Economic bubble

An economic bubble occurs when the price of an asset rises far above its intrinsic valuation. Intrinsic valuation is the actual value based on long-term economic fundamentals. During a bubble, investors often ignore these fundamentals. They may focus on overly optimistic growth projections instead. This can happen in many different markets. You might see bubbles in stocks, real estate, or commodities like uranium. Even modern assets like cryptocurrency can experience bubbles.

Bubbles typically form due to two main factors. One cause is excess liquidity, which means there is a lot of money moving through the markets. Another cause is a shift in investor psychology. In large multi-asset bubbles, central banking liquidity often plays a role. For example, the 1980s Japanese asset bubble was linked to central bank actions. The 2020–21 "Everything bubble" is another example of this phenomenon. In the early stages, most investors do not realize a bubble is forming. They see prices rising and assume the growth is justified.

The term "bubble" has a specific history in finance. It originated during the British South Sea Bubble from 1711 to 1720. Originally, the word described the companies and their inflated stock. The metaphor suggests that prices are expanded on nothing but air. This makes them fragile and easy to burst. Before this term became common, people used the word "mania." A famous example is the Dutch tulip mania.

Economists generally categorize bubbles into two distinct types. The first type is an equity bubble. These involve tangible investments and real assets. They are often driven by actual innovations that boost confidence. Examples include the dot-com bubble and the Roaring Twenties. The second type is a debt bubble. These involve intangible or credit-based investments. They are not backed by real assets and rely on frivolous lending. Debt bubbles are often more dangerous to the entire financial system. The 2000s US housing bubble is a major example of this.

When a bubble bursts, the results can be quite severe. Prices usually undergo a rapid and significant decline. This can lead to massive financial losses for many people. Some theories suggest bubbles burst all at once. However, other theories like debt deflation suggest a more progressive collapse. In a progressive collapse, the most highly-leveraged assets fail first. Leverage refers to using borrowed money to invest. The collapse then spreads throughout the wider economy. This can cause a long period of economic malaise.

Bubbles also create a phenomenon called the "wealth effect." When asset prices rise, people feel much richer than they are. This feeling often causes them to increase their discretionary spending. This spending can temporarily stimulate the economy. However, when the bubble pops, the opposite happens. People feel a sudden loss of wealth and stop spending. This reduction in spending can make an economic slowdown much worse. Central banks may try to stop this by raising interest rates. Higher interest rates increase the cost of borrowing money.

Some thinkers use the concept of "reflexivity" to explain these cycles. Investor George Soros is a well-known promoter of this idea. Reflexivity suggests that prices actually influence economic fundamentals. For example, rising house prices might change how banks lend money. Banks may ease their lending standards when prices are high. Then, they raise standards when prices begin to fall. This creates a self-reinforcing pattern of boom and bust. This process keeps the market in a state of disequilibrium. While debated, this idea helps explain why markets move in cycles.