What is a ‘Bubble’
A bubble is aneconomic cycle characterized by rapid escalation of asset prices followed by a contraction. It is created by a surge in asset prices unwarranted by the fundamentals of the asset and driven by exuberant market behavior. When no more investors are willing to buy at the elevated price, a massive selloff occurs, causing the bubble to deflate.
BREAKING DOWN ‘Bubble’
Bubbles form in economies, securities, stock markets and business sectors because of a change in investor behavior. This can be a real change, as occurred in the bubble economy of Japan in the 1980s when banks were partially deregulated, or a paradigm shift, as happened during the dot-com boom in the late 1990s and early 2000s. During the boom, people bought tech stocks at high prices, believing they could sell them at a higher price until confidence was lost and a large market correction, or crash, occurred. Bubbles in equities markets and economies cause resources to be transferred to areas of rapid growth. At the end of a bubble, resources are moved again, causing prices to deflate.
The First Bubble
Recent history includes two of the most consequential bubbles: the dot-com bubble of the 1990s and the housing bubble in 2007-2008. However, the first recorded speculative bubble, which occurred in
Holland from 1634 to 1637, provides an illustrative lesson that applies to this day.
To even suggest a flower could bring down a whole economy seems to reasonable minds an absurdity, but that is exactly what happened in Holland near the turn of the 16th century. The tulip bulb trade started inadvertently when a botanist brought tulip bulbs from Constantinople and planted them for his own scientific research. Neighbors then stole the bulbs and began selling them. The wealthy began to collect some of the rarer varieties as a luxury good. As their demand increased, the prices of bulbs surged with rare varieties commanding astronomical prices.
Bulbs were traded for anything with a store of value, including homes and acreage. At its peak, Tulipomania had whipped up so much of a frenzy that fortunes were made overnight. The creation of a futures exchange, where tulips were bought and sold through contracts with no actual delivery, fueled the speculative pricing.
The bubble burst when a seller arranged a big purchase with a buyer, but the buyer failed to show. The realization set in that price increases were unsustainable. This created a panic that spiraled throughout Europe, driving the worth of any tulip bulb down to a tiny fraction of its recent price. Dutch authorities stepped in to calm the panic by allowing contract holders to be freed from their contracts for 10% of the contract value. In the end, fortunes were lost by noblemen and laymen alike.