Financial bubbles: types and causes
Question from the audience: There are "bubbles" in the economy, according to finance and economics. And when bubbles start to form, it's usually not a good sign. What I'm wondering is how many distinct sorts of "bubbles" there are. For example, the real estate or stock market bubbles. What causes them to form, and what are their economic consequences?
Bubbles are often defined as a situation in which the price of assets or financial instruments rises rapidly due to speculative demand and is unsustainable in the long run. The bubble 'bursts' at a particular price, and prices fall to a level that more closely reflects the core economic value. A bubble strongly implies that psychological factors such as unreasonable excitement and overconfidence contribute to the asset's increased value.
Different Types of Bubbles
There is a market bubble. When the price of something in a specific market skyrockets. This could be a housing bubble, for example.
Bubble in commodities. When the price of a single commodity or a group of goods rises. For example, the price of gold may experience a speculative bubble, as it did in the 1970s and 1980s.
There is a stock market bubble. When the value of stocks and shares rises quickly, for example, when prices rise faster than earnings. When market traders believe the bubble prices are over-inflated, a stock market bubble is subject to a fall.
Bubbles in the credit market. Rapid expansion of consumer and commercial credit to support increased consumer spending.
A boom or a bubble in the economy. The idea of a universal economic boom is related to the concept of market bubbles. A boom occurs when the economy grows at an unsustainable rate, resulting in inflation (e.g. aggregate demand grows faster than productive capacity). In the end, an economic boom is usually unsustainable. Market bubbles and economic booms may have a strong relationship. For example, a housing price bubble could result in increased wealth and confidence, which would lead to increased consumer spending and economic development. Higher economic growth, in turn, fuels the housing bubble.
1711-1720 South Sea Bubble A corporation formed to benefit from British trade with South America. The price of shares soared, but as the corporation failed to earn a significant profit, share values plummeted in 1720, returning to pre-issue levels.
In the 1630s, there was a tulip mania. When the price of tulips soared to over 500 times its previous high before falling due to a lack of buyers.
Credit in the 1920s and the housing bubble in the United States In the United States, credit grew rapidly in the 1920s. This helped finance a housing boom as well as a stock market boom. This growth in credit and stock values came to a halt in 1929, when prices plummeted.
Bubble in the dot-com industry. Between 1997 and 2000, the value of internet stocks grew at a breakneck pace.
The credit bubble of the 2000s was characterised by an increase in asset prices and bank lending.
House price bubble
House prices increased by 80% between 2000 and 2006, with house price-to-earning ratios exceeding long-term averages. This was fueled in part by an increase in subprime mortgage lending. The housing market began to shift when interest rates climbed modestly in 2004/05, and prices plummeted from 2006 to 2012.
Causes of Bubbles
Typically, bubbles emerge due to sound economic reasons. Low borrowing rates and economic growth, for example, encouraged individuals to buy homes in the early 2000s. Internet stocks offered good potential growth for this new sector in the 1990s. Rising prices and demand, on the other hand, might create a dynamic in which good news motivates people to take more risks, causing prices to climb faster than they should. Bubbles can be caused by a variety of factors, including:
Exuberance that is irrational. Investors can buy assets under specific conditions due to significant psychological forces that drive them to ignore the asset's underlying value and believe that prices will continue to rise.
This is herding behaviour. People frequently believe that the majority cannot be incorrect. They assume that if banks and well-known financial executives are buying, it must be a solid investment. (irrationality and the economics of herding)
People make decisions based on the short-term rather than the long-term. This is known as short-termism.
Expectations that adapt. People frequently assess the state of a market and economy based on current events.
I'm hoping they can outperform the market. People feel that they can outsmart the market and exit before the bubble bursts.
Filtering out the negative news and hunting for opinions that confirm their ideas - this is cognitive dissonance.
Hypothesis of financial instability The hypothesis that when the economy is doing well, investors become more risky, resulting in financial instability.
Policy monetary. Bubbles can sometimes arise as an unintended result of monetary policy. The Federal Reserve's choice to keep interest rates low in the United States, for example, aided the credit boom of the 2000s. Because people need a place to deposit their money, excess liquidity can easily lead to bubbles.
Global inequalities. Some say that a money infusion from outside created the US financial bubble of the 2000s. The United States had a trade imbalance and attracted large inflows of hot money, resulting in increased demand for US securities. This kept interest rates low and US values higher than they would have been otherwise
On the psychological underpinning of bubbles, Yale economist Robert Shiller said:
“A speculative bubble's psychological foundation is irrational enthusiasm. I'll define a speculative bubble as "a situation in which news of price increases stokes investor enthusiasm, which spreads through psychological contagion from person to person, amplifying stories that might justify the price increase and attracting a larger and larger class of investors who, despite doubts about the investment's real value, are drawn to it partly through envy of others' successes and partly through gambler's excitement."
Effects of Bubbles
Bubbles can be harmful to the economy as a whole, especially if they occur in a crucial market like housing or the stock market. A stock market meltdown can result in a loss of confidence as well as reduced spending. The stock market fall in 1929 was one of the major factors that precipitated the Great Depression. Stock market crashes, on the other hand, do not invariably result in a recession. The stock market fall in 1987, for example, had no effect on economic development.
Because home is the most valuable form of wealth, a housing market bubble is more harmful. If house values fall rapidly, it can lead to a major drop in consumer expenditure and a recession; for example, the 1991 property slump contributed to the UK recession. House price bubbles and busts were a major element in Ireland and Spain's recessions.
The economic impact of commodity bubbles is less certain. A sharp drop in gold and oil prices, for example, will cause some investors to lose a lot of money. Falling oil prices, on the other hand, will assist raise consumer disposable income, which will help the economy.