Economic bubble

An economic bubble (sometimes referred to as a speculative bubble, a market bubble, a price bubble, a financial bubble, or a speculative mania) is “trade in high volumes at prices that are considerably at variance with intrinsic values”.

While some economists deny that bubbles occur, 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, speculation, or bounded rationality. Most recently, it has been suggested that bubbles might ultimately be caused by processes of price coordination or emerging social norms. Because it is often difficult to observe intrinsic values in real-life markets, bubbles are often 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.

Impact

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. 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 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, 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 poorness and tend to cut discretionary spending at the same time, hindering economic growth or, worse, exacerbating the economic slowdown. Therefore, it is imperative for the central bank to keep its eyes 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).

Bubbles and purported bubbles: examples

Examples of economic bubbles include:

Tulip mania (top 1637)
The South Sea Company (1720)
Mississippi Company (1720)
Railway Mania (1840s)
Florida speculative building bubble (1926)
The Nifty Fifty American stocks of the late 1960s and early 1970s
Poseidon bubble (1970)
Sports cards and comic books in the 1980s and early 1990s
TY Beanie Babies (1996)
The Dot-com bubble (circa 1995–2001)
Japanese asset price bubble (1980s)
1997 Asian Financial Crisis (1997)
Exotic Livestock production in North America (i.e. llamas, white tail deer, elk, wild boar, and to a lesser extent bison)
Real estate bubble

British property bubble (as of 2006)
Irish property bubble (as of 2006)
Spanish property bubble (as of 2006)
Romanian property bubble (as of 2008)
United States housing bubble (as of 2007)

(The former Florida swampland real estate bubble)

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

Aftermath of bubbles: examples

Great Depression
Panic of 1837

References

1. King, Ronald R.; Smith, Vernon L.; Williams, Arlington W. and van Boening, Mark V. "The Robustness of Bubbles and Crashes in Experimental Stock Markets," R. H. Day and P. Chen, Nonlinear Dynamics and Evolutionary Economics. Oxford, England: Oxford University Press, 1993
2. Lahart, Justin, "Bernanke's Bubble Laboratory, Princeton Protégés of Fed Chief Study the Economics of Manias", The Wall Street Journal, May 16, 2008; Page A1 [1]
3. Peter Garber (2001), Famous First Bubbles: The Fundamentals of Early Manias. MIT Press, ISBN 0262571536.
4. Smith, Vernon L., Gerry L. Suchanek, and Arlington W. Williams. 1988. "Bubbles, Crashes, and Endogenous Expectations in Experimental Spot Asset Markets." Econometrica 56:1119-1151
5. Lei, Vivian, Charles N. Noussair, and Charles R. Plott. 2001. "Nonspeculative Bubbles in Experimental Asset Markets: Lack of Common Knowledge of Rationality Vs. Actual Irrationality." Econometrica 69:831
6. Levine, Sheen S. and Zajac, Edward J., "The Institutional Nature of Price Bubbles" (June 20, 2007). Available at SSRN: http://ssrn.com/abstract=960178
7. Hommes, Cars, Joep Sonnemans, Jan Tuinstra, and Henk van de Velden. 2005. "Coordination of Expectations in Asset Pricing Experiments." Review of Financial Studies 18:955-980
8. Garber, Peter M. 1990. "Famous First Bubbles." The Journal of Economic Perspectives 4:35-54
9. Froot, Kenneth A., and Maurice Obstfeld. 1991. "Intrinsic Bubbles: The Case of Stock Prices." American Economic Review 81:1189-1214
10. Topol, Richard. 1991. "Bubbles and Volatility of Stock Prices: Effect of Mimetic Contagion." The Economic Journal 101:786-800.
11. Buchanan, Mark Why economic theory is out of whack New Scientist, 19 July 2008

Links

• Discussion of the recent stock market bubble
• Discussion of the US housing bubble and conflicting opinions.
• When Bubbles Burst (PDF), World Economic Outlook, International Monetary Fund, April 2003.

This guide is licensed under the GNU Free Documentation License. It uses material from the Wikipedia.

Video: Causes of Economic Recession (The bursting of the housing market bubble of the United States and the unfolding credit crisis of other countries are some contributing factors for a global recession.)