What Is a Bubble?
A bubble is an economic cycle characterized by the rapid escalation of asset prices followed by a contraction. It is created by a surge in asset prices unwarranted by the fundamentals of the asset and driven by exuberant market behavior. When no more investors are willing to buy at the elevated price, a massive sell-off occurs, causing the bubble to deflate.
How a Bubble Works
Bubbles form in economies, securities, stock markets and business sectors because of a change in investor behavior. This can be a real change — as seen in the bubble economy of Japan in the 1980s when banks were partially deregulated, or a paradigm shift — which took place during the dot-com boom in the late 1990s and early 2000s. During the boom, people bought tech stocks at high prices, believing they could sell them at a higher price until confidence was lost and a large market correction, or crash, occurred. Bubbles in equities markets and economies cause resources to be transferred to areas of rapid growth. At the end of a bubble, resources are moved again, causing prices to deflate.
- A bubble is a rapid escalation of asset prices followed by a contraction, often created by a surge in asset prices that is fundamentally unwarranted.
- Changes in investor behavior are the primary causes of bubbles that form in economies, securities, stock markets, and business sectors.
The Five Steps of a Bubble
Economist Hyman P. Minsky, who was one of the first to explain the development of financial instability and the relationship it has with the economy, identified five stages in a typical credit cycle. The pattern of a bubble is pretty consistent, despite variations in how the cycle is interpreted.
- Displacement: This stage takes place when investors start to notice a new paradigm, like a new product or technology, or historically low interest rates — basically anything that gets their attention.
- Boom: Prices start to rise at first, then get momentum as more investors enter the market. This sets up the stage for the boom. There is an overall sense of failing to jump in, causing even more people to start buying assets.
- Euphoria: When euphoria hits and asset prices skyrocket, caution is thrown out the window.
- Profit taking: Figuring out when the bubble will burst isn’t easy; once a bubble has burst, it will not inflate again. But anyone who looks at the warning signs will make money by selling off positions.
- Panic: Asset prices change course and drop as quickly as they rose. Investors and others want to liquidate them at any price. Asset prices decline as supply outshines demand.
The First Bubble
Recent history includes two of the most consequential bubbles: the dot-com bubble of the 1990s and the housing bubble between 2007 and 2008. However, the first recorded speculative bubble, which occurred in Holland from 1634 to 1637, provides an illustrative lesson that applies to this day.
To even suggest a flower could bring down a whole economy seems, to reasonable minds, an absurdity, but that is exactly what happened in Holland in the early 1600s. The tulip bulb trade started inadvertently when a botanist brought tulip bulbs from Constantinople and planted them for his own scientific research. Neighbors then stole the bulbs and began selling them. The wealthy began to collect some of the rarer varieties as a luxury good. As their demand increased, the prices of bulbs surged with rare varieties commanding astronomical prices.
Bulbs were traded for anything with a store of value, including homes and acreage. At its peak, Tulipomania had whipped up so much of a frenzy that fortunes were made overnight. The creation of a futures exchange, where tulips were bought and sold through contracts with no actual delivery, fueled the speculative pricing.
The bubble burst when a seller arranged a big purchase with a buyer, but the buyer failed to show. The realization set in that price increases were unsustainable. This created a panic that spiraled throughout Europe, driving the worth of any tulip bulb down to a tiny fraction of its recent price. Dutch authorities stepped in to calm the panic by allowing contract holders to be freed from their contracts for 10 percent of the contract value. In the end, fortunes were lost by noblemen and laymen alike.
As mentioned above, the dot-com bubble took place in the late 1990s and was characterized by a rise in equity markets that was fueled by investments in internet and technology-based companies. It grew out of a combination of speculative investing and the overabundance of venture capital going into startups. Investors started to pour money into internet startups in the '90s, with the express hope that they would be profitable.
As technology advanced and the internet started to be commercialized, startup dot-com companies helped fuel the surge in the stock market, which began in 1995. The subsequent bubble was formed by cheap money and easy capital. Many of these companies barely generated any profits or even a significant product, but were offering initial public offerings (IPOs). Their stock prices saw incredible highs, creating a frenzy among interested investors.
But as the market peaked, panic among investors ensued, leading to about a 10 percent loss in the stock market. The once easy capital started to dry up and companies with millions in market capitalization became worthless in a very short amount of time. As the year 2001 ended, a good portion of the public dot-com companies folded.
U.S. Housing Bubble
This was a real estate bubble that affected more than half of the United States in the mid-2000s and was partially the result of the dot-com bubble. As the markets began to crash, values in real estate started to rise and the demand for homeownership started to grow, at almost alarming levels. Interest rates started to decline and whatever strict lending requirements banks and lenders had were all but thrown out the window — which meant almost anyone could become a homeowner. In fact, almost 56 percent of people who purchased homes in that time would never have been able to do so under normal circumstances.
With the government encouraging home ownership, banks reduced their requirements to borrow and started to lower their interest rates. Adjustable-rate mortgages (ARMs) became a favorite, with low introductory rates and refinancing options within three to five years. Many people started to buy homes and flipped them for profits. But at one point, the stock market started to rise again (following the dot-com crash), interest rates started to rise and those adjustable-rate mortgages started to refinance at higher rates. When it became obvious that home values could dive, the prices started to crash, which triggered a sell-off in mortgage-backed securities (MBSs), leading to a drop in prices and millions of dollars in mortgage defaults.