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?