Economic Bubble

Article byPriya Choubey
Reviewed byDheeraj Vaidya, CFA, FRM

Economic Bubble Definition

An economic bubble is a market condition where an asset’s price rises rapidly, but its intrinsic value remains significantly lower. Eventually, the overvalued asset experiences a sudden fall in price; the bubble bursts.

An economic bubble is caused by a high demand for a particular asset, an overtly optimistic investor sentiment, a positive news story, and speculations. Famous financial bubbles include the Tulip Mania, South Sea Bubble, Mississippi Bubble, Dotcom Bubble, and the US Housing Bubble. 

Key Takeaways

  • The economic bubble is an artificial inflation of stock price over a period. The asset or stock trades at a price that is significantly above its real value.
  • It occurs when investors anticipate a huge gain from a particular stock or asset. Most such trends are triggered by positive news and resulting speculation.
  • When the bubble bursts, the price fall is steep, resulting in a market crash. Very often, a bubble burst results in a recession.
  • Some investors make the right judgment; they anticipate the upcoming burst and start withdrawing their money. These investors end up selling stocks at a profit.

Economic Bubble Explained

An economic bubble is not formed overnight; it takes months or years of gradual price rise. On the one hand, the price of a particular stock escalates; meanwhile, its real value remains considerably low. The bloated market price is so high that it becomes a multiple of the asset’s intrinsic value.

But when the price reaches its highest, the bubble bursts, and the stock price collapses—falls to an all-time low. When the bubble bursts, the stock market is caught by surprise—resulting in an economic downturn. Shareholders face huge losses.  

Stock market peaks are followed by a downward trend—the bubble bursts. The economic bubble is divided into five stages:

Economic Bubble

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  1. Displacement: Positive news takes investors by storm and flares an optimistic market sentiment towards investing in a particular stock or asset.
  2. Boom: As the stock’s demand rises—price skyrockets—a boom is created.
  3. Euphoria: Many investors fail to anticipate a possible downturn—they keep investing in the stock at the maximum price and continue expecting good returns.
  4. Profit-taking: Some investors make the right judgment—they anticipate the upcoming burst—start withdrawing their money. These investors end up selling stocks at a profit.
  5. Panic: This is the bubble burst phase—asset price plummets to the lowest value.

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Examples

Let us now have a look at the real examples of economic bubbles below:

#1 – Economic Bubble Japan

In the 1980s, Japan’s economy hit a record high annual growth of 3.89%. This pace was even higher than US’s growth rate. Also, stock prices went up by almost thrice the profit yield for that firm. The real estate price showed the highest boom valuing around 2000 trillion yen.

In 1989, the stock’s price-to-earnings ratio reached an all-time high, i.e., 60, indicating the asset’s overvaluation. But soon, this bubble burst—stock prices crashed. As a result, Japan witnessed a prolonged economic slowdown, lasting ten years. Therefore, in Japan, the 1990s are referred to as the lost decade.

#2 – Economic Bubble China

Despite the Covid pandemic, China’s economy marked a 2.3% growth in 2020. In 2021 the country’s economic growth rose to 8.1%. However, economists anticipate an economic slowdown in 2022—down to 5 percent growth.

Real Estate Bubble

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Moreover, the real estate bubble was created due to excessive debt—as high as 92%. Xi Jinping believes in managing economic crises internally. Therefore, China is taking all the necessary measures to deleverage the economy.

History

Tulip Mania

The history of the economic bubble can be traced back to the 1630s Tulip Mania. It is also known as the Dutch Tulip Bubble that occurred in the Netherlands. This central Asian flower ended up becoming a status symbol for the Europeans. It was traded in the futures market at exorbitantly high prices.

However, in February 1637, tulip prices tumbled—buyers failed to execute the trade under the futures contract.

South Sea Bubble

The 1720 South Sea Bubble is another example. The British Government established the South Sea Company in 1711—to monopolize British trade with South America’s Spanish colonies.

Anticipating a tremendous success like the East India Company, the investors showed immense interest in the company’s stocks. By 1720, South Sea Company shares multiplied eight times—reaching a record high price of 775 British pounds. But, in August 1720, the bubble burst—prices plummeted to 290 British pounds.

Mississippi Bubble

In 1716, John Law established a bank—Banque Générale—it was authorized to issue notes. Law was an economic theorist, adventurer, and financial wizard from Scotland.

Later, Law also started a firm—the Compagnie d’Occident. The company revitalized French territories. He attained a monopoly in the African slave trade and French tobacco. In 1719, Law renamed his company: ‘Compagnie des Indes.’

Soon, he controlled a significant share of the nation’s foreign trade. As Law printed and issued more banknotes, his company’s share prices soared. It rose from 500 Livres to a peak of 18000 Livres. But soon, stockholders tried to redeem their notes into coins—the bubble burst—the stock market crashed in 1720.

Frequently Asked Questions (FAQs)

What are economic bubbles?

An economic bubble is an artificial inflation of stock prices. In a bubble, the price deviates from the stock’s real value. However, the price hike is not permanent—eventually, the bubble bursts—the price fall is sudden.

What was the first economic bubble incident in the world?

The first financial bubble was witnessed in the 1630s. It is now called the tulip bubble. It resulted from the Tulip Mania that broke across the Netherlands. Back then, Europeans considered tulips a luxury item. The rising demand for the central Asian flower resulted in exorbitant prices. Eventually, Tulips became the most preferred commodity in the European futures market. However, this bubble burst in February 1637—buyers backed out of their contract—demand fell suddenly.

What causes an economic bubble?

These bubbles are seen when the market price of an asset increases excessively—it deviates from its real value.

What happens when a bubble bursts?

When a financial bubble bursts, the asset or stock price tumbles down to its intrinsic value or even lower. The price fall is sudden, resulting in a stock market crash. Investors incur massive losses. The economy can slip into a recession.

This has been a guide to what is Economic Bubble and its definition. We discuss economic bubble, bursts, meaning, history, & examples from Japan, & China. You can learn more about it from the following articles – 

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