Asset Price Bubble
An asset price bubble is a situation in which the price of an asset—such as shares, real estate, or a commodity—rises far above the level justified by its underlying economic fundamentals, driven primarily by expectations of further price increases rather than by the income or utility the asset can generate. Bubbles are characterised by rapid price growth, high trading volumes, and widespread optimism, and they typically end in a sharp contraction known as a crash.
Definition and characteristics
An asset price bubble exists when market prices deviate substantially and persistently from intrinsic value. Intrinsic value is commonly estimated by the present value of the asset's expected future cash flows, so a bubble implies that investors are paying far more than the discounted value of the income they expect to receive.
The defining feature of a bubble is that price increases become self-reinforcing. Rising prices generate capital gains, which attract new buyers, which push prices higher still. This feedback loop can persist for a considerable time, because investors who recognise that prices are excessive may nevertheless expect to profit from further increases before the bubble bursts—a form of behaviour sometimes described as "greater fool" reasoning.
Phases of a bubble
Financial economists commonly identify several phases in the life cycle of a bubble.
The displacement phase is triggered by some fundamental development—a new technology, a shift in policy, or a change in market conditions—that creates genuine new profit opportunities and attracts attention.
The boom phase follows, in which credit expands and prices begin to rise, drawing in increasing numbers of investors. Positive feedback between rising prices and increased credit availability amplifies the upward movement.
The euphoria phase is marked by widespread optimism, the entry of inexperienced investors, and the use of leverage. Valuation methods are stretched or abandoned, and caution is displaced by the fear of missing out.
The profit-taking phase begins when some informed investors decide to sell. Prices stall, and the momentum that sustained the boom weakens.
The panic phase follows, in which prices fall sharply as investors rush to sell. Leveraged positions are liquidated, credit contracts, and the declines feed on themselves, potentially spreading to other markets and to the broader economy.
Well-known historical episodes
The history of finance is punctuated by bubbles. The Dutch tulip mania of the 1630s saw the prices of rare tulip bulbs rise to extraordinary levels before collapsing. The South Sea Bubble in England and the Mississippi Bubble in France, both in the early eighteenth century, involved speculative frenzies in the shares of trading companies. The railway mania of the 1840s was followed by the Florida land boom of the 1920s.
More recently, the dot-com bubble of the late 1990s saw the valuations of internet companies soar far beyond any plausible earnings, before collapsing in 2000. The United States housing bubble of the 2000s, fuelled by easy credit and the securitisation of mortgages, ended in the global financial crisis of 2007–2008. The Japanese asset price bubble of the 1980s, involving both equities and real estate, was followed by decades of stagnation.
Causes
A range of factors contribute to the formation of bubbles. Easy credit and low interest rates increase the funds available for speculation. Leverage magnifies both gains and losses, encouraging risk-taking. Expectations of appreciation become self-fulfilling for a time. Herding behaviour leads investors to follow the crowd rather than to assess fundamentals independently. Information asymmetry allows insiders and early investors to profit at the expense of latecomers. Financial innovation can obscure risk, as occurred with complex mortgage-backed securities before the global financial crisis.
Behavioural economics has emphasised the role of cognitive biases. Overconfidence leads investors to overestimate their ability to time the market. Anchoring causes them to place excessive weight on recent price movements. Representativeness leads them to extrapolate recent gains into the indefinite future.
Consequences
The collapse of a bubble can impose severe costs. Direct losses fall on investors who bought near the peak. Contagion may spread through the financial system if leveraged institutions fail, as occurred when the collapse of the United States housing market triggered a global banking crisis. Wealth effects reduce household consumption, and uncertainty depresses business investment. Governments may be forced to bail out failing institutions, transferring losses to taxpayers.
Because the bursting of a bubble has such wide-ranging consequences, central banks and regulators devote considerable attention to identifying and containing speculative excess. This raises the difficult issue of whether, and how, authorities should respond to apparent bubbles—a debate that pits the view that central banks should "lean against the wind" against the view that they should act only after a bubble bursts.
Detecting and responding to bubbles
Identifying a bubble in real time is notoriously difficult, because price rises that later appear irrational may initially reflect genuine changes in fundamentals. Analysts look at indicators such as the price-to-earnings ratio, the ratio of house prices to rents, the growth of credit, and measures of investor sentiment, but no single indicator is reliable.
Policy responses to bubbles include macroprudential regulation, such as limits on loan-to-value ratios and capital requirements; monetary policy, which may tighten to restrain speculation but risks harming the broader economy; and disclosure and transparency measures to improve market information. The challenge is to act decisively enough to prevent the build-up of systemic risk without stifling legitimate investment and growth.