Economic bubbles occur when, for any number of reasons, excessive investment in commodities (such as oil), securities (such as stocks and bonds), real estate, or collectibles drives up prices well beyond the item’s intrinsic value. The inevitable result of this boom in price is a crash or bust. The price falls sharply once it becomes clear that it has grown far beyond the purchasing power of potential customers.
Speculators risk money in such investments because they hope that the price of an asset they purchase will quickly increase. Since most speculators are nervous about where they invest their money, bubbles are by no means the norm. After all, every investment entails the risk that it is overpriced. Speculators also know that rising prices will encourage either greater production of a commodity or greater willingness of current owners to sell. Either of these conditions can serve as a “negative feedback” mechanism that adjusts prices downward. As an analogy, think of negative economic feedback like your eyes. As the light gets brighter, your pupils get smaller and let in less light. But what if, instead, your eyes worked as a “positive feedback” mechanism? In sunlight, your pupils would open wide and damage your eyes.
Economic bubbles occur when prices trending sharply upward spur positive, rather than negative, feedback. For whatever reason (fear of shortages, greed, an excessively optimistic attitude toward the future, or flaws in the analysis of an asset’s underlying value), buyers believe that the value of the asset will continue to rise. If the price rises, overly enthusiastic speculators buy more, or those who missed out on the lower price flock to buy before the price rises any higher. The foremost explanation is the “greater fool theory”: Buyers justify their purchases by assuring themselves they will find “a greater fool” who will pay even more. Buyer enthusiasm infects other buyers, amplifying the effect even further. Under the right conditions, prices can reach dizzying heights before falling. One famous example is the tulip-buying bubble which happened in the Netherlands in the 1630s when a single tulip bulb could cost a year’s salary.
Most bubbles are easily assimilated or averted by an elastic market. Provided the bubble is small enough, the losers earn wisdom in retrospect, and the winners earn a lot of money. But the effects of a bubble might become cumulative if many owners of an overpriced asset feel rich and spend foolishly, especially in a period of deregulation. Imagine this: You buy a house for $200,000, for which you borrowed $160,000 beforehand. You have $40,000 in equity in the house. Over the next five years, the market appraisal rises to $500,000. Now you have $340,000 in equity ($500,000 – $160,000), so you borrow another $240,000 from a bank using this equity to secure the loan. You still have $100,000 in equity in your home, and you have $240,000 to spend. You suddenly feel less need to be economical with your purchases and allocate more money for things like a vacation home and a new car.
But equity is not revenue. The market holds long enough for you to spend the money. Then it crashes and the value of your home falls to $325,000. Now you have negative equity and owe the bank $400,000. So you default on your loan and give your house, car, and vacation home to the bank. If this situation is widespread, it can culminate in the failure of those banks and a severe blow to the lending needed to grow the economy.
There are also stock market bubbles. In a normal market, investors buy stock in a company because they anticipate that future profits will become dividends and they believe the value of the company’s assets will increase. Sometimes, though, a “herd mentality” sets in and too many brokers rush to buy, driving prices like mercury up a thermometer to levels that prove unrealistic. Eventually, it becomes clear that further increases are not forthcoming and price deterioration develops, followed by a swift drop. When this happens to too many companies in aggregate, it is called a stock market crash.
A striking example of a stock market bubble is the “dot-com” bubble. The buzz about the economic possibilities of the Internet encouraged investors to fund the creation of many dot-com companies – too many, it turned out. For several years, dozens of entrepreneurs sought to duplicate for themselves the results of those that had come before. Many investors envisaged wealth for any business with a website that could advertise on TV or billboards, even if its actual services were ambiguous. Instead, on March 10, 2000, the dot-com boom reached its peak when the stock index hit 5,132.52. Over the next two and a half years, the index dropped to as low as 1,108.49. Very few companies bucked the trend. Most had blundered into awful financial difficulties, selling off their assets to healthier companies.
Bubbles are not limited to the arena of real estate or “get-rich” stock offerings. In the 1990s, a series of stuffed animal toys became such a fad that speculators bought up large quantities, assuming that their value as collectibles would continue to rise. Did anyone make money on that fad? If you check out their prices on an online auction site, you can decide whether any of these sellers have struck it rich.