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Economic Bubbles: What They Are, Why They Happen, and Why You Should Care

You don’t need a Ph.D. in economics to know that economic bubbles—and their ensuing POPS!—can take us all for a wild ride.

Bubbles occur anytime asset prices appreciate unrealistically; and they happen more often than we think. In the United States alone we have seen two in the past twenty years: The dot-com bubble in the late nineties and the mid-2000s real estate craze that has resulted in today’s downtrodden economy.

Bubbles happen everywhere. Japan, for example, experienced a huge surge in real estate and stock prices in the late 1980’s. Apartment prices doubled or even tripled in value in only a few years. By 1990, the value of Japan’s real estate had grown to five times the value of the entire U.S.; The Imperial Palace alone was valued as much as the entire state of California.

At the end of the boom, however, Japan’s balloon economy became distressed and fell hard, entering into a decade-long deflationary slump. This so-called lost decade is a painful reminder of what can result from such a bubble. In fact, Japan is still struggling to revive its economy today, in part due to the recent global financial crisis.

Why Do Bubbles Occur?

There is no single, widely-accepted theory to explain why certain assets sometimes grow rapidly and unsustainably.

One theory is that as an economy gains momentum, companies report higher earnings and pay individuals higher salaries. Instead of putting aside money in savings, individuals spend more than they should, purchasing a home that’s beyond their means thinking that as prices appreciate, they will be able to pay it off easily. They may also be more inclined to make risky stock market plays. This causes a contagious domino effect that eventually leads to a bubble.

An alternative theory is that as an expanding economy pumps more money into the financial system (liquidity), borrowing money becomes cheaper. With interest rates down, investors are more likely to leverage their capital by borrowing money from banks and investing in other assets such as real estate. When investors are putting too much money into a limited number of assets, prices rise. Multiply this effect by the number of individuals and large institutions that participate, and you get a classic bubble.

In my opinion, these and other theories are neither right nor wrong; many factors combine to create the “perfect storm” that leads to a bubble.

Should We Prevent Bubbles?

The more appropriate question might be: Can we prevent bubbles?

Although increased regulation can partially depress bubbles, economists have a difficult time accurately identifying bubbles and an even harder time implementing policies that won’t negatively affect other areas of the economy.

Most commonly, the Federal Reserve attempts to stifle bubbles by creating monetary policy aimed at controlling rising asset prices. The Fed increases the federal funds rate when there are inflation concerns and lowers the rate to spur economic growth. And when banks raise interest rates, borrowers have a harder time getting loans to fund investments or small businesses.

But even as the Fed raise interest rates up to 6.75% back in 2006, the U.S. real estate bubble continued to expand until its crash in 2008.

Looking back, bubbles seem obvious. Unfortunately, however, bubbles are difficult to detect as they occur because they typically begin with modest and innocent optimism.

That makes bubbles inherently difficult to stop a bubble from forming. Besides, who wants to be the guy taking away the punch bowl as the party just gets started?

Can Bubbles Benefit the Economy?

Bubbles scar the economy, and the healing process is long and painful. Just look at Japan.

But if you’ve ever enjoyed getting an incredible job offer, earning a plump salary, or making a lucrative investment during a bubble, you might be wondering: “Well, bubbles can’t be all bad”.

One benefit of bubbles are extensive standard-of-living increases for large segments of the population. Bubbles are capitalism’s way of rapidly metamorphosing an economy.

Without the Internet bubble we might have missed companies like AOL, which connected virtually every American household to the Web. Although 1999’s inflated salaries and stock prices are ancient history, the Internet remains and has transformed the way we share information and do business.

Looking back even further, electricity was commercially available in America as early as the 1880s, but utility companies faced certain barriers that delayed the implementation of electricity until the 1920s. The bubble of sorts preceding of the Great Depression contributed to electricity’s spread into rural areas and consequently, electrical household appliances that drastically improved Americans’ way of life.

Not all bubbles are transformational, but those that are enhance our quality of life and pave the way for future innovation. So as we endure the present downturn and look back on the culprit bubble as a cancer, we can remember that this cycle may actually be making our lives better and our economy stronger for the long run.

What do you think? Can bubbles be avoided? Do you see them as good in any way? What do you see as their negative or positive impacts?

Published or updated on February 10, 2010

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  1. Don says:

    It seems that everybody focuses on the end result of bubbles. True it can be a bad thing if you stay in particular thing too long. However not too many things are meant to go on forever. Lets take flying via airplanes as an example. Yes you can cover large distances in a short period of time on a tank of fuel. At some point in time the plane must land and end it’s flight to refuel or fall out of the sky. Why? Simply because fuel is a fundamental or basic requirement for many flights in safety.

  2. Honey says:

    As an English TA I received partial tuition remission and a salary of $12K/year. It took me 8 years total (2 for the MA and 6 for the PhD) so I supplemented quite a bit with loans (though I feel now I could’ve been a bit more frugal, I will admit that in going straight to grad school from undergrad I deprived myself of the opportunity to get a sense of “real-world” salaries, money management, etc.). Some loans would have been necessary, though.

    Now I manage a PhD in anthropology and our students finish, on average, in 8 years with an annual stipend (for the 50% or so of students who are supported) of $13K/year.

  3. Edwin says:

    While I think the tuition increases, at least short term, won’t change the financial advantage of a degree, I still think it is a massive problem.

    Our economy needs people going through higher education to do the high value added jobs (and no, working for Goldman Sachs does not count!) such as research, medicine, starting productive companies, etc.

    Other countries are doing this far better than we are and the increased tuition is another step towards making the U.S. economy far less competitive in the future.

  4. Stan says:

    The education bubble didn’t really occur to me, but it really does make sense. Tuition is accelerating and it seems like students don’t have a total grasp of what they’re actually paying for, let alone the magnitude of their loans.

    Whenever the government steps in to support any aspect of our lives, there seems to be some type of bubble. I’m worried that all this government intervention now will come back to haunt us later on.

  5. David Weliver says:

    I’m enjoying the discussion here and just laughed because I was a sociology major. And when I started college in 1999 all the seniors were getting $60k (or more) jobs working at dot.coms, so I kind of expected the same thing. We all know how that turned out.

    I do think tuition increases are a huge problem; I had never really thought of it as a bubble before, but I suppose it is. I just hope it pops soon…I used some calculator that said if I had a child today a private college could cost nearly a half million dollars in 18 years. WHAT?

    On another note, Edwin my anecdotal experience has been the same: My friends in PhD programs are paying their way through school with TAs and such. They’re poor at the moment, but they aren’t going into the boatloads of student loan debt like the MBA, law and med students.

  6. Edwin says:

    This could be totally inaccurate but I have a few friends who are PhD students (don’t have it yet). One is in bio-science and another in accounting. Both get to attend school for free and get paid about $24k while doing this. On the other hand something like an MBA costs a boatload of money.

  7. Honey says:

    Fortunately I will pay off my credit cards this year and then I can afford to switch to the fixed repayment plan! Haha (I have a PhD in English, of all things…)

  8. Edwin says:

    Honey, you are totally right. It can be very tough dealing with student loans at the very beginning. It’s even worse if you graduated in a poor economy even if you do have high paying degrees. It’s even worse if you are in a field like sociology which pays poorly and still costs a ton of money (I know a few people like this). Hell, at least they enjoy their jobs.

  9. Honey says:

    I see what you are saying, Edwin, but if you graduate with enough loans that you’re on a graduated repayment plan and can’t afford the interest-only payments, then it’s just like an ARM – you’re underwater on your education even if you are going to earn more over your lifetime as a result.

    I hear you on the entitlement thing, though. I remember the semester that all my business writing students (who were retail and consumer science or family studies majors, mostly) said they expected to make $60K as a starting salary when they graduated. Oh, and they were all going to be buyers for Macy’s. Straight out of college. I couldn’t think of anything to say but my mind was like ?!?!?!?!

  10. Edwin says:

    The difference between college education and other loans is that the fundamentals are still sound on the education… well… in most fields of study.

    With the crazy inflation of tuition rates I’ve seen plenty of articles written about whether college is actually worthwhile. And even with all the differing viewpoints the answer is a resounding yes.

    Even with having to bear a giant debt right into ones working life, the value added from a college education more than makes up for it. So while tuition is increasing greatly, it is still valuable. This is quite a contrast to the housing market where the house prices were increasing, but the value (price to rent ratio) was become worse and worse.

    Another, non bubble related, issue with tuition is that students tend to think its a free ticket to whatever job they want so don’t put in the actual work required to get their desired job. So they sit on their thumbs waiting for the job to just drop into their lap rather than expanding into different lines of work that can use their expertise.

  11. Honey says:

    I never thought about government “encouragement” as a cause to a bubble, but it makes sense.

    I have a PhD and have really only ever worked in universities, so lots of reasons and experience behind my prediction :-)

    It will be interesting (and probably inevitable at this point) because on the one hand, student loans do not get discharged in bancruptcies, so you still have to pay…yet on the other hand, if you can’t make your payments I am pretty sure that your loans stay with the lender (i.e. don’t get sold to collectors like other types of debt).

    Obama is trying to forestall this by capping the percentage of your salary lenders can set repayments at, but what’s going to happen when you’ve borrowed so much that the capped payment amount doesn’t even cover interest on the loan? Capping payments does no good unless you’re actively trying to discourage people from borrowing, and THAT’S not happening…

  12. Edwin says:

    Yes government policies can have an effect on bubbles but its not really a “major” reason. Anytime someone buys anything on credit they aren’t using their own money. Government alone will never cause a bubble without major assistance from other factors (such as getting away from fundamental pricing).

  13. Nick says:

    Bubbles occur for a number of reasons. One major cause is because of government intervention in the economy. When the feds try to “encourage” home ownership, prices artificially rise because people aren’t using their own money to buy. When the feds declare that a company is “too big to fail” and bails it out, the company is encouraged to take on more risk. This can appear to be good in the short term, but the market will eventually correct itself, as we are seeing today.

    I agree with the above reply about student loans. Once again, the government is trying to “encourage” people to go into higher education. This will probably cause an artificial increase in tuition. It will also cause a crash similar to the housing market. Too many people with bad credit can get $100k in student loans and none of them will pay it back. Do the math! :)

  14. Edwin says:

    While there are lots of people saying that x industry will collapse any moment (and have been for a very long time), there are still legitimate people who have predicted past bubbles.

    This is generally people who’s career it is to be involved in understanding the fundamentals of that specific industry. These people tend to be research economists.

    Generally no one notices because bubbles seem like a benefit for most people. Big institutions are looking for short term profits and increased value to the shareholders while individuals tend to follow the hype of institutional marketing and media.

  15. Honey says:

    The next bubble will be tuition, but it’s not because universities are paying their employees more – the side effects of the housing crisis have led state institutions to have significant cuts handed down to them from their legislators. The debt has been pushed around and this is where it’s going to pop up next, but instead of having overappreciated tangible assets like homes or stocks, there will be a total meltdown of higher education in the US.

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