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WTF: Economic Bubble Trouble

photo by Jay Morgan via Flickr

Economic bubbles happen all the time. What is a bubble and what happens when they burst? 

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Basically, an economic bubble is an imbalance between investment and the true worth of a thing.  So why is it that an economic bubble is so hard to spot, and so damaging once it pops?

Economic Bubble Attributes

In specific, the bubble analogy refers to the rapid increase of an assets value (the bubble expanding) and the inevitable deflation of said value (the bubble bursting).

Bubbles have stemmed from various scenarios throughout history, including the dotcom boom in the 1990’s which caused rapid inflation (and eventually deflation) in the tech industry and stock market, to the US housing bubble in the early 2000s which saw a mass influx of investment in the real estate market, only to have the bubble burst and leave many stranded economically.

How do they work?

Though the specifics of each economic bubble vary on a case by case basis, the essentials remain the same.

Economic bubbles are characterized by a couple of key elements, which include:

  • The bubble expanding: An asset (whether it be oil, mortgages, or any other commodity) experiences a sharp rise in prices, as speculation sends its value through the roof
  • The bubble bursting: An eventual steep and often sudden decline in an assets value after its worth is undermined

The first element is caused most frequently by rampant speculation on a specific asset. For example, during the dotcom boom in the 1990s  investors saw huge potential in burgeoning tech companies, and as a result they began to pour money into the equities market, inflating stock prices wildly.

The second element (the bubble burst), however, can be caused by many different things, all of which are rooted in either a sudden lack of confidence in a market or asset or a paradigm-shifting economic event.

Again, using the dotcom bubble as an example, when investors began to lose faith in the tech market (due in part to the flop of many startups) inflated prices began to drop precipitously.

From the peak of the boom to the bottom, the NASDAQ composite lost 78 percent of its value and the number of tech IPOs declined from 457 in 1999 to 76 in 2001.

Similarly in 2008 when the sub-prime mortgage crisis gutted the value of housing prices, a booming market turned into a gloomy one, causing some to lose as much as 50 percent of their home values.

Examples of bubbles throughout history

Though the dotcom and housing market bubble may be two of the more infamous examples of economic bubbles, they are far from the only ones.

Economic bubbles have spawned out of some of the most unassuming assets–most notably flowers.

  • The Dutch Tulip – In 1634 a virus swept Dutch tulips. Though the ailment didn’t kill them, it made them start blooming in a large variety of unique colors. Because of their rarity, gardens began to buy tulips in mass, and the prices skyrocketed. Eventually prices would plummet as demand fell, and the tulip which could at its peak buy an estate was worth no more than a common onion.
  • Bitcoin Bubble – bitcoin, which at its peak in 2013 was valued at over $1,100 is now worth just $280. It’s fluctuations are due mainly to lack of regulation, and skittish investors.

The results

Economic bubbles typically aren’t good for anyone. As exemplified by the housing bubble in 2008, depending on their breadth, they can have a long standing impact on national economic growth and prosperity

The bursting of an economic bubble can cause a number of adverse results:

  • Slowed economic investment – by instilling distrust in financial markets, economic bubbles can adversely affect the rate of investment
  • Tepid economic growth – if the bubble causes a widespread capital loss, people are less likely to spend, and therefore deflation and economic stagnation can run wild
  • Numerous ripple effects – as witnessed by the great recession, which followed the housing bubble, side effects like rampant unemployment and slowed GDP growth are possible

Originally published on March 4, 2015. 

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