Possible Causes of Economic Bubbles

An economic bubble (sometimes referred to as a speculative bubble, a market bubble, a price bubble, a financial bubble, or a speculative mania) is “trade in high volumes at prices that are considerably at variance with intrinsic values”. (Another way to describe it is: trade in products or assets with inflated values.)

While some economists deny that bubbles occur, the cause of bubbles remains a challenge to those who are convinced that asset prices often deviate strongly from intrinsic values.

While many explanations have been suggested, it has been recently shown that bubbles appear even without uncertainty, speculation, or bounded rationality. It has also been suggested that bubbles might ultimately be caused by processes of price coordination or emerging social norms. Because it is often difficult to observe intrinsic values in real-life markets, bubbles are often conclusively identified only in retrospect, when a sudden drop in prices appears. Such a drop is known as a crash or a bubble burst. Both the boom and the bust phases of the bubble are examples of a positive feedback mechanism, in contrast to the negative feedback mechanism that determines the equilibrium price under normal market circumstances. Prices in an economic bubble can fluctuate erratically, and become impossible to predict from supply and demand alone.

It has been variously suggested that bubbles may be rational, intrinsic, and contagious. To date, there is no widely accepted theory to explain their occurrence. Recent computer-generated agency models suggest excessive leverage could be a key factor in causing financial bubbles.

One possible cause of bubbles is excessive monetary liquidity in the financial system, inducing lax or inappropriate lending standards by the banks, which then causes asset markets to be vulnerable to volatile hyperinflation caused by short-term, leveraged speculation.

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