have been suggested and research has recently shown that bubbles may appear even without uncertainty, speculation or bounded rationality. In this case, they can be called non-speculative bubbles or sunspot equilibria. In such cases, the bubbles may be argued to be rational, where investors at every market are fully compensated for the possibility that the bubble might collapse by higher returns.
These approaches require that the timing of the bubble collapse can only be forecast probabilistically and the bubble process is often modelled using a switching model developed by Markov. Similar explanations suggest that bubbles might ultimately be caused by processes of price coordination.
More recent theories of asset bubble formation suggest that these events are sociologically driven. Explanations have focused on emerging social norms and the role that culturally-situated stories or narratives play in these events.
The term “economic bubble”, in reference to financial crisis, originated in the 1700s in the British South Sea Bubble. It referred to the companies and their inflated inventories, rather than the crisis itself. This was one of the earliest modern financial crises, other episodes were termed “manias”, as in the Netherlands tulip mania.
The metaphor indicated that the prices of the inventories were inflated and fragile. Some commentators have extended the metaphor to emphasise the suddenness, suggesting that economic bubbles end, all at once and nothing first, just as bubbles do when they burst. Though, the theories of financial crises such as debt-deflation and financial instability hypothesis suggest instead that bubbles burst progressively, with the most vulnerable or highly leveraged assets failing first and the collapse spreading throughout the economy.
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 are. Within mainstream economics, many believe that bubbles cannot be identified in advance and prevented from forming.
The authorities deal with economic bubble by using monetary and fiscal policies. Robert Wright, a political economist, argued that bubbles can be identified with high confidence before the facts become bear. 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 cause 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. Many observers quote the housing market in the UK, Spain, Australia and other parts of US 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 (the cost of borrowing money). Historically, this is not the only approach taken by central banks. It has been argued that they should stay out of an economic bubble and let it, if it is one, take its course.
Economists and other professionals evolved the possible causes of an economic bubble. Excess monetary expansion can create massive commodities bubbles. A central bank could rein in excess money and raise interest rates, to bring down the popped commodities bubbles.
Similarly, low interest rate policies could be used to exacerbate economic bubbles. It has also been variously suggested that economic bubbles may be rational, intrinsic and contagious. To date, there is no widely accepted theory to explain their occurrences. Recent computer-generated agency models suggest excessive leverage could be a key factor in causing economic bubbles.
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.
Nevertheless, bubbles have been observed repeatedly in experimental markets, even with participants such as business students, managers and all other practitioners. Experimental bubbles have proven robust to a variety of conditions, including short-selling, margin buying and insider trading.
While there is no clear agreement on what causes economic bubbles, there is evidence to suggest that they are not caused by bounded rationality or assumptions about the irrationality of others. It has also been shown that bubbles appear even when market participants are well-capable of pricing assets correctly. Further, it has been shown that bubbles appear even when speculation is not possible or when over-confidence is absent.
Most recent theories of asset bubble formation suggests that they are likely sociologically-driven events. Explanations here merely involve fundamental factors or snippets of human behaviour. Quantitative researchers argue that market speculation is driven by culturally-situated narratives that are deeply embedded in and supported by the prevailing institutions of the time.
They cite factors such as bubbles forming during periods of innovations, easy credit, loose regulations and internationalised investment as reasons why narratives play such an influential role in the growth of asset bubbles.
Another possible cause of economic bubble is excessive monetary liquidity in the financial system, inducing lax or inappropriate lending standards by the banks, which makes markets vulnerable to volatile asset price inflation caused by short-term and leveraged speculation.
The former president of the Deutsche Bundesbank, Axel Weber, 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. According to the explanation, excessive monetary liquidity potentially occurs while fractional reserve banks are implementing expansionary monetary policy.
This explanation may differ in certain details according to economic philosophy. Those who believe the money supply is controlled exogenously by a central bank may attribute an expansionary monetary policy to the said bank and a governing body or institution and others who believe that the money supply is created endogenously by the banking sector may attribute such a policy with the behaviour of the financial sector itself and view the state as a passive or reactive factor.
This may determine how central or relatively inconsequential policies like fractional reserve banking and the central bank’s efforts to raise or lower short-term interest rates are to one’s view on the creation, inflation and ultimate implosion of an economic bubble.
In conclusion, economic bubbles often occur when too much money is chasing too few assets, causing both good and bad assets to appreciate excessively beyond their fundamentals to an unsustainable level. Once the bubble bursts, the fall in prices causes the collapse of unsustainable investment schemes, which leads to a crisis of consumer confidence that may result in a financial panic and crisis.
If there is monetary authority like the central bank, it may be forced to take a number of measures in order to soak up the liquidity in the financial system or risk a collapse of its currency. This may involve actions like bailouts of the financial system but also others that reverse the trend of monetary accommodation, commonly termed as “forms of contractionary monetary policy”.