Irrational exuberance: two rather unremarkable words, but when put together they had enough force to cause stock markets around the world to plunge. When in 1996 Alan Greenspan, then Chairman of the Federal Reserve, warned that this was what markets could be experiencing, it caused a major slide in prices as investors questioned whether they were trapped inside a bubble.
Greenspan had realized that the share prices of technology firms were rising far faster than one might have expected. People were getting carried away, allowing their excitement about the Internet boom to push them into buying shares for more than they were reasonably worth. The result, in the early days of the dot-com share bubble, had been to send prices soaring. Greenspan’s warning caused the Dow Jones share index in Wall Street to dip by 145 points the following day, but confidence recovered until after the turn of the millennium.
This “irrational exuberance” affair illustrates two key points about financial markets and bubbles: first, it is extremely difficult to identify a bubble, still more so to work out how close it is to popping; second, it is not always easy to bring bubbles back under control.
Identifying bubbles Economic bubbles occur when speculators’ and investors’ excitement about a particular asset causes its price to be pushed higher than it ought to be. Of course, gauging the “right” price is subjective, hence the problem. Even as Internet share prices scaled dizzy heights in 2000 there were plenty of analysts and experts who maintained they were fairly valued. The same was true of house prices in the US and the UK in 2006 before they started to slump during the following economic crisis.
“Our [investment decisions] can only be taken as the result of animal spirits—a spontaneous urge to action rather than inaction.”
John Maynard Keynes
Bubbles are by no means a new phenomenon. They have recurred since the earliest days of markets: from 17th-century Holland, where investors rushed into buying tulips, and the South Sea and Mississippi Company bubbles of the 18th century (associated with profits to be made from European colonies), through to the various property crazes of the 20th century.
While it is obvious with hindsight that these were bubbles, it was hard to identify them in advance. Prices can rise for what economists call “fundamental” reasons. House prices, for example, may increase because more people want to live in a certain country or region—in other words, there’s an increase in demand—or because the number of homes being built falls—in other words, there’s a constraint on supply.
Leaning against the wind Many economic experts, including Alan Greenspan, have argued that policymakers should not attempt to clamp down on bubbles—to “lean against the wind” by, most obviously, raising interest rates or slapping down new regulations—but should instead concentrate on mopping up the mess after they burst. Their rationale is twofold. First, it is difficult to identify whether rising prices are the symptom of a bubble or a benign manifestation of economic growth. Second, given that economic tools such as interest rates and regulation are blunt, the likelihood is that employing them will lead to collateral damage in other parts of the economy.
Feedback loops
When a bubble is brewing or bursting, it affects the economy through a virtuous or vicious cycle, which economists call a positive or negative feedback loop. As prices rise, people feel wealthier, causing them to spend more, which propels the wider economy forward. When prices slump, people spend less, which in turn causes prices to fall even further and banks to lend less cash. During the 2008 financial crisis, a negative feedback loop developed, in which banks stopped lending freely to the public, which prompted people to cut back on their spending, which only served to reinforce banks’ reluctance to lend. These loops are the most dangerous of all economic phenomena, since once started they are very difficult for anyone—from central banks to politicians—to arrest.
Some have actually suggested that bubbles are an integral part of a well-functioning economy, encouraging large-scale investment that would not otherwise have occurred. For instance, the dot-com boom of the late 1990s sparked a race to lay massive fiber-optic links across the world. The result was an international network of far greater capacity than was needed at the time. Many of the firms involved went bust, but the increase in bandwidth was partly responsible for driving economic growth in the post dot-com years, as it brought down the price of international communication. Similarly, some argue that the popping of a bubble rids the economy of its least successful businesses through the process of creative destruction (see Creative destruction).
The damage done However, such arguments can seem questionable when an economy has just suffered the bursting of a bubble. The slump or recession that follows can be highly damaging. As banks start rationing credit, for example, even simple financial transactions can become significantly more expensive (see Credit crunches). One has only to look at the Great Depression, which followed on from the Wall Street Crash of 1929, to realize how serious the long-term economic implications of a bursting bubble can be.
Some maintain that economic bubbles distract people with the lure of easy money from what they ought to be investing in. In economic terms, they cause a misallocation of resources that would be better used elsewhere. For example, investors may buy up houses in the belief that the price will appreciate, rather than spend the money on shares or putting it into savings.
Dulling the cycle There are various ways in which those running an economy can prevent bubbles from developing. The first tool of choice is simply to signal—through a speech or some other public announcement—that policymakers are concerned about a bubble developing (possibly indicating also that measures will be taken to prevent it). However, as the dot-com crash showed, this is not guaranteed to prevent the bubble from ballooning. The second option is to raise interest rates, which can dampen the growth of the bubble but at the cost of slowing growth in other parts of the economy. A third idea is to regulate banks more tightly to ensure they do not lend out cash too freely when times are good, and then, in the wake of a burst bubble, simply shut up shop. Such policies are known as counter-cyclical since they aim to prevent the economy swinging from boom into bust—as opposed to pro-cyclical policies, which encourage bubbles and then painful slumps.
In the wake of the 2008 crisis, central banks pledged to do more to “lean against the wind” and prevent house-price bubbles from emerging again—as had happened so disastrously during that decade. However, economists have become increasingly convinced that bubbles remain an unavoidable part of economic growth. For as long as humans remain irrational and unpredictable, bubbles are likely to be a permanent part of life.
the condensed idea
Humans are addicted to bubbles
| timeline | |
|---|---|
| 1637 | Tulip bubble in the Netherlands |
| 1720 | South Sea bubble, Mississippi Company bubble |
| 1840 | Mania in railway investment |
| 1926 | Florida property crash |
| 1989 | UK property bubble bursts |
| 2001 | Dot-com bubble pops |
| 2006–8 | Property bubbles pop in the US, UK and much of the Western world |