Financial Bubbles and How They Burst

financial bubblesA financial bubble is a period of time in which rapid economic expansion is followed by a significant economic contraction. The bubble can represent the expansion and contraction cycle of a particular part of the economy or the economy as a whole.

 

A Historical Perspective

There have been a number of devastating financial bubbles in modern history. The first of which was “Tulipmania” which occurred in Holland in the mid-1630’s as speculation in the tulip market ratcheted out of control.

What was once the domain of the wealthy caught on with lower-level investors who were selling other valuable commodities to get in on the game. As demand increased, so did the prices, which reached fever pitch in 1637 as people scrambled to buy prized tulip bulbs. The bubble burst just as quickly as it had formed leaving people with worthless scraps of plants.

We saw the same phenomenon in the United States in the mid-late 1920’s, when the concept of consumer credit first took off. Not only were people using credit to buy durable goods, they were also going into debt to buy stock on the speculation that the bull market would continue to grow unchecked. Of course, as with all bubbles, the market began to deflate. The widespread panic that ensued created the “Crash of 1929,” which would ultimately herald in The Great Depression.

 

The 2008 Financial Crisis

The 2008 financial crisis, which we are still working through today, was, by all accounts, initially caused by a bubble in the housing market. Residential and commercial development peaked in the United States in 2005, when construction comprised a full 6.5 percent of GDP (Gross Domestic Product). This was a full two points higher than the prior 25 years in the housing market, when the average amounted to 4.4 percent of GDP.

With more property on the market than ever before, builders and banks sought new ways to finance the purchase of new homes and developments. Monetary policy had loosened to help lower-income families achieve the American Dream of home ownership. Creative lending options – like low-doc and no-doc loans – also made it possible for buyers to get into homes they would never have been able to afford under traditional mortgage practices.

Still, the amount of building activity outpaced demand, resulting in a glut of unwanted property. As per the unyielding rules of supply and demand, property values plummeted in this saturated market. Home owners saw values plunge. Plans to flip the home or take equity from the property went awry. They began defaulting on their mortgages, which in turn cut into the cash flow of the banks holding those mortgages. Worse yet, firms that were heavily invested in mortgage-backed securities became increasingly less solvent.

It seemed to happen overnight, as one large financial institution after another found itself on the verge of bankruptcy. Deeming these businesses as “too big to fail,” the U.S. government created a bailout plan to lessen the impact of the crisis.

That wasn’t the end of it, however, as we saw major auto companies and others line up for help. Homeowners were feeling flush during those years that their homes increased in value with each new assessment, so they bought new cars and other goods. They’d over consumed and, again, supply was outpacing demand.

Further escalation came as companies started laying off workers or began closing altogether. Millions of suddenly unemployed Americans couldn’t pay their bills. Homes went into foreclosure, food banks ran out of donations, and The Great Recession was in full swing.

Today, the U.S. economy is still climbing back. Certain business sectors are thriving, while others struggle. Hiring is back up, but millions are out of work. All the money that should have been put toward the children’s education and retirement planning is gone. When the financial bubble bursts, it leaks slowly for very long time.

 

Emerging Research

Understanding what a “bubble’ is truly is an important area of financial study that has been spearheaded by think tanks such as The Leir Center for Financial Bubble Research within the New Jersey Institute of Technology’s School of Management.

The goal of the ongoing studies in this area is to leverage quantitative and qualitative research to identify an actual financial bubble, including its stages of development. Behavioral characteristics during a bubble and its aftermath such as over-optimism or pessimism regarding policy, investments, or contracts are also subjects of inquiry.

 

Sources

http://www.pbs.org/wgbh/pages/frontline/shows/dotcon/historical/bubbles.html
http://www.huffingtonpost.com/dean-baker/the-simple-reason-for-the_b_3938762.html
http://www.downsizinggovernment.org/hud/housing-finance-2008-financial-crisis
http://management.njit.edu/research-centers/leir_center_for_financial_bubble_research.php