Understanding Economic Bubbles: How They Form and Burst, With Examples

An economic bubble is marked by rapid escalation in asset prices, often due to speculative behavior, followed by a sharp contraction. These bubbles can be difficult to identify in real-time and are usually recognized only after they've burst, leading to significant economic consequences. Notable examples include the Japanese economy in the 1980s and the Dot-Com Bubble of the late 1990s.

What Is a Bubble?

A bubble is an economic cycle that is characterized by the rapid escalation of market value, particularly in the price of assets. This fast inflation is followed by a quick decrease in value, or a contraction, that is sometimes referred to as a "crash" or a "bubble burst."

A bubble usually forms when asset prices surge due to highly optimistic market behavior. During a bubble, assets typically trade at a price, or within a price range, that greatly exceeds the asset's intrinsic value (the price does not align with the fundamentals of the asset).

The cause of bubbles is disputed by economists; some economists even disagree that bubbles occur at all (on the basis that asset prices frequently deviate from their intrinsic value). However, bubbles are usually only identified and studied in retrospect, after a massive drop in prices occurs.

The Mechanics of an Economic Bubble

An economic bubble occurs any time that the price of a good rises far above the item's real value. Bubbles are typically attributed to a change in investor behavior, although what causes this change in behavior is debated.

In equities markets and economies, bubbles shift resources to rapidly growing areas, and when the bubble bursts, resources shift again, causing prices to drop.

The Japanese economy experienced a bubble in the 1980s after the country's banks were partially deregulated. This caused a huge surge in the prices of real estate and stock prices. The dot-com boom, also called the dot-com bubble, was a stock market bubble in the late 1990s. It was characterized by excessive speculation in Internet-related companies. During the dot-com boom, people bought technology stocks at high prices, expecting to sell them for even more until confidence waned, leading to a major market correction.

Economist Hyman P. Minsky's research explains financial instability and outlines characteristics of financial crises. Minsky identified five stages of a typical credit cycle through his research. Although Minsky's theories were overlooked for decades, the 2008 subprime mortgage crisis renewed interest in them, as they help explain bubble patterns.

Displacement

This stage begins when investors notice a new trend, such as a new product, technology, or very low interest rates—anything that catches their attention.

Boom

Prices begin to rise and gain momentum as more investors enter the market, setting the stage for a boom. The fear of missing out drives more people to buy assets.

Euphoria

During euphoria, asset prices soar, and investors largely abandon caution.

Profit-Taking

Predicting when a bubble will burst is difficult; once it bursts, it won't reinflate. It is possible to have an echo bubble, which is only a temporary rally. However, those who spot early warning signs can profit by selling their positions.

Panic

Asset prices reverse and fall, often as quickly as they had risen. Investors want to liquidate them at any price. Asset prices decline as supply outshines demand. 

Historical Instances of Economic Bubbles

Recent history features two significant bubbles: the 1990s dot-com bubble and the 2007-2008 housing bubble. The first recorded speculative bubble in Holland from 1634 to 1637 offers lessons for today.

The Tulip Mania: A Classic Example of Speculation

Although it seems absurd, a flower did impact Holland's economy in the early 1600s. The tulip bulb trade initially started by accident. A botanist brought tulip bulbs from Constantinople and planted them for his own scientific research. Neighbors then stole the bulbs and began selling them. The wealthy began to collect some of the rarer varieties as a luxury good. As their demand increased, the prices of bulbs surged. Some rare varieties of tulips commanded astronomical prices.

Tulip bulbs were exchanged for items of value, like homes and land. At its peak, tulip mania was so frenzied that fortunes were made overnight. A futures exchange for tulips, where they were traded via contracts without delivery, fueled speculative pricing.

The bubble burst when a seller arranged a big purchase with a buyer, and the buyer failed to show. At that point, price increases were clearly unsustainable. This created a panic that spiraled throughout Europe, driving the worth of any tulip bulb down to a tiny fraction of its recent price. Dutch authorities stepped in to calm the panic by allowing contract holders to be freed from their contracts for 10% of the contract value. In the end, fortunes were lost by noblemen and laymen alike.

The Dot-Com Bubble: Internet Frenzy of the 1990s

The dot-com bubble featured a rise in equity markets, driven by investments in internet and tech companies. It stemmed from speculative investing and excessive venture capital in startups. Investors started to pour money into internet startups in the 1990s, with the express hope that they would be profitable. 

As technology advanced and the internet started to be commercialized, startup companies in the Internet and technology sector helped fuel the surge in the stock market that began in 1995. The subsequent bubble was formed by cheap money and easy capital. Many of these companies had little profit or a significant product. Regardless, they were able to offer initial public offerings (IPOs). Their stock prices saw incredible highs, creating a frenzy among interested investors. 

As the market peaked, investor panic followed. This resulted in a 10% stock market loss. The capital that was once easy to obtain started to dry up; companies with millions in market capitalization became worthless in a very short amount of time. By the end of 2001, many public dot-com companies had failed.

The U.S. Housing Bubble: Market Expansion and Collapse 

The U.S. housing bubble was a real estate bubble that affected more than half of the United States in the mid-2000s. It was partially the result of the dot-com bubble. As the markets began to crash, values in real estate started to rise. At the same time, the demand for homeownership started to grow at almost alarming levels. Interest rates started to decline. A concurrent force was a lenient approach on the part of lenders; this meant that almost anyone could become a homeowner.

Banks lowered borrowing requirements and interest rates. Adjustable-rate mortgages (ARMs) were popular for their low introductory rates and three- to five-year refinancing options. Many people started to buy homes, and some people flipped them for profits. When the stock market rose again, interest rates followed. For homeowners with ARMs, their mortgages started to refinance at higher rates. Home values plummeted, triggering a sell-off in mortgage-backed securities (MBSs). This led to an environment with millions in mortgage defaults.

The Bottom Line

Economic bubbles, marked by rapid asset price inflation followed by sharp contraction, often stem from shifts in investor behavior. Key historical examples, such as Tulip Mania, the dot-com bubble, and the U.S. housing bubble, underline the pattern of bubbles: displacement, boom, euphoria, profit-taking, and panic.

Knowing these stages can empower investors to recognize potential bubbles early, allowing them to make informed decisions. Although identifying bubbles in real-time is challenging, awareness of market fundamentals and cautious investing during euphoric phases can mitigate risks associated with economic bubbles.