Economic Bubble – Definition

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Economic Bubble Definition

A bubble as an economic season with a very fast increase in the asset prices with subsequent shrinkage of the economy. Bubble creation occurs when there is inrush in the asset prices unwarranted by the asset’s primary principle and facilitated by free-market behavior. An overwhelming sell-off occurs when investors are not willing to buy at the super increased price leading to the deflation of the bubble.

A Little More on What is a Economic Bubble

The change of investors’ behaviors causes the formation of bubbles in economies, securities, stock markets, and business sectors. The changes can be existing and real as Japan’s bubble of the 1980s during the partial regulation of banks or pattern shift that happened during 1990s and first quarter of 2000 dot-com boom. There were high sales of high priced stocks during the boom anticipating higher selling prices until the confidence in the forecasts were lost leading to the huge shrinkage occurs as a market correction. There is asset transfer to areas with higher growth as a result of bubbles in the equity market and economies. There are asset movements towards the end of the bubble causing the deflation of prices.

The Five Steps of a Bubble

Five stages of a bubble by Economist Hyman P. Minsky, the first to explain the growth of financial instability and its relationship it has with the economy. The bubble’s cycle is consistent even though there is variation in the cycles’ interpretation.

The steps include:

Displacement

This is the first stage when the investors’ attention is drawn by the paradigm such as product, technology, historically low-interest rates and other attention-drawing things.

Boom

After the investors’ attention drawn, more investors get into the market resulting to the increase in the prices and as more investors get in and the prices steadily increase reaching the highest maximum price resulting to more assets being bought.

Euphoria

This is a stage of excitement and joy in the market as prices skyrocket and people confidence in the increases.

Profit taking

This a stage where people see the warnings will start to sell off the assets at high prices and make a profit even though the warnings of the bubble bursting is difficult to see and notice.

The First Bubble

There are two consequential bubbles in the previous history: the 1190s dot-com bubble and the housing bubble that occurred between 2007 and 2008. In addition to these, the first bubble that occurred from 1634 to 1637 gives applicable experimental lessons.

Dot-Com Bubble

The bubble took place in the late 1990s when the equity market rise was as a result of investments in internet and technology-based firms. The dot-com bubble grew out a combination of speculation and the existence of more than enough venture capital headed to startups. Investors began investing a huge amount of money in the internet startups with profit anticipation. With the increase in the technology development and the start of internet commercialization, startup companies contributed to the fastening of the surge in the stock market that started in 1995. The following bubble formation was by cheap money and easy capital. These startup companies were not profitable but resorted to issuing initial public offer (IPOs), and their stock prices were highly quoted creating investors’ panic.

As the market reached its pinnacle, investors lost confidence and started fearing to lead to the about 10% loss in the stock market. The once so-called capital begun to diminish with companies with millions in market capitalization started to start losing value and ended being worthless and as the 2001 year end, most of the Dot-Com companies were liquidated.

U.S. Housing Bubble

The bubble occurred in the real estate sector as a result of a dot-com bubble. The housing bubble affected at least half of the United States. With the onset of the market crash, the real estate value begun rising and homeownership demand started climbing up at warning levels. There was a decline in the interest rates, and the strict bank regulations were dropped enabling anyone to purchase homes. This enabled about 56% of those who bought homes during that time to do so, and they could not have bought it not for the bubble.

As the government supported home ownership, banks reduced the borrowing requirements in addition to lowering the interest rates. Adjustable-rate mortgages become of preference with low initial rates and three to five years refinancing options. Many houses were bought, developed and sold at profits. Following the Dot-Com crash, the stock market for houses started to rise, interest rates and those of adjustable mortgages begun to be refinanced at higher interest rates. When there was an emergence of a clear indication in the dive of the home values, prices started crashing resulting in sell-off in mortgage-backed securities leading to prices drop and loss of mortgage million dollars

References for Bursting Bubble Principle

Academic Research on Bursting Bubble Principle

  • Why Central Banks Should Burst Bubbles*, Roubini, N. (2006). International Finance, 9(1), 87-107. The author states that the two factors giving rise to the difficulties in asset price bubbles are: price agents expectations that are more important asset price determination especially in short run resulting disentangling difficulties of the purely psychological part from fair asset valuation. The second factor is too much reaction to information concerning the law. The paper suggests that for equity prices be a significant determinant in the monetary policy, a clear association between the monetary policy change and changes in equity prices and inflation should be developed.
  • How should we respond to asset price bubbles?, Mishkin, F. S. (2008). Financial Stability Review, 12, 65-74. The paper deals with the examination of the response of economic policies to the probable asset price bubbles, the author puts three statements into consideration; they include: Whether there exists more problematic are some asset price bubble concerning others, the response of monetary policy to asset price bubble and finally, the other appropriate policy responses. The conclusion was that the asset price bubble related to credit boom has specific problems because their busting leads to financial stability with the economy-damaging effect.
  • Bubbles, fads, and stock price volatility tests: a partial evaluation, West, K. D. (1988). The Journal of Finance, 43(3), 639-656.  The paper provides the overview and its interpretation on some of the literature about the stock price explosion that was facilitated by Leroy and Porter 28and Shiller 40. Stock price variation was not adequately explained by small-sample bias, rational bubbles and some models for expected returns. There was a suggestion of some nonstandard model for expected returns. There is fads model in which the naïve investors’ trading noise is important. Currently, there is less direct evidence on the existence of fads role on the determination of stock prices.
  • Leverage and asset bubbles: averting Armageddon with Chapter 11?, Miller, M., & Stiglitz, J. (2010). The Economic Journal, 120(544), 500-518. An example model is having high leverage and overvalued security assets is used to examine the increasing mechanisms driving the asset prices to surpass the equilibrium when there is the bubble of the asset resulting to threatened widespread insolvency and balance sheet recession. The bubble crisis resolution involves interest rate reduction, asset buying, and capital restructuring. Although the use of bankruptcy method’s failure to internalize the price impact of assets to pay debts, there has been a discussion on the official intervention in Super form Chapter 11 actions helps in the asset price’s prevention causing widespread economic vitalization.
  • The quality of financial statements: Perspectives from the recent stock market bubble, Penman, S. H. (2003). The paper outlines the violent attack on the traditional financial reporting model as backward-looking and out of date system during the previous bubble in the stock market. With the bursting of a bubble, the financial reporting quality was subjected to examination for not complying the traditional laws for sound earning measurements, assets and liability recording. The author’s reasoning was the need for financial reporting to serve as a tool during bubbles to check speculations. The paper explains that there are failures of GAAP and identification of financial disclosure that if not recognized will facilitate the momentum investments and stock market bubbles.
  • Asset Process and Monetary Policy, Issing, O. (2009). Cato J., 29, 45. The paper suggests that besides dealing with the immediate challenges, all crises bring out the question of why and where we got there and the teachings that should be learned to stop repeating the past developments without causing new unfortunate events. For central banks, monetary and asset prices relationship has attracted new attention, and the significant view has been criticized. The main consensus about the central bank roles is the maintenance of price stability. The paper concludes that money’s purchasing power is affected by an increase in consumer prices and with price stability, money serves best as account’s unit, the medium of exchange and store of value.
  • Corporate governance and responsibility, Witherell, B. (2002). OECD Observer, (234). The author outlines the recent failures and breakdown in honest accounting that has negatively affected people’s financial reporting faith, corporate leadership, and the market integrity. The author continued to explain the scandals has resulted in the liquidation of high-tech companies. As a result of the bursting of the high-tech bubble, the share prices were discounted, and venture capital suffered together with many shareholders. The conclusion is that the unfortunate part is that there were possibilities in preventing these events by effective corporate governance
  • Bubbles and crises, Allen, F., & Gale, D. (2000). The economic journal, 110(460), 236-255. The paper is about the previous bubble, where asset price is followed by collapse and widespread defaulting. Agency relationships in the banking sector are the causes of the bubble. Investors invest the money borrowed from banks into risky but reasonably attractive assets. This is because investors can decline the low profitable states by default. The shifting of risks allows the investors in bidding up asset prices. The paper finalizes by indicating that sources of risks could be both real and financial sector. When a favorable credit expansion is insufficient for prevention of crisis, financial volatility results.
  • Monetary policy strategy: lessons from the crisis, Mishkin, F. S. (2011). (No. w16755). National Bureau of Economic Research. The paper deals with the examination of learned things and the need for monetary policy’s strategy change in our thoughts about following the 2007-2009 financial crisis. The paper starts with the science of monetary policy discussion before the crisis and central banks’ perception of the monetary policy strategy. The paper continued to undertake an examination of how the crisis changed the thinking of macro and monetary economist and central banks. The paper finalizes by looking at how much science of monetary policy needed to be changed and outlines the monetary change implications.
  • Economic theory and asset bubbles, Barlevy, G. (2007). The author gives an overview of economic theory on the asset price bubbles occurrence, and the welfare implications result from bursting them. Sometimes, busting a bubble can lead to a society becoming worse off by making market distortion worse than whatever led to the first bubble.
  • Market fundamentals versus price-level bubbles: the first tests, Flood, R. P., & Garber, P. M. (1980). Journal of political economy, 88(4), 745-770.  The paper states that when the existing market price partly depends on the anticipated market rate change, there is a possibility of market launching itself into a price bubble which is controlled by arbitrary, self-fulfilling elements in anticipation. This paper’s purpose is the provision of tests of the proposition that the bubble was not present during the German hyperinflation, an assumption we are not able to reject. The test procedure that was proposed was general enough in application to other historical and modern occurrences.
  • Monetary policy after bubbles burst: the zero lower bound, the liquidity trap and the credit deadlock, Laidler, D. (2004). Canadian Public Policy/Analyse de Politiques, 333-340. The current extensive use of model of monetary policy connecting the expenditure and interest rate while ignoring the economic demand and supply for money relationship in the transmission mechanism failed in clarification of numerous significant policy issues and begun to create professional memory loss in these areas. The author states that the previous examination on the performance of monetary policy in the wake for financial crisis illustrates the claim. For instance, Short interest rates are close to zero for example in Japan previously.
  • Asset bubbles, endogenous growth, and financial frictions, Hirano, T., & Yanagawa, N. (2010). The paper carries out analysis on the existence and impacts of a bubble in an internal growth model with financial frictions and different investments. There are high chances of bubbles occurring when the pledgeability is in the medium range. Improving the financial market has the possibility of causing bubbles. Other findings state that relatively lower pledgeability results in bubble boosting long-run growth. The effects of the bubble bursting examination were also carried out, and the finding was that the impact of busting depends on pledge ability degree

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