What Is an Economic Bubble and How Does It Work, With Examples

What Is a Bubble?

A bubble is an economic cycle that is characterized by the rapid escalation of market value, particularly in the price of assets. This fast inflation is followed by a quick decrease in value, or a contraction, that is sometimes referred to as a "crash" or a "bubble burst."

Typically, a bubble is created by a surge in asset prices that is driven by exuberant market behavior. During a bubble, assets typically trade at a price, or within a price range, that greatly exceeds the asset's intrinsic value (the price does not align with the fundamentals of the asset).

The cause of bubbles is disputed by economists; some economists even disagree that bubbles occur at all (on the basis that asset prices frequently deviate from their intrinsic value). However, bubbles are usually only identified and studied in retrospect, after a massive drop in prices occurs.

How a Bubble Works

An economic bubble occurs any time that the price of a good rises far above the item's real value. Bubbles are typically attributed to a change in investor behavior, although what causes this change in behavior is debated.

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.

The Japanese economy experienced a bubble in the 1980s after the country's banks were partially deregulated. This caused a huge surge in the prices of real estate and stock prices. The dot-com boom, also called the dot-com bubble, was a stock market bubble in the late 1990s. It was characterized by excessive speculation in Internet-related companies. During the dot-com boom, people bought technology stocks at high prices—believing they could sell them at a higher price—until confidence was lost and a large market correction occurred.

The research of American economist Hyman P. Minsky helps to explain the development of financial instability and provides one explanation of the characteristics of financial crises. Through his research, Minsky identified five stages in a typical credit cycle. While his theories went largely under-the-radar for many decades, the subprime mortgage crisis of 2008 renewed interest in his formulations, which also help to explain some of the patterns of a bubble.

Displacement

This stage takes place when investors start to notice a new paradigm, like a new product or technology, or historically low interest rates. This can be basically anything that gets their attention. 

Boom

Prices start to rise. Then, they get even more 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, it could be said that caution on the part of investors is mostly thrown out the window. 

Profit-Taking

Figuring out when the bubble will burst isn’t easy; once it has burst, it will not inflate again. It is possible to have an echo bubble, which is only a temporary rally. But anyone who can identify the early warning signs will make money by selling off positions. 

Panic

Asset prices change course and drop (sometimes as rapidly as they rose). Investors want to liquidate them at any price. Asset prices decline as supply outshines demand. 

Examples of Bubbles

Recent history includes two very 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 the modern-day.

Tulip Mania

While it may seem absurd to suggest that a flower could bring down a whole economy, that is exactly what happened in Holland in the early 1600s. The tulip bulb trade initially started by accident. 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. Some rare varieties of tulips commanded astronomical prices.

Bulbs were traded for anything with a store of value, including homes and acreage. At its peak, tulip mania had created such 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, and the buyer failed to show. At this point, it was clear 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% of the contract value. In the end, fortunes were lost by noblemen and laymen alike.

Dot-Com Bubble

The dot-com bubble 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 startup companies. Investors started to pour money into internet startups in the 1990s, with the express hope that they would be profitable. 

As technology advanced and the internet started to be commercialized, startup companies in the Internet and technology sector helped fuel the surge in the stock market that 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. Regardless, they were able to offer 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. This led to about a 10% loss in the stock market. The capital that was once easy to obtain started to dry up; 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 had folded.

U.S. Housing Bubble 

The U.S. housing bubble was a real estate bubble that affected more than half of the United States in the mid-2000s. It was partially the result of the dot-com bubble. As the markets began to crash, values in real estate started to rise. At the same time, the demand for homeownership started to grow at almost alarming levels. Interest rates started to decline. A concurrent force was a lenient approach on the part of lenders; this meant that almost anyone could become a homeowner.

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 some people flipped them for profits. But when the stock market began to rise again, interest rates also started to rise. For homeowners with ARMs, their mortgages started to refinance at higher rates. The value of these homes took a nosedive, which triggered a sell-off in mortgage-backed securities (MBSs). This eventually led to an environment that resulted in millions of dollars in mortgage defaults.