Overview of Economic Bubbles and Asset Bubbles

Understanding economic trends is quite interesting and is also unpredictable. One such interesting phase of the economy is economic bubbles. It is a situation when the valuation of securities and assets increases at a much higher rate than their actual value. The intrinsic value gets overshadowed by this bubble. You may wonder why it happens! In this blog, we will discuss all about economic bubbles, stages of bubbles, and liquidity traps. So, continue reading to learn more!

Causes and Stages of Economic Bubbles

Answering what causes an economic bubble may be tough as there is no one particular reason behind it. However, let’s get into some insightful details about the causes and stages of economic bubbles:

• What Causes an Economic Bubble?

The probable reason for an economic bubble can be a boom in an economy. This boom increases the purchasing and investment capacity of people. Hence, more and more people participate in stock investment which in turn increases the valuation of assets and creates a bubble.

Another reason could be an increase in the number of liquid assets. Investors may also start borrowing money to invest more since the lending rates fall. All these in turn aid in the increasing price of these assets.

• Stages of an Economic Bubble

There can be five different stages of economic bubbles. These are:

• Displacement

The first stage is when investors start to notice a new change in the economy. It could be the launch of a new technology, a product, a service, or anything that catches attention.

• Boom

Boom is the phase when Investors start entering the market and prices start increasing. More and more investors participate which amounts to the popularity of the asset.

• Euphoria

This is the time when prices keep rising. In euphoria, prices skyrocket. In this phase, it is common for many investors to lose their caution and sway away with the flow of investment.

• Profit-making

Those who understand the bubble at an early stage may now make a profit out of it by selling assets. Although, realising the bubble is not that easy.

• Panic and burst

This is the last stage where the market trends take a turn. Investors start panicking which eventually leads to a bubble burst, maybe as swiftly as it increases. 

Types of Bubbles

Economic bubbles could be of different types. It majorly depends on the type of market sector it is affecting. Here are the different types of economic bubbles:

• Stock Market Bubble

It primarily involves overall stock market shares, exchange-traded funds (ETFs), and online businesses. 

• Credit Bubble

A credit bubble happens when business or consumer loans surge. It may include student loans, business loans, etc.

• Commodity Bubble

It refers to the price increase of specific commodity items like gold, metals, agro products, etc.

• Asset market Bubble

Asset market bubble involves assets other than equities. For instance, real estate, bitcoin, etc.

Understanding Asset Bubbles and Liquidity Trap

You may be aware of the dot-com bubble of the 1990s. It is one of the classic examples of asset bubbles. Let’s discuss asset bubbles, how they affect the market, and what is a liquid trap. 

• Introduction to Asset Bubbles and Liquidity Trap

An asset bubble may happen due to the irrational exuberance and over-speculation of the market. When investors keep on investing in an overvalued asset, the bursting of such a bubble can cause widespread losses to investors.

On the other hand, a liquid trap usually happens when the central banks become helpless. When the central bank is no longer in a position to stimulate the economy and manage the movements, it may suffer recession or even depression. This is usually a time when the interest rates have gone down to almost zero.

Asset bubbles may cause a liquidity trap or vice-versa. Understanding the relationship between the two during an asset bubble can be a daunting task at times.

• Understanding the Causes of Asset Bubbles

There can be various causes behind asset bubbles. Some of these may include:

• High purchasing power

When an economy has excessive liquidity, it may lead to increased purchasing and investment capacity of investors. Hence, the demand may outperform supply and the prices of assets may skyrocket. All these in turn can create asset bubbles.

• Tempting herd

Sometimes it can be seen that various investors invest in an asset irrespective of their clear understanding of the asset. It happens when a specific asset becomes popular and a herd of investors starts investing in it. Such herd behaviour can cause overvaluation of an asset and bubble formation.

• Competitive speculation 

Usually, at the profit-making stage of an asset bubble, it is wise to sell off assets to make a profit. However, sometimes, investors may overlook it due to high speculations. When the bubble bursts, it may cause huge losses.

• Quick credit

Amid asset bubble formation, some lenders may offer easy credit to investors. This helps them increase their investment capacity and thus, increase asset investment.

• The Role of Central Banks in Bursting Asset Bubbles

Central Banks can play a crucial role in bursting asset bubbles. Some experts believe that the central bank should intervene when there is a probability of bubbles. On the other hand, some believe that banks should only intervene when the bubble has been formed.

Central banks could increase interest rates to discourage investors from seeking high loan amounts. It can also ask commercial banks to limit their lending amount or increase their balance amount to avoid lending high loan amounts. Whatever the movement, central banks can play a decisive role in managing or bursting an asset bubble.

• The Importance of Interest Rates in Liquidity Trap

Interest rates can play a central role in liquidity traps. It happens when the nominal interest rates go down to as low as zero. High interest rates can limit loan borrowing and lending, thus creating a balance.

• The Impact of Asset Bubbles on the Economy

The economy can sustain lasting impressions of an asset bubble burst. Investors who sell their assets before the bubble becomes the winner while those who sell assets during the bubble burst may sustain huge losses. Also, the economy may go into recession due to financial instability and unemployment. In the end, the government may intervene to bring back the lost balance. However, it may take years to get the normal economy back.

• The Current State of Asset Bubbles in the Global Economy

In the current market scenario, some people are expecting a bull-run scenario for the stock market since some shares have witnessed all-time highs. Real estate has also witnessed a price increase. However, experts also believe that it may be an outcome of increasing work-from-home demand post-pandemic and thus, an increase in demand for real estate properties.

Cryptocurrencies have also seen a surge in price and demand. Although, many blame the unregulated market as the cause behind it. Also, some economies have witnessed financial instability due to COVID-19, which has forced the government to use expansionary monetary policies.

• Strategies for Investors to Navigate Asset Bubbles

Investors need to be cautious while investing in any market scenario, especially when expecting an asset bubble. One possible way out of it is market research. Make sure to do in-depth market research before investing in an oh-so-popular share. Diversifying a portfolio is another helpful strategy for staying safe as an investor. Loss of one investment may be balanced by the profit in another.

Above all, try to make an investment plan and stick to it. Getting tempted by market movements may not always be beneficial.

• Preventing Asset Bubbles and Liquidity Traps in the Future

Classic examples of asset bubbles teach us the importance of preventing such incidents in the future. There can be various measures that investors and governments may follow to avoid liquidity traps and asset bubbles. Strong regulations by the central government, regulated market investment, appropriate monetary policies, spreading financial education among budding investors, and responsible investment are some of the key factors!

Conclusion

Geopolitics, socio-economic factors, and various other factors may affect economic bubbles. It is crucial to be cautious while investing or borrowing loans in such times. Realising when the market is shifting towards the economic bubble is also crucial!