Why Are Asset Bubbles And Bursts So Important?

Unreasonable speculative rise of asset prices that reaches unprecedented heights without any real economic basis form the classical instances of asset bubbles. Such bubbles which have been observed in history all too often, invariably end up in a sudden unexpected burst, leaving lots of investors high and dry, and creates major crisis in the economy as significant value is eroded in a matter of days or weeks!
Why are Asset Bubbles and Bursts So Important?
Source - Wikimedia Commons (https://commons.wikimedia.org/wiki/File%3ATulip_price_index1.svg)

Human history ought to be read by all… even those who spend their life in something as different as trading in stock, commodities or real estate, for it is because of their ignorance of human economic history, that asset bubbles and their consequent bursts continue to create havoc in the economies. Sometimes, they lead to local economic crisis, whereas on other occasions, when they involve large open economies, they can even lead to a global crisis.

Understanding Asset Bubbles and how they Develop

Asset bubbles mean 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 are primarily a result of expectations about the future price rise of assets.

These bubbles almost invariably end in the form of sudden "bursts" - an even more rapid fall in prices. The investors holding those assets at the time of bust have to suffer significant losses. Such Asset bursts can seriously damage investors and economy and lead to crisis similar to one that was faced by the global economy in 2007-08.

Asset Bubbles in History

Asset bubbles are a result of speculative mispricing of assets. Hence, their history almost coincides with the develop of modern currency, and other assets. One of the first asset bubbles in recorded history, however, did not involve currency or stock or real estate, but was created by speculative unreasonable price rise of tulip bulbs. This very interesting episode of asset bubble development in one of the most unlikely of assets took place in Dutch economy in 1636-37, lasting only a few months, during which the market price of tulips multiplied several times, before the burst arrived in February, 1637.

Similar bubbles took place in the shares of companies in the next century, involving shares of South Sea Company in Great Britain and Mississippi Company in France, both in the year 1720. In both cases, extraordinary rise of share prices based on unreasonable expectations of further expectations was the cause, and did a great damage to investors’ wealth.

In the last two centuries, the asset bubbles have recurred in different classes of assets, with alarming frequency, involving almost every asset class. The real estate bubbles happen with unfailing frequency almost every 18 years, while the stock and commodity bubbles are more frequent. The fact that they still continue to recur is a testimony to the very short public memory and probably, the practical disdain that people, and in particular, merchants and traders have, towards history and its lessons!

The Economic Significance of Asset Bubbles

The 2007 global economic crisis has its origin in asset bubbles created in some countries especially the United States. Asset bubbles are the latest challenge for economists, policy makers and central bankers. The rapid fall in asset prices can upset the whole economy. In the recent 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 returns consist 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.

The Role of Expectations

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 soons '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 or Greece can affect the global stock prices throughout the world, even when there is no relationship between economy of Dubai or Greece with asset prices and other sectors of economy in other countries.

How to deal with Asset Bubbles

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.

As of now, even the economists do not fully understand or appreciate the nature and character of asset bubbles. There are still no adequate models for explaining the volatility of asset prices or the different dynamics of the asset prices. One of the reason is that the ‘rational expectations theory’ on which most of the econometric models are based has virtually failed in case of asset prices.

If Governments wish to be effective in dealing in Asset Bubbles, then they will need proper models using which they could monitor the variations and volatility of asset prices, and have some inkling when an asset bubble begins to start building.



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