What Causes Bubbles?

By Amy Fontinelle | September 14, 2011 AAA

Bubbles occur when prices for a particular item rise far above the item's real value. Examples include houses, Internet stocks, gold or baseball cards. Sooner or later, the high prices become unsustainable and they fall dramatically until the item is valued at or even below its true worth.

While most people agree that asset bubbles are a real phenomenon, they don't always agree on whether a specified asset bubble exists at a given time. There is no definitive, universally accepted explanation of how bubbles form. Each school of economics has its own view. Let's take a look at some of the most common economic perspectives on the causes of asset bubbles.

TUTORIAL: The Austrian School Of Economics

The Classical-Liberal Perspective
The accepted mainstream view about central banks, such as the Federal Reserve, is that we need them to manage economic growth and ensure prosperity through interest rate manipulation and other interventions. However, classical liberal economists think the Fed is unnecessary and that its interventions distort markets, yielding negative consequences. They see central bank monetary policies as a prime cause of asset bubbles.

In his book "Early Speculative Bubbles and Increases in the Money Supply," Austrian-school economist Douglas E. French writes that when the government prints money, interest rates fall below their natural rate, encouraging entrepreneurs to invest in ways that they otherwise would not, and fueling a bubble that eventually must burst and force these malinvestments to be liquidated. He also states, "While history clearly shows that ... government meddling in monetary affairs ... leads to financial market booms and the inevitable busts that follow, mainstream economists either deny that financial bubbles can occur or claim that the 'animal spirits' of market participants are to blame."

The Internet stock bubble of the late 1990s and early 2000s provides an example of how a central bank's easy money policy can encourage unwise investments. Under Fed Chairman Alan Greenspan, writes award-winning financial reporter Peter Eavis in a 2004 article, "credit growth was rampant through the late '90s, which led to excessive investment by businesses, particularly in high-technology items. This investment led to the Nasdaq boom, but it took only a small uptick in interest rates to cause the whole technology sector to collapse in 1999 and 2000."

The Keynesian Perspective
The "animal spirits" idea that French refers to represents another take on bubbles that was coined by the early 19th century economist John Maynard Keynes. Keynes's theories form the basis of the well-known Keynesian school of economics. Keynesian ideas are still alive today and are greatly at odds with Austrian ideas. (For related reading, see Giants Of Finance: John Maynard Keynes.)

Whereas Austrian economists believe that government interventions cause the periods of economic boom and bust known as business cycles, Keynesian economists believe that recessions and depressions are unavoidable and that an activist central bank can mitigate fluctuations in the business cycle.

In his famous book, "The General Theory of Employment, Interest and Money," Keynes writes, "a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic ... if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die; though fears of loss may have a basis no more reasonable than hopes of profit had before." "Animal spirits" thus refers to the tendency to for investment prices to rise and fall based on human emotion rather than intrinsic value.

The boom years before the Great Depression exemplify the animal spirits concept. In the stock market boom that preceded the Depression, suddenly everyone was an investor. People thought the market would always go up and that there was no risk in investing. The herd mentality of ignorant investors contributed to the run-up in stock prices and to their subsequent collapse.

There is some disagreement over the idea that we are currently experiencing a gold bubble. Investopedia analyst Arthur Pinkasovitch, for example, believes that a long-term change in fundamentals has been driving up gold prices slowly but steadily. (Throughout history, gold has held its value against paper currencies. For more, see Gold: The Other Currency.)

However, there is a compelling argument that the gold bubble is real and that the "everything is different now" philosophy won't be any more true with today's gold prices than it was with past Internet stock and housing prices.

Historically, gold prices have largely been flat or grown incrementally. A spike to $615 an ounce occurred in 1980 followed by a crash to around $300 an ounce, where prices more or less remained until 2006. Since that year, gold prices have risen higher than $1,900 an ounce before falling down to the $1,600 range recently. The Wall Street Journal reports that gold returns over the last five years are a compounded 25% per year, far above average returns on most other assets.

"Animal spirits" might be driving gold prices higher, but so might central bank policies that are contributing to (or at least failing to control) economic uncertainty and instability. Uncertainty tends to make gold appear to be a safe, inflation-protected store of long-term value.

One Problem, Multiple Causes

Any number of factors, from easy money to irrational exuberance to speculation to policy-driven market distortions, may have a hand in the inflation and bursting of bubbles. Each school of thought thinks that its analysis is the correct one, but we have yet to reach a consensus on the truth. (For related reading, see When The Federal Reserve Intervenes And Why.)

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