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Asset Bubbles and their Economic Effects

Asset bubbles refer to the increase or sudden rise in the value of assets, like bonds, equities, commodities or real estate. This rise is above their rational or fundamental level. This dramatic rise in the value or price is over a short period and is not supported by the value of the asset. The distinctive feature of asset bubbles is irrational exuberance- a phenomenon where everyone starts buying the same asset or commodity. When buyers flock to a particular asset class, such as gold or real estate, its demand increases, which leads to an increase in the price as well.

Asset bubbles are created due to various combinations of low interest rates, modern technology, unprecedented increases in demand for a particular asset, and leverage. During a bubble, the investors continue to buy and hence, bid-up the value/ price of assets. This value is beyond any real or sustainable value and eventually, the bubble “bursts”. These bubble bursts are characterized by crashing prices, falling demand, reducing investment and consumption expenditure by the businesses and households. This leads to a potential decline in the economy.

Three primary conditions which contribute to irrational exuberance, asset inflation and subsequent asset bubble are:

  • Low-interest rates: Lower interest rates lead to cheap credit, which boosts investment spending in the economy. However, at these rates, investors are unable to receive good returns on their investments. Hence, they move their money to assets with higher yields, higher-risk asset classes and assets with spiking prices.

  • Demand-pull inflation: Demand-side inflation occurs when the aggregate demand for an asset exceeds the available aggregate supply of that asset. As a result, prices of these assets rise and due to this, everyone wants to receive a share of the profits.

  • Asset shortage: This is a supply side mechanism where investors think that the supply of a given asset is low and not enough to go around. This shortage mentality makes asset bubbles more likely as the imbalance of the demand and the supply leads to appreciation of prices beyond the asset’s value.

There is no doubt the mentioned factors played an important role in most asset bubbles and financial crises in the past. But they are proximate causes nonetheless. These factors are based on the assumption that people always act rationally and markets are efficient. However, neither are people always rational nor are markets always efficient.

As per behavioural finance, asset bubbles are studies two things very closely linked to financial markets – fear and greed. Naturally, asset bubbles begin with greed. The first signs of greed become visible once the smart money correctly identifies a potential upward trend followed by the institutional investors pushing prices above their long-run average. The finance media gets a story to publish and explain the surge in prices through the creation of “new economic value”. Such publicity quickly motivates buyers through what is known as FOMO, a fear of missing out, who in turn drive prices even higher. These buyers start to shape market sentiment pushing the asset prices significantly above their historical normals.

The media and those who have already invested however are keen to announce this new price level as the “new normal” to another leading to a wave of FOMO buyers joining the herd. This herd mentality later intensifies and a powerful euphoria takes over as investors promptly cast aside the fundamentals of their investment and only the incredible gains they have made are visible to them. This eventually culminates in the final stage of the bubble where investors overlook the fundamentals of the particular asset and buy simply based on past returns that have been extraordinary so future returns will be equally as stunning. Unavoidably though there is a trigger which ends this era of greed and marks prices come off their former highs.

This initial fall in price often sends investor’s particularly those who enter these positions at the peak into a period of dissent. These investors, who are still in denial, often get ambushed in a bull trap as they enter a new position believing the asset can still run higher. This provides short term price comfort but ultimately it proved to be futile as those who entered at the peak sold off their losing positions, driving further fall in price and selling. This leads to fear and more dramatic fall in asset prices, more dramatic than the initial rise, often to levels substantially below the most conservative estimates of intrinsic value.

(Source: Wikipedia)

Whilst it’s important to understand how behavioural finance believes asset bubbles work perhaps the most important lesson from behavioural finance is that investors need to honestly and thoughtfully examine their decision-making process. Investors should look to the insights provided by behavioural finance as a means of scrutinising their own decision making to ensure even during the mania of a bubble that their decisions remain rational and thought out.

As the definition of bubble suggests- unlikely to last, asset bubbles also burst some or the other day. We have already discussed the factors resulting in the formation of an asset bubble, presently let us see the bursting of this bubble. In this scenario, the price shoots up not because of demand-supply equilibrium but due to the increased money supply and credit flown in an economy. Consequently, the interest rate will fall and individuals will in general build their speculations. But the early players were already playing in the market and they exploited the value rise.

The hopelessness begins when the value continues rising and because of this, new unpracticed financial investors go to the spot in the desire for benefit. The subsequent progression of cash into the assets pushes the price up to considerably more inflated levels. However, at that point, the earlier financial specialists sell their stocks understanding the colossal benefit and realizing the price will fall at any point in the near future.

Therefore, these late buyers acknowledge little or no gains as the price bubble stalls for want of new money. Eventually, when the flow of money falls sustainably, this is when the bubble finally burst. This can inevitably lead to a recession; needless to say, we saw many such examples such as the stock market bubble in the 1990s, the real asset bubble in 2008.

After the effect of few asset bubbles:

1. The 1920s Stock Market Bubble

This bubble started in 1921 when the Fed attempted to increase the money supply by lowering down the interest rate hoping to spur borrowing and strengthen the economy. The credit continued expanding and by 1929, the obligation was expanded by different folds which created the strain between the banks and people in general about the speculative losses. The shrewd purchasers detected the circumstance in advance and they short all the stocks to pick up benefits. As a massive sell took off, the market smashed and everybody pulled back cash at any rate and this quickly intensified the circumstance prompting the accident of 1929, which saw the indebtedness of a few enormous banks. The crash touched off the Great Depression, still known as the worst economic crisis in modern American history.

2. The 2000s Real Estate Bubble

In the 2000s, The Fed dropped its target interest rate to historic lows and money supply grew an average of 6.5% per year, due to which getting house loans had become so easier. Thus each individual requested a new house for themselves and evidently, real estate agents, brokers, bankers, and builders were making huge money out of it. This bubble fueled in large part by the practice of loaning hundreds of thousands of money to people and as one might expect, people were just taking the loans without providing substantial collateral. Thus, soon large banks including Lehman Brothers became insolvent because people were not able to repay their dues. This resulted in the Great Recession which crashed markets around the globe, put many millions out of work, and permanently reshaped the structure of the economy.

As stated by Robert J. Shiller, Speculative bubbles do not end like a short story, novel, or play. There is no final denouement that brings all the strands of a narrative into an impressive final conclusion. In the real world, we never know when the story is over. Hence, we can’t claim that the bursting of a bubble would ultimately lead to recession or depression but it’s quite certain to happen.

Case study: Dotcom bubble

Business is life and life is business. It provides livelihood to people. But just like business, economics and economics can go wrong and such failure is many times referred to as a bubble. The failure of the stock market is often referred to as a bubble burst. A bubble basically occurs when an asset is overvalued (or) when the value of an asset strongly exceeds its intrinsic value. One such bubble is the Dot-com bubble which is further explained below.

The Internet Mania that came to rest in 2000 is labeled the ‘forefather of all bubbles’. The huge dollar losses in the millions of portfolios due to the dot-com bubble easily exceeded $1 trillion.

The bubble was fueled by enthusiasm for numerous products and services that could eventually be developed using the web: Software Sales, Internet Service Providers, Search Engines, Portals, Web Services, Website Auctions, Sales over the web and B2B Networks were among the many ideas to have been developed. In addition, the internet system would require greater capacity and speed.

Thus, billions or maybe over trillions of dollars of network equipment would be required. By 1995, the investment concept was born.

The big question was, ‘Who will profit?’

Eventually, the answer became clear to most internet investors, that is ‘Not everybody!’

Netscape Communications was founded by young and prescient Marc Andreesen and a shrewd millionaire entrepreneur, James Clark. Netscape was an early kingpin in the field by having developed an advanced browser software called “Navigator.” Revenues increased rapidly and the company’s initial public offering on August 8, 1995 was the most successful ever up to that time. In under five months, the stock progressed from the IPO price of $28 to $171 per share. At its high, the company’s shares clocked a market value of over $6.5 billion which was seemingly around 80 times their 1995 revenues! Many seasoned observers held that Microsoft’s momentum as a chief competitor was the turning point for Netscape, eventually acquired (after a plunge of 80%) by America. Never did the people realise the saying by famous author Benjamin Graham, “High growth potential of a company does not necessarily provide the stakeholders with high returns.” It was not too late until the Dot-com prices plunged heavily. This plunge in the prices of Dot-com stocks did not only affect the stock market but the lifetime savings of millions of people.

We must not be attracted towards the other investors investing in a stock. Rather we would have to perform our own thorough research before flushing money into the market.

The Dutch Tulip Mania:

Today, you can buy several tulips for just Rs. 25 but durin 1637, you could buy a villa on the streets for a couple of tulips. The year is 1637, right in the middle of Dutch Golden Age. Even though it was the Golden Age, a thing as small as a flower had created a collapse in the Dutch Economy. For those who might be thinking if the tulips created a bubble in the economy, yes they did. This was when the first financial bubble had burst and is the story of a Tulip Mania.

Let us understand an economic bubble through the example of tulips. Suppose you are an individual who says that you had just purchased a Tulip for Rs. 100 and sells it for Rs. 150 after a certain period of time. The same evening, you happen to meet with your friends and explain to them how you just made a profit of Rs. 50 by selling a tulip. Fascinated by this transaction, all of your friends go agog to purchase tulips with the hope that even they could make profits like you. In this situation, the market is flooded with buyers but nobody realises that there aren’t going to be any such buyers in the future because everybody already has a treasury of tulips. As the demand had increased adversely, the prices of the tulips had also increased requiring the people to pay more than what the tulips were actually worth. Supply remains constant and due to decrease in demand, the prices tend to fall and you would want to sell the tulips in this situation and make as much money as possible but you are not able to do so because there are no buyers in the market. Thus, the bubble bursts.

The tulips originated in Persia and travelled via the Ottomon trade to Europe. Tulips originally come in a variety of colors and they were begun to be priced over all the other flowers. The increasing middle class families in the Dutch Republic were willing to pay large sums of money for the newest, the latest and the spectacular tulips. Each year, new varieties were cultivated. Tulip traders usually had their own private gardens and there were no particular tulip cultivators. All these men started loving to grow tulips on their land and the surge in tulip prices encouraged them even more. Since they started growing exotic varieties of the flower and made special contracts with the buyers that they could not further sell the tulips without the authorization of its original seller. This created a monopoly in the market and the prices of the original seller kept on rising. It was when one such buyer purchased tulips and sold them further, not abiding by the contract between himself and the buyer, the tulips were available at a cheaper rate and thus, the bubble burst creating chaos in the Dutch Economy.

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