Everything about Economic Bubble totally explained
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 from
intrinsic values”.
The cause of bubbles remains a challenge to economic theory. 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 institutionalization. intrinsic, and contagious,. To date, there's no widely accepted theory to explain their occurrence.
Puzzlingly, 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 sophisticated 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.
While it isn't clear what causes bubbles, there's evidence to suggest that they're 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.
Further, it has been shown that bubbles appear even when
speculation isn't possible
or when
over-confidence is absent.
Greater Fool theory
Popular among laymen but recently discredited by empirical research,
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 rapacious 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.
Liquidity
Others argue that the cause of bubbles is excessive monetary liquidity in the financial system. However, this explanation can't be complete, because bubbles appear even in experimental markets that are carefully controlled.
According to the explanation, excessive monetary liquidity (easy credit, large disposable incomes) potentially occurs while central banks are implementing expansionary monetary policy (for example 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. The bubbles will burst only when the central bank reverses its monetary accommodation policy and soaks up the liquidity in the financial system. 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.
Greed
Another insufficient explanation is that economic bubbles are mainly driven by the greed and
irrational exuberance of overly bullish investors. They argue 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're no longer well compensated for holding those risky assets, that'll start to demand higher rates of return on their investments.
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's 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".
Bubbles and purported bubbles: examples
Examples of economic bubbles include:
Other goods which have produced bubbles include
postage stamps and coin collecting.
Aftermath of bubbles: examples
Great Depression
Panic of 1837Further Information
Get more info on 'Economic Bubble'.
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