An economic bubble or asset bubble sometimes also referred to as a speculative bubble , a market bubble , a price bubble , a financial bubble , a speculative mania , or a balloon is trade in an asset at a price or price range that strongly exceeds the asset's intrinsic value. Because it is often difficult to observe intrinsic values in real-life markets, bubbles are often conclusively identified only in retrospect, once a sudden drop in prices has occurred.

Such a drop is known as a crash or a bubble burst. Both the boom and the burst phases of the bubble are examples of a positive feedback mechanism, in contrast to the negative feedback mechanism that determines the equilibrium price under normal market circumstances.

Prices in an economic bubble can fluctuate erratically, and become impossible to predict from supply and demand alone. Many explanations have been suggested, and research has recently shown that bubbles may appear even without uncertainty , [7] speculation , [8] or bounded rationality , [9] in which case they can be called non-speculative bubbles or sunspot equilibria.

In such cases, the bubbles may be argued to be rational, where investors at every point are fully compensated for the possibility that the bubble might collapse by higher returns. These approaches require that the timing of the bubble collapse can only be forecast probabilistically and the bubble process is often modelled using a Markov switching model.

More recent theories of asset bubble formation suggest that these events are sociologically driven. For instance, explanations have focused on emerging social norms [9] and the role that culturally-situated stories or narratives play in these events. The term "bubble", in reference to financial crisis, originated in the — British South Sea Bubble , and originally referred to the companies themselves, and their inflated stock, rather than to the crisis itself.

This was one of the earliest modern financial crises; other episodes were referred to as "manias", as in the Dutch tulip mania. The metaphor indicated that the prices of the stock were inflated and fragile — expanded based on nothing but air, and vulnerable to a sudden burst, as in fact occurred. The impact of economic bubbles is debated within and between schools of economic thought ; they are not generally considered beneficial, but it is debated how harmful their formation and bursting is.

Within mainstream economics , many believe that bubbles cannot be identified in advance, cannot be prevented from forming, that attempts to "prick" the bubble may cause financial crisis , and that instead authorities should wait for bubbles to burst of their own accord, dealing with the aftermath via monetary policy and fiscal policy.

Within Austrian economics , economic bubbles are generally considered to have a negative impact on the economy because they tend to cause misallocation of resources into non-optimal uses; this forms the basis of Austrian business cycle theory.

Political economist Robert E. Wright argues that bubbles can be identified before the fact with high confidence. In addition, the crash which usually follows an economic bubble can destroy a large amount of wealth and cause continuing economic malaise; this view is particularly associated with the debt-deflation theory of Irving Fisher , and elaborated within Post-Keynesian economics.

A protracted period of low risk premiums can simply prolong the downturn in asset price deflation as was the case of the Great Depression in the s for much of the world and the s for Japan. Not only can the aftermath of a crash devastate the economy of a nation, but its effects can also reverberate beyond its borders.

Another important aspect of economic bubbles is their impact on spending habits. Market participants with overvalued assets tend to spend more because they "feel" richer the wealth effect. Many observers quote the housing market in the United Kingdom , Australia , New Zealand , Spain and parts of the United States in recent times, as an example of this effect.

When the bubble inevitably bursts, those who hold on to these overvalued assets usually experience a feeling of reduced wealth and tend to cut discretionary spending at the same time, hindering economic growth or, worse, exacerbating the economic slowdown.

In an economy with a central bank, the bank may therefore attempt to keep an eye on asset price appreciation and take measures to curb high levels of speculative activity in financial assets. Historically, this is not the only approach taken by central banks.

It has been argued [15] that they should stay out of it and let the bubble, if it is one, take its course. In the s, excess monetary expansion after the U. These bubbles only ended when the U. Similarly, low interest rate policies by the U. Federal Reserve in the — are believed to have exacerbated housing and commodities bubbles.

The housing bubble popped as subprime mortgages began to default at much higher rates than expected, which also coincided with the rising of the fed funds rate.

It has also been variously suggested that bubbles may be rational, [16] intrinsic, [17] and contagious. Puzzlingly for some, bubbles occur even in highly predictable experimental markets, where uncertainty is eliminated and market participants should be able to calculate the intrinsic value of the assets simply by examining the expected stream of dividends.

Experimental bubbles have proven robust to a variety of conditions, including short-selling, margin buying, and insider trading. While there is no clear agreement on what causes bubbles, there is evidence [ citation needed ] to suggest that they are not caused by bounded rationality or assumptions about the irrationality of others, as assumed by greater fool theory. It has also been shown that bubbles appear even when market participants are well-capable of pricing assets correctly.

How to Profit From the Next Investing Bubble - MarketWatch

More recent theories of asset bubble formation suggest that they are likely sociologically-driven events, thus explanations that merely involve fundamental factors or snippets of human behavior are incomplete at best. For instance, qualitative researchers Preston Teeter and Jorgen Sandberg argue that market speculation is driven by culturally-situated narratives that are deeply embedded in and supported by the prevailing institutions of the time. One possible cause of bubbles is excessive monetary liquidity in the financial system, inducing lax or inappropriate lending standards by the banks , which makes markets vulnerable to volatile asset price inflation caused by short-term, leveraged speculation.

Weber , the former president of the Deutsche Bundesbank , has argued that "The past has shown that an overly generous provision of liquidity in global financial markets in connection with a very low level of interest rates promotes the formation of asset-price bubbles.

According to the explanation, excessive monetary liquidity easy credit, large disposable incomes potentially occurs while fractional reserve banks are implementing expansionary monetary policy i. Those who believe the money supply is controlled exogenously by a central bank may attribute an 'expansionary monetary policy' to said bank and should one exist a governing body or institution; others who believe that the money supply is created endogenously by the banking sector may attribute such a 'policy' with the behavior of the financial sector itself, and view the state as a passive or reactive factor.

Explanations focusing on interest rates tend to take on a common form, however: When interest rates are set excessively low, regardless of the mechanism by which it is accomplished investors tend to avoid putting their capital into savings accounts.

Instead, investors tend to leverage their capital by borrowing from banks and invest the leveraged capital in financial assets such as stocks and real estate. Risky leveraged behavior like speculation and Ponzi schemes can lead to an increasingly fragile economy, and may also be part of what pushes asset prices artificially upward until the bubble pops. Simply put, economic bubbles often occur when too much money is chasing too few assets, causing both good assets and bad assets to appreciate excessively beyond their fundamentals to an unsustainable level.

This may involve actions like bailouts of the financial system, but also others that reverse the trend of monetary accommodation, commonly termed forms of 'contractionary monetary policy'. Ideally, such countermeasures lessen the impact of a downturn by strengthening financial institutions while the economy is strong. Advocates of perspectives stressing the role of credit money in an economy often refer to such bubbles as "credit bubbles," and look at such measures of financial leverage as debt to GDP ratios to identify bubbles.

Typically the collapse of any economic bubble results in an economic contraction termed if less severe a recession or if more severe a depression; what economic policies to follow in reaction to such a contraction is a hotly debated perennial topic of political economy. The importance of liquidity was derived in a mathematical setting [22] and in an experimental setting [23] [24] see Section "Experimental and mathematical economics".

Greater fool theory states that bubbles are driven by the behavior of a perennially optimistic market participants the fools who buy overvalued assets in anticipation of selling it to other speculators the greater fools at a much higher price. According to this explanation, the bubbles continue as long as the fools can find greater fools to pay up for the overvalued asset.

The bubbles will end only when the greater fool becomes the greatest fool who pays the top price for the overvalued asset and can no longer find another buyer to pay for it at a higher price. This theory is popular among laymen, but has not yet been fully confirmed by empirical research. Extrapolation is projecting historical data into the future on the same basis; if prices have risen at a certain rate in the past, they will continue to rise at that rate forever.

The argument is that investors tend to extrapolate past extraordinary returns on investment of certain assets into the future, causing them to overbid those risky assets in order to attempt to continue to capture those same rates of return.

Overbidding on certain assets will at some point result in uneconomic rates of return for investors; only then the asset price deflation will begin. When investors feel that they are no longer well compensated for holding those risky assets, they will start to demand higher rates of return on their investments. Another related explanation used in behavioral finance lies in herd behavior , the fact that investors tend to buy or sell in the direction of the market trend.

Investment managers, such as stock mutual fund managers, are compensated and retained in part due to their performance relative to peers. Taking a conservative or contrarian position as a bubble builds results in performance unfavorable to peers. This may cause customers to go elsewhere and can affect the investment manager's own employment or compensation.

The typical short-term focus of U. In attempting to maximize returns for clients and maintain their employment, they may rationally participate in a bubble they believe to be forming, as the risks of not doing so outweigh the benefits. Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. A person's belief that they are responsible for the consequences of their own actions is an essential aspect of rational behavior.

An investor must balance the possibility of making a return on their investment with the risk of making a loss — the risk-return relationship. A moral hazard can occur when this relationship is interfered with, often via government policy. A recent example is the Troubled Asset Relief Program TARP , signed into law by U.

Bush on 3 October to provide a Government bailout for many financial and non-financial institutions who speculated in high-risk financial instruments during the housing boom condemned by a story in The Economist titled "The worldwide rise in house prices is the biggest bubble in history". Other causes of perceived insulation from risk may derive from a given entity's predominance in a market relative to other players, and not from state intervention or market regulation.

A firm — or several large firms acting in concert see cartel , oligopoly and collusion — with very large holdings and capital reserves could instigate a market bubble by investing heavily in a given asset, creating a relative scarcity which drives up that asset's price. Because of the signaling power of the large firm or group of colluding firms, the firm's smaller competitors will follow suit, similarly investing in the asset due to its price gains.

When the large firm, cartel or de facto collusive body perceives a maximal peak has been reached in the traded asset's price, it can then proceed to rapidly sell or "dump" its holdings of this asset on the market, precipitating a price decline that forces its competitors into insolvency, bankruptcy or foreclosure.

The large firm or cartel — which has intentionally leveraged itself to withstand the price decline it engineered — can then acquire the capital of its failing or devalued competitors at a low price as well as capture a greater market share e. Some regard bubbles as related to inflation and thus believe that the causes of inflation are also the causes of bubbles. Others take the view that there is a "fundamental value" to an asset , and that bubbles represent a rise over that fundamental value, which must eventually return to that fundamental value.

There are chaotic theories of bubbles which assert that bubbles come from particular "critical" states in the market based on the communication of economic factors. Finally, others regard bubbles as necessary consequences of irrationally valuing assets solely based upon their returns in the recent past without resorting to a rigorous analysis based on their underlying "fundamentals".

Bubbles in financial markets have been studied not only through historical evidence, but also through experiments , mathematical and statistical works. Smith, Suchanek and Williams [7] designed a set of experiments in which an asset that gave a dividend with expected value 24 cents at the end of each of 15 periods and were subsequently worthless was traded through a computer network.

They found instead that prices started well below this fundamental value and rose far above the expected return in dividends. The bubble subsequently crashed before the end of the experiment. This laboratory bubble has been repeated hundreds of times in many economics laboratories in the world, with similar results.

The existence of bubbles and crashes in such a simple context was unsettling for the economics community that tried to resolve the paradox on various features of the experiments. To address these issues Porter and Smith [30] and others performed a series of experiments in which short selling, margin trading, professional traders all led to bubbles a fortiori.

Much of the puzzle has been resolved through mathematical modeling and additional experiments. In particular, starting in , Gunduz Caginalp and collaborators [22] [31] modeled the trading with two concepts that are generally missing in classical economics and finance.

First, they assumed that supply and demand of an asset depended not only on valuation, but on factors such as the price trend. Second, they assumed that the available cash and asset are finite as they are in the laboratory.

Observations: Years of Stock Market History (log graph)

Utilizing these assumptions together with differential equations, they predicted the following: An epistemological difference between most microeconomic modeling and these works is that the latter offer an opportunity to test implications of their theory in a quantitative manner. This opens up the possibility of comparison between experiments and world markets. When price collars were used to keep prices low in the initial time periods, the bubble became larger.

Caginalp's asset flow differential equations provide a link between the laboratory experiments and world market data. Since the parameters can be calibrated with either market, one can compare the lab data with the world market data. The asset flow equations stipulate that price trend is a factor in the supply and demand for an asset that is a key ingredient in the formation of a bubble. While many studies of market data have shown a rather minimal trend effect, the work of Caginalp and DeSantis [32] on large scale data adjusts for changes in valuation, thereby illuminating a strong role for trend, and providing the empirical justification for the modeling.

The asset flow equations have been used to study the formation of bubbles from a different standpoint in [33] where it was shown that a stable equilibrium could become unstable with the influx of additional cash or the change to a shorter time scale on the part of the momentum investors. This phenomenon on a short time scale may be the explanation for flash crashes.

Other goods which have produced bubbles include postage stamps and coin collecting. From Wikipedia, the free encyclopedia. Tipper and See-Saw Time Tulip mania top South Sea Company Mississippi Company Railway Mania s Encilhamento "Mounting" — Florida speculative building bubble Roaring Twenties stock-market bubble c. Overheating economics Stock market bubble Real estate bubble Carbon bubble List of commodity booms Economic collapse Financial crisis Fictitious capital Boom and bust Speculation Business cycle Hyman Minsky , especially his Financial Instability Hypothesis Jesse Lauriston Livermore The Boy Plunger Extraordinary Popular Delusions and the Madness of Crowds Irrational Exuberance by Robert Shiller Unicorn bubble.

Nonlinear Dynamics and Evolutionary Economics. The Wall Street Journal.

Market Crashes: The South Sea Bubble

Retrieved 17 August A speculative bubble is a social epidemic whose contagion is mediated by price movements. News of price increase enriches the early investors, creating word-of-mouth stories about their successes, which stir envy and interest.

The excitement then lures more and more people into the market, which causes prices to increase further, attracting yet more people and fueling 'new era' stories, and so on, in successive feedback loops as the bubble grows.

Retrieved 10 May The Fundamentals of Early Manias. Lack of Common Knowledge of Rationality Vs. Review of Financial Studies. A Lighthearted, Serious Look at America's Economic Ills Buffalo, N. Prometheus, , 51— The Journal of Economic Perspectives. The Case of Stock Prices". Effect of Mimetic Contagion". Retrieved 15 December Retrieved August 24, Philosophical Transactions of the Royal Society A. Proceedings of the National Academy of Sciences.

Excess Cash, Momentum and Incomplete Information". Psychology and Financial Markets. Retrieved November 11, The worldwide rise in house prices is the biggest bubble in history. Prepare for the economic pain when it pops. Nonlinear Trend, Volume, Volatility, Resistance and Money Supply". Retrieved 19 February Aspects of capitalism academic views.

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List of stock market crashes and bear markets. Economic history of the Netherlands. Amsterdam Stock Exchange Bank of Amsterdam Amsterdamsche Wisselbank Brabantsche Compagnie Compagnie van Verre Dutch East India Company Dutch West India Company New Netherland Company Noordsche Compagnie. De Nederlandsche Bank Stichting Max Havelaar. Pieter de la Court Joseph de la Vega Louis De Geer Gerard Adriaan Heineken Isaac Le Maire Johan Palmstruch Anton Philips Gerard Philips Nico Roozen Coenraad Johannes van Houten Frans van der Hoff A.

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