What Leads To Asset Bubbles And Busts?

As economy continues to accumulate more and more assets, and as these assets become proportionally bigger than productions and consumption, the asset price dynamics will become more and more important in economy, both at the local and global level. The free flow of capital combined with restrictions on movement on assets make this dynamics even more complex, and further augments the self fulfilling nature of expectations in it.
What Leads to Asset Bubbles and Busts?
Source - Wikimedia Commons (https://commons.wikimedia.org/wiki/File%3AShiller_IE2_Fig_2-1.png)

It was in later part of 2007 that the global economy that has been running like the bullet train since the hiccups at the turn of the millennium in spite of several oddities, suddenly and came to a screeching halt.. well, almost. The immediate precipitant was the sub-prime mortgage loan default crisis, but the underlying phenomenon was a real estate bubble in the developed world, especially the United States.

What has followed since has been a lost decade, which recovered largely due to the shale gas revolution, that freed the US economy from the oil import deficits, reduced oil prices globally,

and improved prospects of recovery. Yet, it will not wrong to say that in the process, almost a decade has been largely lost, reminding in more ways than one, the lost decades of Japanese economy after the 1980’s real estate crisis.

It is not a coincidence that these two great financial crisis in two the largest economies of the world resulted from asset bubbles and the consequent asset busts. What is surprising that in spite of large scale disruption that they causes, our understanding of asset bubbles and busts is still rather poor.

Asset Bubbles & Asset Busts: What are they & How they happen

Asset bubbles are unsustainable rapid rise in prices of assets which are primarily a result of expectations about the future price rise of assets.

The asset bubble 'busts' are an even more rapid fall in prices, which can seriously damage investors and economy and lead to crisis similar to one we are facing at a global scale right now.

The asset bubbles usually involve rapid rise in the prices of assets like equity shares, land, houses, gold, metal and commodities, without any obvious reason that can explain such price rise. The asset bubbles are inherently unsustainable, and they usually end up in the form of sudden "busts" - an even more rapid fall in prices. The investors holding those assets at the time of bust have to suffer significant losses, and on many occasions, they get trapped in speculative investments that prove to be equally damaging in the long run, both to individual as well as the economy as the whole.

The Global Economic Crisis of the Last Decade

Asset bubbles are the latest challenge for economists, policy makers and central bankers. The 2007 global economic crisis had its origin in asset bubbles created in some countries especially the United States. The rapid fall in asset prices can upset the whole economy. In the sub-prime crisis, the fall in housing prices was one of the main reasons for defaults in loan payments, which in turn caused the bankruptcy of many

financial institutions and even threatened the life of Freddy Mac and Fanny Mae.

The price of an asset should rationally represent the returns from that asset in future. In case of equity shares, these returns come in the form of dividends as well as the expected future rise in prices of that share. In the case of houses, the return consists of rental value of that house. In case of gold and other commodities, the asset-returns are the rise in prices of that metal or commodity that is expected in future months and years.

Expectations & Asset Bubbles

Thus, the most important components of asset prices are expectations. In fact, asset prices are a case of 'self-fulfilling prophecies'. When people expect price of a share to rise next week, they buy it today to get the profit. This increases the demand of that share today, and as a result, the price rises today itself (instead of next week). It also means that even when there is no other reason for asset price rise, the mere existence of an expectation of a future price rise can still be enough to raise prices.

Another aspect of expectations based asset prices is that when prices rise, the expectations of future price rise also increase. As a result, prices rise even higher. This can easily become a vicious cycle where prices rise exponentially for a short time, leading to a "bubble" like phenomenon, which is not sustainable and soon 'busts' leaving investors high and dry.

The 'expectations' of asset prices are not perfectly rational. Instead they are usually based on some heuristics or thumb rules like past trend of price rise, average rise over last few months or years, forecasts etc. These expectations can also change very quickly in the presence of adverse news, a phenomenon called "announcement effects". Thus, even a small news item like that of a crisis in Dubai can affect the global stock prices throughout the world, even when there is no relationship between Dubai real estate prices and other sectors of economy.

The whole world is still struggling with asset bubbles, and trying to find ways of preventing the damage that asset bubble busts can lead to. One of ways that we can contribute to this objective is by understanding how they happen and improving global consciousness about them.

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