In economic terms, a bubble refers to a phenomenon where trading volumes are exceptionally high for assets priced significantly above their true intrinsic value. This can be simplified as the exchange of overvalued assets. Various terms are used to describe this occurrence, including market bubbles, speculative bubbles, balloons, financial bubbles, and speculation mania.
During a bubble, price fluctuations can be extreme and unpredictable, often defying conventional market forces of supply and demand. Despite numerous attempts to explain bubble formation, even in markets without speculation, uncertainty, or limited rationality, no single definitive cause has been identified. Some theories suggest that bubbles might arise from price interactions and shifting social dynamics.
Typically, bubbles are conclusively identified only after they have collapsed, characterized by sharp price declines. This retrospective recognition stems from the challenge of accurately determining intrinsic values in active trading environments. The termination of a bubble, often referred to as a crash or bursting bubble, can be abrupt and severe.
Mainstream economic theory speculates that bubbles cannot be accurately predicted or identified during their formation, nor can their development be prevented. This school of thought advises against attempting to deflate bubbles gradually, as such efforts may trigger financial crises. Instead, it recommends that authorities should remain vigilant and allow bubbles to burst naturally, then address the aftermath using fiscal and monetary policy instruments.
Contrastingly, the Austrian school of economics views economic bubbles as predominantly detrimental to economies. They argue that bubbles lead to the misallocation of economic resources towards inefficient and unproductive uses. This perspective forms the foundation of the Austrian business cycle theory.
The United States economy has experienced numerous economic bubbles. In the 1970s, following the abandonment of the gold standard, U.S. monetary expansion resulted in significant commodity bubbles. These bubbles eventually burst when the Federal Reserve dramatically tightened the money supply by raising interest rates above 14%, causing gold and oil prices to return to more typical historical levels.
Another instance of price bubbles occurred during the prolonged period of low interest rates implemented by the Federal Reserve from 2001 to 2004, which fueled bubbles in both housing and stock markets. These bubbles burst once interest rates returned to more normal levels, resulting in substantial dislocation in the following years as the bubble’s impact rippled through the financial system and the entire economy in 2007 and 2008. The Great Recession and financial collapse were the outcomes of this bursting bubble. This example illustrates how the larger a bubble grows before it finally bursts, the more dangerous and damaging it becomes when it does.
