How Do Asset Bubbles Cause Recessions?

Asset price bubbles shoulder the blame for some of the most devastating recessions in history. The stock market bubble of the 1920s, the dot-com bubble of the 1990s, and the real estate bubble of the 2000s were asset bubbles followed by sharp economic downturns.

Asset bubbles are especially devastating for individuals and businesses who invest too late, meaning shortly before the bubble bursts. In this regard, asset price bubbles bear a similarity to Ponzi or pyramid scams. The inevitable collapse of asset bubbles wipes out the net worth of investors and causes exposed businesses to fail, potentially touching off a cascade of debt deflation and financial panic that can spread to other parts of the economy, resulting in a period of higher unemployment and lower production that characterizes a recession.

Key Takeaways

  • Asset bubbles exist when market prices in some sectors increase over time and trade far higher than fundamentals would suggest.
  • Expansion of the supply of money and credit in an economy provides the necessary fuel for bubbles.
  • Technological factors, incentives created by public policies, and the particular historical circumstances around a given bubble help to determine which asset classes and industries are the focus of a bubble.
  • Market psychology and emotions like greed and herding instincts are thought to magnify the bubble further. 
  • When bubbles eventually burst, they tend to leave economic pain in their wake, including recession or even economic depression.

How Asset Bubbles Can Lead to Recession

An asset bubble occurs when the price of an asset, such as stocks, bonds, real estate, or commodities, rises at a rapid pace without underlying fundamentals to justify the price spike.

It is normal to see prices rise and fall over time as buyers and sellers discover and move toward equilibrium in a series of successive trades over time. It is normal to see prices overshoot (and undershoot) the prices implied by the fundamentals of supply and demand as this process proceeds, and this has been readily demonstrated by economists in controlled experiments and classroom exercises. 

Price Discovery

Prices normally rise and fall in any market, but they tend toward the fundamental value of the traded goods or assets over time.

In actual markets, prices may always be either above or below the implicit equilibrium price at any given point as the fundamentals of supply and demand change over time while the price discovery process is simultaneously in motion. However, there is always a tendency for prices to seek or move toward the implicit equilibrium price over time as market participants gain experience and information about market fundamentals and the past series of prices. 

What makes a bubble different is that the prices for a given class of assets or goods overshoot the implied market equilibrium price, remain persistently high, and even continue to climb rather than correcting toward the expected equilibrium prices. This happens because of an increase in the supply of money and credit flowing into that market, which gives buyers the ability to continue to bid prices higher and higher. 

Asset Price Bubbles

In an asset price bubble, new money entering the market keeps prices rising well beyond the fundamental value of the underlying assets implied by simple supply and demand.

When a central bank or other monetary authority expands the supply of money and credit in an economy, the new units of money always enter the economy at a specific point in time and into the hands of specific market participants, and then spread out gradually as the new money changes hands in successive transactions. Over time, this causes most or all prices to adjust upward, in the familiar process of price inflation, but this does not happen instantaneously to all prices. 

Early recipients of the new money are thus able to bid up prices for the assets and goods that they purchase before prices in the rest of the economy rise. This is part of the economic phenomenon known as the Cantillon Effect. When buying activity in the market is focused on a specific asset class of assets or economic goods by the circumstances of the time, then the relative prices of those assets rise compared to other goods in the economy. This is what produces an asset price bubble. The prices of these assets no longer reflect just the real conditions of supply and demand relative to all other goods in the economy, but are driven higher by the Cantillon Effect of the new money entering the economy.

Richard Cantillon

Richard Cantillon was an 18th-century economist and investor who participated in and later wrote about asset price bubbles and the effects of monetary expansion.

Like a snowball, an asset bubble feeds on itself. When an asset price begins rising at a rate appreciably higher than the broader market, opportunistic investors and speculators jump in and bid the price up even more. This leads to further speculation and further price increases not supported by market fundamentals. The expectation of future price appreciation in the bubble assets itself drives buyers to bid prices higher. The resulting flood of investment dollars into the asset pushes the price to even more inflated levels.

The real trouble starts when the asset bubble picks up so much speed that everyday people, effectively the last recipients of the newly created money as it trickles down through to their wages and business income, many of whom have little to no investing experience, take notice and decide they too can profit from rising prices. At this point, prices throughout the economy already have begun to rise, as the new money has spread through the economy to reach the pockets of these everyday people. Because it is now circulating throughout the economy, the new money no longer has the power to continue pushing the relative prices of the bubble assets up compared with other goods and assets. 

Early recipients of the new money sell to the latecomers, realizing outsized profits. These late buyers, however, realize little or no gains as the price bubble stalls for want of new money. The price bubble is no longer sustainable without additional injections of new money (or credit) by the central bank or monetary authority.    

The bubble then begins to deflate. Other prices in the economy are rising to normalize the relative prices of the bubble assets, and no new money is entering the economy to fuel more bubble price rises, both of which also damp expectations of future bubble price appreciation. Late buyers are disappointed by lackluster gains and the speculative optimism that magnified the bubble‘s rise now reverses. Bubble prices begin to fall back toward those implied by market fundamentals. 

The central bank or other monetary authority may at this point try to continue inflating the bubble by injecting more new money and repeating the process described above. Alternatively, after a sustained period of monetary injections and bubble inflation, it may cut back on injecting new money to tamp down consumer price and wage inflation. Sometimes a real economic shock, such as a spike in oil prices, helps trigger a cutback in monetary injections. 

When the flow of new money stops, or even slows substantially, this can cause the asset bubble to burst. This sends prices falling precipitously and wreaks havoc for latecomers to the game, most of whom lose a large percentage of their investments. The bursting of the bubble is also the final realization of the Cantillon Effect. What unfolds is not just a change in relative prices on paper during the rise of the bubble, but a large-scale transfer of real wealth and income from the latecomers to the early recipients of the newly created money who started the bubble. 

Redistribution of Wealth

This redistribution of wealth and income from late investors to the early recipients of newly created money and credit who got in on the ground floor is what makes the formation and collapse of asset price bubbles very much like a pyramid or Ponzi scheme.

When this process is driven by money in its modern form of a fiat currency mostly made of fractional reserve credit created by the central bank and the banking system, then the bursting of the bubble not only induces losses to the then-current holders of the bubble assets, but it also can lead to a process of debt deflation that spreads beyond those exposed directly to the bubble assets to all other debtors as well. This means that any sufficiently large bubble can crash the entire economy into recession under the right monetary conditions.  

Historical Examples of Asset Bubbles

The biggest asset bubbles in recent history have been followed by deep recessions. The reverse is equally true: The largest and most high-profile economic crises in the U.S. have been preceded by asset bubbles.

While the correlation between asset bubbles and recessions is irrefutable, economists debate the strength of the cause-and-effect relationship. Many argue that other economic factors may contribute to recessions, or that each recession is unique, so general causes can’t really be identified.

Some economists even dispute the existence of bubbles at all, arguing that large real economic shocks randomly knock the economy into a recession from time to time, independent of financial factors, and that price bubbles and crashes are simply the optimal market response to changing real fundamentals.

Broader agreement exists, however, that the bursting of an asset bubble has played at least some role in each of the following economic recessions.

The 1920s Stock Market Bubble/The Great Depression

The 1920s began with a deep but short recession that gave way to a prolonged period of economic expansion. Lavish wealth, the kind depicted in F. Scott Fitzgerald's "The Great Gatsby," became an American mainstay during the so-called Roaring Twenties. The bubble started when the Fed eased credit requirements and lowered interest rates in the second half of 1921 through 1922, hoping to spur borrowing, increase the money supply, and stimulate the economy.

It worked, but too well. Consumers and businesses began taking on more debt than ever. By the middle of the decade, there was an additional $500 million in circulation compared with five years earlier. The Fed’s easy money policies extended through most of the 1920s and stock prices soared as a result of the new money flowing into the economy through the banking system.

The Roaring '20s

The steady expansion of the supply of money and credit through the 1920s fueled a massive bubble in stock prices. Widespread adoption of the telephone and the shift from a majority rural to a majority urban population increased the appeal of more sophisticated savings and investment strategies such as stock ownership versus traditionally popular savings accounts and life insurance policies.

The excess of the 1920s was fun while it lasted but far from sustainable. By 1929, cracks began to appear in the facade. The problem was that debt had fueled too much of the decade's extravagance. The investors, the general public, and the banks eventually became skeptical that the continuous extension of new credit could go on forever, and began to cut back to protect themselves from the eventual speculative losses. Savvy investors, the ones tuned in to the idea the good times were about to end, began profit-taking. They locked in their gains, anticipating a coming market decline. 

Before too long, a massive sell-off took hold. People and businesses began withdrawing their money at such a rate that the banks didn't have the available capital to meet the requests. Debt deflation set in despite Fed attempts to reinflate. The rapidly worsening situation culminated with the crash of 1929, which led to the insolvency of several large banks due to bank runs.

The crash touched off The Great Depression, still known as the worst economic crisis in modern American history. While the official years of the Depression were from 1929 to 1939, the economy did not regain footing on a long-term basis until World War II ended in 1945.

The 1990s Dot-Com Bubble/Early 2000s Recession

In the year 1990, the words internet, web, and online did not even exist in the common lexicon. By 1999, they dominated the economy. The Nasdaq index, which tracks mostly tech-based stocks, hovered just above 710 in October 1990. By the turn of the century, it had soared past 6,700.

In 1995, the Fed began easing monetary policy to support the government bailout of the holders of Mexican bonds in response to the Mexican debt crisis. U.S. M2 money-supply growth quickly accelerated from less than 1% per year to more than 5% as the Fed began injecting new reserves into the banking system, peaking at over 8% by early 1999.

The new liquid credit that the Fed added to the economy began to flow into the emerging tech sector. As the Fed dropped interest rates starting in 1995, the Nasdaq began to really take off, internet service provider Netscape launched its IPO, and the dot-com bubble began.   

Market Hype

The hype of new technologies can attract the flow of new money investment that leads to a bubble.

The internet changed the way the world lives and does business. Many robust companies launched during the dot-com bubble, such as Google, Yahoo, and Amazon. Accompanying these success stories, however, was a number of fly-by-night companies with no long-term vision, no innovation, and often no product at all. Because investors were swept up in dot-com mania, these companies still attracted millions of investment dollars, with many even managing to go public without ever releasing a product to the market.

As wage and consumer price pressures mounted amid a flood of liquidity meant to combat the underwhelming effects of the Y2K bug, the Fed began cutting back money-supply growth and raising interest rates in early 2000. This pulled the rug out from under the Fed-fueled mania of the tech boom. 

A Nasdaq sell-off in March 2000 marked the end of the dot-com bubble. The recession that followed was relatively shallow for the broader economy but devastating for the tech industry. The Bay Area in California, home to tech-heavy Silicon Valley, experienced a sharp rise in unemployment.

The 2000s Real Estate Bubble/The Great Recession

Many factors coalesced to produce the 2000s real estate bubble. The biggest was monetary expansion leading to low interest rates and significantly relaxed lending standards.

The Fed dropped its target interest rate to successive historic lows from 2000 to mid-2004 and the M2 money supply grew an average of 6.5% per year. Federal housing policies under the general heading of the “Ownership Society” championed by President George W. Bush helped drive newly created credit into the housing sector, and deregulation of the financial sector allowed the multiplication of exotic new home-loan products and credit derivatives based on them.

Government Policies

Government policies that try to shape economic trends are almost bound to guide the growth of bubbles in the presence of the expansion of money and credit.

As house buying fever spread like a drought-fueled conflagration. Lenders, particularly those in the high-risk arena known as subprime, began competing with each other on who could relax standards the most and attract the riskiest buyers. One loan product that best embodies the level of insanity reached by subprime lenders in the mid-2000s is the NINJA loan; no income, no job, or asset verification were required for approval.

For much of the 2000s, getting a mortgage was easier than getting approved to rent an apartment. As a result, demand for real estate surged. Real estate agents, builders, bankers, and mortgage brokers frolicked in the excess, making piles of money as easily as the 1980s Wall Street Masters of the Universe portrayed in Tom Wolfe's "Bonfire of the Vanities."

As one might expect, a bubble fueled in large part by the practice of lending hundreds of thousands of dollars to people unable to prove they had assets or even jobs was unsustainable. In certain parts of the country, such as Florida and Las Vegas, home prices began to tumble as early as 2006.

By 2008, the entire country was in full economic meltdown. Large banks, including the storied Lehman Brothers, became insolvent—a result of tying up too much money in securities backed by the aforementioned subprime mortgages. Housing prices tumbled by more than 50% in some areas. The resulting Great Recession crashed markets around the globe, put many millions out of work, and permanently reshaped the structure of the economy.

What Happens When the Market Is in a Bubble?

The clearest sign that a market is in a bubble is when assets trade for way more than what they are truly worth. A sudden surge in prices without any clear justifying factor generally suggests a bubble is underway. 

What Happens When Financial Bubbles Burst?

When the bubble bursts, prices tumble. Those who failed to sell up before this happened can lose significant amounts of their invested capital and companies may be forced to curtail spending and slash budgets. When the victims of a bubble are numerous, it can have a huge impact on the economy, sparking mass unemployment, reduced consumer spending, and debt deflation.

How Do Bubbles Affect the Economy?

Bubbles affect the economy because they prompt members of the population to lose lots of money and often culminate in monetary policy being tightened. Widespread losses can create financial panic, erode spending, and trigger unmanageable debt.

The Bottom Line

The stock market bubble of the 1920s, the dot-com bubble of the 1990s, and the real estate bubble of the 2000s offer clear examples of how bullish investor sentiment can destroy economies and deepen inequality. While each of these bubbles has its own story, there are aspects that tie them together, including that they were driven by a flow of cheap money being pumped into the economy via monetary expansion and lower borrowing rates.

Eventually, policies are reversed, money dries up, and people begin realizing that assets are trading way beyond what they are truly worth. When this happens, the results can be catastrophic—not just for the participants but everyone in the economy.

Article Sources
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