“When Internet Stocks have done very well, people might well buy Internet Stocks, even if by that point they’ve become a bad investment.” – Nudge: Improving decisions about Health, Wealth and Happiness by R. Thaler and C. Sunstein
In economic terms, a bubble is created by a trend in the markets. It is a period of unusually high success. But bubbles burst. And when it does, it can cause fluctuations and job losses in an economy. The first bubble to be recorded in history was the Tulip Mania, which happened during the Dutch Golden Age. A recently introduced tulip bulb reached extremely high price levels and collapsed suddenly in February 1637. There have been many asset bubbles (and bursts) since then- The South Sea Bubble (1720), Japan’s Real Estate and Stock Market Bubble (1991), The Dot Com Bubble (2002) and the US Housing Bubble (2008) which resulted in a global economic contraction.
An asset bubble is created when certain assets see an extraordinary rise in price over a brief period of time. This rise in price is not reflected by the actual value of the product. In a speech given at the American Enterprise Institute during the dot com bubble, Alan Greenspan (Federal Reserve Board Chairman) used the phrase “Irrational Exuberance” to explain the unfounded market optimism that causes bubbles to burst. Low interest rates, demand-pull inflation, and asset shortages are the chief causes of asset bubbles. The 2005 asset bubble was caused due to mortgage brokers and bankers providing home loans to a lot of households.
All these reasons have behavioral/ psychological underpinning. Robert J. Shiller, an American Economist, provided an important account of how herd behavior and psychological factors can explain the irrational mechanisms that drive investor decisions, especially in volatile markets. He contended that the most important element to understand speculative bubbles is the “social contagion of boom thinking”. He argues that public knowledge is subject to a spiral, wherein people believe that the optimistic view is true, just because everyone else assumes it to be true. Feedback loops (through media endorsements) cause the prices to increase further. This creates a bubble that eventually bursts because decisions were made on the basis of social judgements that are not sustainable in the long run.
Herd behavior may seem rational when looked upon individually, but when everyone behaves in the same way it seems irrational. John Maynard Keynes, in his General Theory of Employment, Interest, and Money, explains animal spirits as “a spontaneous urge to action rather than inaction, and not as an outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.” These animal spirits can cause “irrationally exuberant” investment decisions that can cause entire economies to spiral into a recession.
Each bubble is different. But the common thread that runs through them is the willingness of investors to ignore the increasing number of cautionary signs and to hang disbelief entirely. It has also been noticed that bigger bubbles cause greater damage to the economy, once burst. Even with all the evidences and lessons within economic history, the present world still holds many potential bubble bursts. The Bitcoin Asset Bubble was created in 2017 when Japan’s Financial Service Agency recognized Bitcoins as a legitimate payment method. Even today, 56% of the entire Bitcoin market comprises of Japanese traders. On November 29th , 2017, the price of a single bitcoin was $11,500. Another potential bubble is the New Stock market assets bubble. As of January 2020, the Dow stands over 28,900, causing economists to expect a market correction, or worse, a crash. Yet another likely bubble would be the emerging student loan bubble, which has been building up for the past 15 years. In 2018, an average student took a loan between $20,000 and $24,999 as compared to only $17,172 in 2005. This is accompanied by the fact many students are falling back on interest payments. This is a cause for extreme worry because such a bubble burst would have a lot of social consequences, especially for the next generation. Students with no or limited government support and substantial outstanding debts may have to switch to a different career. It may also cause them to delay important life events such as marriage, growing a family, or even buying property.
As mentioned before, there are a few chief economic or market factors that can cause a bubble to be created. But what expands it and makes it bigger and dangerous is the “irrational exuberance”. When people end up influencing each other so much that the market sees unfounded and dramatic upward movements, the economy and investors would find themselves at much greater risk. One solution could be to regulate leverage in order to prevent misallocation of resources. At an individual level, diversifying one’s assets is a feasible way to avoid being trapped in a speculative bubble. As Richard Thaler and Cass Sunstein put it- When your neighbor tells you to buy something just because everyone else is, it is probably a sign for you to understand that it would not necessarily be the best investment you are looking for.
References
Elvis Picardo (Feb 11, 2020); Asset bubbles through history: The 5 Biggest. Available at: investopedia.com/articles/personal-finance/062315/five-largest-asset-bubbles-history.asp
R. Thaler, C. Sunstein (2008); Nudge: Improving decisions about Health, Wealth and Happiness
Robert D. Hormats (December 2004); Born to Herd. Available at: https://hbr.org/2004/12/born-to-herd
Kimberly Amadeo (April 1, 2020); Asset bubbles: Causes and trends. Available at: https://www.thebalance.com/asset-bubble-causes-examples-and-how-to-protect-yourself-3305908
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