Economic Bubble

An economic bubble, also called an asset bubble or speculative bubble, is a period in which the price of an asset or class of assets rises far above any reasonable estimate of its underlying value, driven largely by expectations of further price rises. Bubbles can form in shares, property, commodities, collectibles or crypto-assets, and they usually end in a rapid fall in prices known as a crash or "burst."

Bubbles are a recurring feature of financial history and a common trigger of a boom and bust cycle. Economists disagree about how to define them precisely and whether they can be identified before they burst, a debate tied to the efficient market hypothesis. Central banks and regulators watch for them because the collapse of a debt-financed bubble can trigger a banking crisis and a deep recession.

Imagine a playground craze for a particular trading card. At first the card is popular because it is genuinely rare. Then children start buying it simply because the price keeps going up and they expect to sell it on to someone else for more. Soon a card is "worth" a month's pocket money, though nobody plans to use it. One day the next buyer doesn't appear, and the price collapses.

Financial bubbles follow the same logic. As long as new buyers keep arriving, prices rise and early buyers profit. The bubble bursts when the supply of new buyers, or of cheap borrowed money, runs out.

One way to frame a bubble is as the gap between the market price and a fundamental value based on expected income. For a share, a simple version of the dividend discount model values the stock as:

• $F$ is the fundamental value per share.
• $D_{1}$ is the dividend expected next year.
• $r$ is the return investors require, including a risk premium.
• $g$ is the expected long-run growth rate of dividends.

With a $4 dividend, an 8% required return and 4% growth, $F = 4 \div (0.08 - 0.04) = 100$, or $100 a share. If the share trades at $150, the extra $50 can be read as a bubble component. In practice the inputs are uncertain, which is why measures such as the price-to-earnings ratio, price-to-rent ratios for housing and the cyclically adjusted P/E popularized by Robert Shiller are used as rough warning signs rather than proof.

Economic historian Charles Kindleberger, drawing on Hyman Minsky, described a typical sequence in his 1978 book "Manias, Panics, and Crashes": a displacement (a new technology or policy change) creates real opportunities; easy credit and rising leverage fuel a boom; speculation and euphoria take over as people buy to resell; insiders start taking profits; and a panic follows when prices stop rising, often at a Minsky moment. Psychological forces such as herd behaviour, overconfidence and the fear of missing out, studied in behavioral economics, help explain why rational individuals join in. Some economists also describe "rational bubbles," in which buying an overpriced asset makes sense as long as a buyer can be expected to pay more later.

• Dutch tulip mania (1636–1637). Prices for rare tulip bulbs rose sharply and then collapsed; some historians, such as Anne Goldgar, argue that its scale and economic damage were exaggerated in later retellings.
• The Mississippi and South Sea bubbles (1719–1720). Shares in John Law's Mississippi Company in France and Britain's South Sea Company soared and crashed within months.
• The 1920s US stock boom. It ended in the 1929 crash, a prelude to the Great Depression.
• Japan's asset bubble. The Nikkei 225 peaked at 38,915.87 on 29 December 1989 and did not surpass that level until February 2024; land prices also collapsed.
• The dot-com bubble. The Nasdaq Composite peaked in March 2000 and lost roughly three-quarters of its value by October 2002.
• The US housing bubble. Its collapse after 2006 led to the 2008 financial crisis. More recent booms and busts in crypto-assets are covered under crypto bubble.

The question divides economists. Eugene Fama, a leading advocate of efficient markets, has argued that "bubble" is often applied only with hindsight, while Robert Shiller has shown that prices can stray far from fundamentals for long periods; both shared the 2013 economics Nobel with Lars Peter Hansen. Policymakers have long debated whether to "lean" against suspected bubbles by raising interest rates or to "clean up" afterwards. In December 1996, Federal Reserve chair Alan Greenspan asked how anyone would know when "irrational exuberance" had inflated asset values, yet the Fed did not act directly. Since 2008, many countries have preferred targeted macroprudential policy, such as limits on mortgage lending, to blunt credit-fuelled bubbles without raising rates for the whole economy.

• Nobel Prize: The Prize in Economic Sciences 2013
• Federal Reserve History: Stock Market Crash of 1929