Economic bubble what is

This can happen when asset prices are based on implausible views about the future. The term is often used alongside the business cycle , which is also known as a boom-bust cycle. Bubbles are only identified in retrospect when the price of the asset drops — as it is almost impossible to determine the actual intrinsic value of something in live markets.

When there is an economic bubble, prices constantly change to a point where supply and demand can no longer set the price. Bubbles are often hard to detect in real time because there is disagreement over the fundamental value of the asset.

Research suggests that bubbles can happen without any bounded rationality. In the fourth stage, «profit-taking», more experienced investors sell out their positions in the overvalued asset to make a profit and the price rise eases. Finally, we reach the «panic» stage, with a sharp drop in price and severe losses incurred by those investors who did not «jump off» the bubble in time.

Now that we have explained what bubbles are, we also need to classify them. Economics literature differentiates between two types: rational and irrational. The former occur in economies with rational economic agents. This means that agents properly process all the available information in the markets and take optimal decisions based on it. But, if we assume all individuals are rational, why are there still bubbles?

Economics literature has come up with several theories to explain this apparent paradox. One of the most appealing suggests that some individuals prefer to keep hold of an asset, even though they realise there is a bubble, because they believe a lot of investors are still unaware of its existence.

Such investors expect prices to rise even further. The key lies in jumping early enough, before enough investors are ready for bursting the bubble.

In contrast to the rational models, behavioural economics claims that bubbles are irrational. To justify this claim, several cognitive dysfunctions are said to occur in decision-making.

For instance, the tendency of some investors to invest according to recent performance trend-chasing bias or to overestimate their own ability in making projections overconfidence. Such dysfunctions mean that different investors have very different expectations for the same financial asset because they process the available information differently.

The economist Robert Shiller coined the term «irrational exuberance» to describe such behaviour. This can create bubbles since optimistic investors who decide to buy an asset because they expect its price to increase can considerably push up the price. Some economists have carried out laboratory experiments to study how and when bubbles are created and their findings are certainly interesting. Smith, Suchanek and William s 1 were the first to run such an experiment.

Participants were assigned different amounts of money to invest in a fictitious financial asset that paid out dividends over 15 trading periods from a probability distribution known by all the participants. In the experiment, participants could buy and sell the asset in each round via an auction.

A lot of trading took place during the experiment. The classic bubble pattern was observed with positive, significant price deviations compared with its fundamental value in the initial stages and correction in the final stages, with a sharp drop in prices.

Some economists have seen this as conclusively supporting the theory of irrational bubbles. Fourth comes profit-taking. In this stage, some people predict that the bubble is about to burst — a tricky prediction to make with accuracy — and begin to sell.

The fifth and final stage is panic. Relatively self-explanatory, this stage consists of sharply declining prices sharply and panicking investors selling as quickly as possible. Throughout history, there have been several instances identified as financial bubbles. The Dutch Tulip Bubble, or Tulipmania, is regarded as the first major financial bubble, dates back to the 17th century. A rare type of tulip, which flowered in a striped, multicolored pattern, rather than the usual solid coloration, was particularly coveted.

The high demand for this rare variety of tulip bulb caused the market value of tulips to soar. Since the Dutch Tulip Bubble of the 17th century, many other financial bubbles have been recorded. This enthusiasm resulted in a bubble which ultimately burst, leaving serious financial fallout in its wake.

Minsky identified the five stages to a credit cycle — displacement, boom, euphoria, profit-taking, and panic. These five stages are also applicable to financial bubbles and offer important insight into the mechanisms that underlie this financial phenomenon. As seen in the historical examples, financial bubbles can have serious consequences for entire economies.

At their most extreme, they may lead to recessions. These instances demonstrate how excessive greed and extravagance are unsustainable. The lavish lifestyle associated with the Roaring Twenties preceded the disastrous stock market crash that catalyzed the Great Depression. A key problem with financial bubbles is that they are not always identified until after they burst.

At this point, it is too late for preventative measures. The hope is that, by spreading information on this topic, investors will become more in tune with the cautionary signs and do away with the suspension of disbelief that allows market prices to soar to dangerously high levels.

Bubbles are a controversial topic in and of themselves — whether they even exist is hotly debated. One of the most famous instances of a financial bubble is that of the US Housing Bubble in the early s. The housing bubble resulted from another bubble, known as the dotcom bubble. During the nineties, the rising popularity of the Internet led the value of several dotcom companies to skyrocket as soon as they went public.