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Bubbles

May 11, 2021
Editor(s): Nuoya Liu
Writer(s): Annie Zhu, David Li, Kaiyue Chen

The occurrence of economic bubbles travels as far back as the 1630s entailing the well-known ‘The Dutch Tulip Bubble’. Bubbles often arise from shocks that direct unprecedented amounts of attention and speculation towards an underlying asset. They tend to be associated with surging demands which drive prices far surpassing the asset’s intrinsic value. Unsurprisingly, this rather sentiment-driven market price is highly fragile. Without the protection from the asset’s fundamental value, it becomes extremely vulnerable to any new information or signals (ironically, the quality of which are often disregarded) that arrive. For this reason, bubbles are almost always short-lived – they will eventually ‘pop’, triggering the domino effect of price plummets and investors panicking to short their assets at any price point possible.

Over the years, a pattern has been identified for the cycle of a bubble, separating into 5 stages. A quick overview, the initial displacement where investors are captivated by a new paradigm. Followed with a boom, that as more and more investors draw attention to the asset, momentum is gained and induces an exponential growth. Leading to the Euphoria phase, falling into a trajectory of deprivation in rationality, where the “greater fool” theory arises. Reaching the profit-taking stage, where investors in the initial capital begin to harvest the unprecedented growth in asset. Thus, leading to the term, the “bubble bursts” and as actual valuations set in, people panic as they scramble to liquidate their assets before the value plunges any further.

The above observation can be exemplified by Japan’s real estate and stock market bubble, which crashed in the 1990’s after soaring prices. In the 1980’s, prior to the event, Japan’s GDP of 3.89% positioned them at their pinnacle for the next decade. The bubble formed its initial shape during a 50% surge in Yen that generated waves of investment to be injected into Japan’s economy. However, the effort by Bank of Japan to combat staggering asset prices through raising interest rate eventually led to a liquidity trap, which in combination with a credit crunch, caused the country’s economy to collapse. Subsequently, prices began to fall and with the rising panic and the liquidity trap setting into place, people held on to their cash. Furthermore, as banks tightened their lending requirements, the economy was essentially left with little resources to revive with. The aftermath of the asset price bubble bursting, equity values descended by 60% and land values impacted by a 70% fall.  At the pit of this decade, Japan’s economy was in a stagnated state with price deflation, hence making it more arduous to rebound back to its original state. The following years from 1991 to 2003, Japan’s GDP grew only 1.14% annually.  As witnessed the short façade of a bubble comes with insufferable long-term implications.

Another eminent example of a bubble is the “tulip mania” that occurred in the Netherlands in the mid 1600s. Although there is evidence that when the tulip bubble burst that there were no overwhelming adverse effects on the Dutch economy, it still carries a potent lesson in the dangers of greed, speculation and excess.

Netherlands during the 17th century is different from other European countries in that they had a much more populous middle class, who were pedantic about emulating the lifestyles of those better off than they were. And so, when tulips first became available, being imported from the Middle East, they became a signal of wealth and affluence that many Dutch fawned over. Moreover, the fragile nature of a tulip, and its short blossoming period meant that even the rich were continuously chasing fresh tulips to supply their living rooms.

The demand was so great for these tulips that markets were established in major Dutch cities, and traders began to speculate, building on the manic trance “the passion for tulips will last forever”, echoing throughout the population. The usage of derivatives to purchase tulips further catalysed the bursting of the bubble, as many bought tulips on credit, with the intention of repaying the loan once they sell their own tulip for a profit. If the exorbitantly high prices was a bomb, the widespread purchase of tulips using these derivatives lit the fuse.

As soon as prices began to fall, the market built on tulips collapsed. What caused prices to fall in the first place? It is impossible to know for sure, but it is likely that the increasingly complex trail of credit derivatives, combined with prices reaching up to 6 times an average worker’s annual wage contributed to the decline. Once prices fell, those who purchased tulips on credit were forced to liquidate immediately, lest they lose even money with the rapid decline of prices. This catalysed a chain reaction that caused the tulip market to convulse, as it immediately wiped out the wealth of the speculators who were solely dedicated to tulips. Indeed, it is those from the middle and lower classes who thought that it was a good idea to bet their life savings on a tulip derivative that suffered the most. The experience speculators and upper classes did not bear much of the impact, and as a result the economy did not collapse with the market.

Two lessons can come from this story. Firstly, for the majority of the population, being in a bubble is an “unknown unknown”; even those of exceptional intelligence will be led to think that “prices will keep on increasing”. Secondly, when a market collapses, it is the poor that will suffer. In the words of Mark Baum following the GFC, “they will just blame immigrants and poor people”.

In addition, the burst of asset price bubbles has often been accompanied by economic downturns, or even recessions in the history. The sharp decrease in asset price shrinks people’s wealth and creates long-lasting damages on investor confidence, in the sense that individuals are more likely to reduce consumption and save more for future. Firms reduce the output and lay off staff to minimise loss. Investors are uncertain about future economic performance and hold back investment activities. These all exacerbate and amplify the negative impact of asset price bust, which may finally lead to an increase in unemployment, significant reduction in economic output and a fall in life quality.

What’s worse, the implication of asset price bubble in one country can be contagious that affect the rest of the world through trade flow, financial flow and the change of people’s expectation and behaviour. For example, the house price bubble happened in USA in 2008 evolved into global financial crisis that affect almost every country. Government intervention is crucial to facilitate economic recovery. For example, government can adopt expansionary fiscal policy, increasing government spending and launching more programs that foster employment and economic activities. Tax reduction and subsidy programs can also help to boost consumption and investment.

Though the causes and catalyst of asset price bubble events are still being researched by many scholars, it is without doubt that such events would similarly cause adverse impacts on economic and social development. Further policies such as adjusting financial sector regulation and government intervention in financial market may be helpful to reduce the possibility of such events’ occurrence.

References

5 Stages of A Bubble. (2021). Retrieved 11 May 2021, from https://www.investopedia.com/articles/stocks/10/5-steps-of-a-bubble.asp

Power from the Ground Up: Japan’s Land Bubble. (2021). Retrieved 11 May 2021, from https://hbr.org/1990/05/power-from-the-ground-up-japans-land-bubble

The Lost Decade: Lessons From Japan’s Real Estate Crisis. (2021). Retrieved 11 May 2021, from https://www.investopedia.com/articles/economics/08/japan-1990s-credit-crunch-liquidity-trap.asp

The CAINZ Digest is published by CAINZ, a student society affiliated with the Faculty of Business at the University of Melbourne. Opinions published are not necessarily those of the publishers, printers or editors. CAINZ, our Partners and the University of Melbourne do not accept any responsibility for the accuracy of information contained in the publication.

Meet our authors:

Nuoya Liu
Editor
Annie Zhu
Writer
David Li
Writer

Hi! My name is David, and I am a second year BCom student majoring in Economics and Finance. Outside of uni, I enjoy playing guitar, watching the F1 and making cocktails.

David Li's Articles
Kaiyue Chen
Writer