Everything you need to know about Economic Bubbles 

Although an economic bubble may seem like a complex macroeconomic phenomenon, understanding its dynamics is essential for retail investors. It helps them make informed decisions, ensure capital protection and appreciation, and manage risks effectively. This article will explore the economic bubble definition, its causes, stages, and types. 

What is an economic bubble in finance?

An economic bubble is a phenomenon marked by a quick and sharp rise in the market price of assets or securities. During a bubble, these assets are traded at prices that significantly exceed their intrinsic or true value, which is based on the company’s fundamentals, such as cash flow and earnings. Bubbles are typically followed by a burst that suggests a quick decrease in the value of assets or securities. 

What causes an economic bubble? 

Economists have differing views on the factors that lead to economic bubbles. Some even argue against the validity of such a concept, citing various reasons. For instance, they believe that what may appear as a bubble could simply be a natural market adjustment. Others argue that markets are inherently rational, accounting for all information when determining the value of stocks. 

However, there are economists who strongly believe in the existence of economic bubbles. According to them, here are some factors that contribute to their formation.  

1. Falling interest rates 

Low interest rates imply low borrowing costs. Easier access to capital encourages investors to increase their investments—even at inflated prices—to build wealth. This sudden increase in investment activity, despite rising prices, leads to increased speculation among investors, pushing stock valuations far beyond their intrinsic values. 

2. Speculation 

Speculation occurs when investors buy stocks in anticipation of price increases and not for their real worth or intrinsic value. This speculative demand creates a sense of Fear of Missing Out (FOMO), drawing more and more investors to join the buying trend. As demand amplifies, prices rise further, often disregarding the true potential of the asset. 

3. Technological innovation or market trends 

New technologies or market trends are often viewed through an optimistic lens, with investors believing in their potential to perform and deliver strong returns. This perception fuels enthusiasm, which, in turn, accelerates demand and inflates prices. 

4. Lack of regulation 

Government regulations and policies largely impact market behaviour. The absence of a definite regulatory framework can lead to aggressive investing, with investors recklessly engaging in risky financial practices to drive growth. Over time, this behaviour pushes asset prices to unsustainable levels. 

What are the stages of an economic bubble? 

Economist Hyman P. Minsky outlined the five stages of an economic bubble in his theory, the Financial Instability Hypothesis (FII). 

1. Displacement 

The first stage of an economic bubble starts when investors are drawn to a new paradigm, which refers to revolutionary concepts or new ways of doing things. This could be a new innovation, technology or even a regulatory change. The excitement and intrigue around the new opportunity drive investors away from traditional assets and shift their focus elsewhere. This sets the stage for the creation of a bubble. 

2. Boom 

The widespread knowledge of the new opportunity leads to a significant increase in the number of investors vouching for its potential. This belief, coupled with media hype, adds to the asset’s allure. The FOMO among investors pushes demand further and accelerates price appreciation. As more and more investors join in, the asset becomes unjustifiably overvalued. 

3. Euphoria 

During the euphoria phase, the speculative behaviour is dominant causing investors to ignore asset fundamentals. Despite irrationally high stock prices, investors continue stock trading with the expectation that prices will rise further. Although warning signs of unsustainability start to show up at this point, investors get influenced by emotions and think it is different this time. As a result, the disparity between intrinsic and market value continues to grow.

4. Profit-taking 

At this stage, the warning signs of unsustainability are crystal clear. Realizing that the bubble is about to burst and prices will soon fall, some rational investors begin selling their holdings and lock in whatever profits they can. This shift in behaviour slows the upward momentum and marks the beginning of a potential downturn. 

5. Panic 

As more and more investors race to sell their holdings and salvage whatever they can, asset prices begin to reverse. At this stage, supply outweighs demand, and panic starts to creep in, finally bursting the bubble. 

Types of economic bubbles

Here are some types of economic bubbles: 

1. Stock market bubble: Here, there is a stark difference between a share’s intrinsic value and its market value, with the market value being far higher than its true value, which is based on underlying fundamentals. 

2. Credit bubble: A credit bubble starts when lending rates drop or debt instruments, such as bonds and debentures, offer attractive returns, resulting in a high demand for consumer loans and debt instruments. Increased borrowing and spending lead to inflated prices. 

3. Commodity bubble: Commodities include raw materials such as agricultural products or precious metals. A commodity bubble occurs when the prices of such commodities rise rapidly and reach unsustainable levels. There could be many reasons for the price shift, including speculation.

Notable examples of economic bubbles 

Here are some examples of bubbles that served as cautionary tales for many investors: 

1. Tulip Mania: Known as the first economic bubble, Tulip Mania occurred in the Netherlands during the 17th century when tulip bulbs were considered luxury items and a status symbol. Their prices skyrocketed to astonishing levels, matching the cost of a luxury mansion at one point. However, by early 1637, prices dropped dramatically, causing the bubble to burst. Tulip Mania remains a classic example of how speculation and herd mentality can drive markets to irrational extremes. 

2. The dot-com bubble: Although the internet was introduced in the early 1980s, it saw rapid expansion starting in the mid-1990s, spreading widespread excitement among investors. This led to a surge in the demand for internet-based businesses. However, the enthusiasm was short-lived. As the market reached its peak, the initial euphoria began to wane. Investors started to become cautious and cash out profits, causing the bubble to ultimately break.  

3. Bitcoin bubble: Bitcoin, the first decentralised cryptocurrency, gained widespread attention due to its revolutionary blockchain technology. The year 2017 witnessed a 20-fold bitcoin price surge, from around $1,000 in January to nearly $20,000 by December. However, as with all bubbles, the market reached its saturation point, and enthusiasm started to fade. By December 2018, prices plummeted by about 85%, falling to as low as $3,214. Many questioned its long-term viability. Whether Bitcoin is, in fact, a cryptocurrency bubble will only be determined with time. 

While bubbles may bring wealth creation opportunities, they are usually for the short term. Extreme overvaluations over time eventually cause financial losses. Understanding the dynamics of economic bubbles helps investors capitalize on market opportunities while keeping risk levels in check.