An economic bubble is a term that describes a time period where there is a sudden hike in the prices of goods far beyond their intrinsic value. The market sustains this inflation in prices for a period of time after which the prices of the goods will decline just as fast as it had increased.
Economic bubbles are often related to a specific industry or across multiple industries. But its impact is felt in the entire economy, hence the name. Despite the euphoria that accompanies it, economic bubbles often precede a recession when the economy crashes. This is referred to as a bubble burst.
Economic bubbles are mostly caused by speculation in the market which drives up investment. Once the momentum has started, it is difficult to say how far it will go before the market corrects itself.
Types of economic bubble
Stock market bubbles - these are asset bubbles that involve equities. It could be localized to a particular industry or the entire stock market.
Asset market bubble - this happens in any other industry outside the equity market. Examples housing bubble and the cryptocurrency bubble.
Credit bubble - this involved a sudden rise in credit instruments such as bonds, mortgages, and loans.
Commodity bubble - this involves traded commodities like gold, oil, agricultural products, etc.
Example of an economic bubble
One example of an economic bubble that occurred in the 90s is the dot-com bubble. This was a stock market bubble that lasted for a period of 5 years between 1995 to 2001. It was mostly caused by speculation following the rise of internet-based companies.
The readily available venture capital drove the market further down the rabbit hole. Eventually, the bubble reached its peak when the companies failed to turn up any profit, panic ensued, stocks crashed and many of the companies folded up.
Other well-known economic bubbles are the US housing bubble, the Japanese real estate bubble, the tulip mania market bubble, and the recent Bitcoin bubble.
Stages of an economic bubble
There are 5 recognizable stages of an economic bubble;
A shift in the market - this could be a new technology, low-interest rates, or anything that attracts investors to a given market.
The Spike - this is characterized by sudden inflation in the prices of goods and services as more investors begin to participate in the market.
Euphoria - at this stage all caution is disregarded and the fear of missing out causes anyone with the means to invest in the market. Speculation has reached its peak by now.
Profit-Taking - early investors seize the opportunity to cash in on the growing interest. Also, some investors might grow weary of waiting and decide to sell their positions for a good amount of money while they still can.
Panic - as speculation dies, the smoke clears and many people begin to see that the entire hype was one big illusion. Assets prices drop drastically as investors start pulling out funds.
Although bubbles are generally very risky, it doesn’t make them completely useless. Some of the top tech firms we have today are products of the dot-com bubble. This includes Amazon, Google, and eBay.
In essence after a bubble, the companies left standing often go on to become very successful. But this will depend on the type of bubble.