The Economic Bubble: Its Concept and Implications

The Economic Bubble: Its Concept and Implications

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When talking about the global financial crisis, the term “bubble” is often repeated in mortgages, a phenomenon that begins with the rapid expansion in the rise of asset prices above its basic value in the market and continues to rise, followed by a sharp deflation until it reaches the point of free fall followed by the bubble explosion.
During the bubble, inflation occurs in the price of a financial asset or a certain class of assets, which weakens its correlation with the true value of the asset.
An economic bubble or asset bubble (sometimes also referred to as a speculative bubble , a market bubble , a price bubble ,a financial bubble ), is trade in asset at price or price range that strongly exceeds the asset’s intrinsic value , and the bubble may appear in the case of mutual goods with debts such as ( gold, silver, oils, etc.) and (Government bonds, shares, certificates of real estate and financial derivatives ) .
The bubble description is used for some economies that are very popular for limited periods of time, without a solid production base capable of generating regular income and continuing to prosper and thrive on a permanent and continuous basis.

The history of the economic bubble is associated with speculations on the shares of companies such as the British South Sea company in the early 18th century where the famous mathematician Isaac Newton was one of the most prominent victims of it , acknowledged of his inability to understand man’s obsession despite his success to solve of talisman of the movement of the stars and planets In their orbits.

Economic bubbles have a much earlier history, the most famous of which was the bubble that preceded bubble of the company of “South Sea” for about a century as there was fierce speculation on tulip flowers in the Netherlands as prices jumped to empty levels. Including bubbles that hit the stock market in 1929 , according to the US Dow Jones Index followed by the recession that hit the whole world .
In the modern era, the dotcom bubble occurred since 15 years ago with the boom of technology companies and the Internet in the US stock market, and to find out the magnitude of the negative impact,, Yahoo company, the famous Internet portal of America, its share value was worth $ 240 in the beginning of the year 2000, One year later, it fell to only $ 30.
Including the collapse of Wall Street in the second half of the 1980s , and the collapse of Lehman Brothers Bank followed by sharp decline in 2008 ‘ as most banks and institutions in the US and Europe had billions of dollars in bonds backed by risky mortgages loans . In the first week of January 2009, twelve major international financial institutions lost half of its value, leading to economic recession and bankruptcy of many industrial and commercial establishments that tried to seek financial assistance to get out of its crisis. Also, the Saudi stock market witnessed a collapse after the main index exceeded the barrier of 20000 point in February 2006.

An important feature of the bubble is that it is difficult to detect bubbles when it occurs in the event of a dispute over the fundamental value of the assets, so it is usually distinguished by looking at the past and recovering events after the bubble burst and . in most cases, the bubble related to the price of an asset was followed by a large and sudden collapse in financial stock prices related to it , and the extent of damage to the bubble depends on the economic sector associated with it.
Some economists believe that inflation is an important reason for the occurrence of these bubbles, and has a prominent role in it, whether directly or indirectly. The inflation witnessed by the prices of US stocks as well as domestic Saudi Arabia in the second half of the last decade justifies the sharp decline witnessed despite the apparent difference in the sharp rise that preceded the fall and some believe that there is a so-called “core value” for any asset, and that bubbles represent the increase in the present value above this basic value, and that the present value should eventually be reduced to its basic value.
Minsky’s theory
Minsky identified , the first economist who explained the causes of financial instability and its interaction with the economy, five phases of the economic bubble, based on the typical credit cycle, and with a variety of explanations for this cycle. However, the overall pattern of bubble activity remains constant ,and the phases are as the following :
• Stage of displacement : It appears when investors become enthusiastic for a new model, such as a new technological innovation, low interest rates to its historical lows, and all investments are directed towards a particular type of stock.

An example of the displacement phase was that the Federal Reserve rate cuts the federal interest rate from 6.5% in May 2000 to 1% in June 2003, resulting in r low interest rate on the loan of fixed-rate mortgage for a period of 30 years during these 3 years with amount 2, 5 Cent to become 5.21%, recording its historic low.
• Prosperity phase: Prices rise slowly at first, after the stage of displacement and gain gradually increasing with the entrants in the market. During this stage, the asset concerned attracts wide media coverage, fear of missing large opportunities, and it stimulate much on speculation and increasing the number of participants in this field.
• Ecstasy stage: it does not take caution to consider at this stage where the prices of assets are rising enormously and the theory of “the most stupid” are spread everywhere, according to the theory, profits can be achieved by buying securities, whether they are valued above or less, regardless of quality, Because there will always be someone more stupid willing to buy at a higher price, and here the asset value reaches its maximum limit.
• Profit-taking phase: Capitalists, experienced in the marked who are capable to read warning signals, sell their assets and collect profits, but estimating bubble bursts is very difficult and involves a high risk of financial safety. Economist John Keynes says markets can remain irrational for a longer period of time that can remain financially sound.
• Panic phase: At this stage, asset prices are moving in reverse and it declines as fast as it rises as investors and speculators who face the declining values of their assets are liquidating their assets at any price offered to them. Examples of global panic in the financial markets occurred in October 2008, when the global stock index fell by 22% of its total market value.
Economic bubbles have a negative impact on the economy, because of the unequal distribution of resources, and the resulting of collapse after the economic bubble can destroy a large amount of wealth, leading to economic hardship as in the Great recession of 1930 in the United States which is connected largely to the economic bubbles.

The recession has very serious negative consequences: high unemployment, stagnation of investments , and the disappearances the profits of companies or its decline and the falling cosumer spending rate as the of the 1980s bubble in Japan led to a prolonged economic recession, but since speculation was limited and severely constrained, the damage caused by bubble did not spread to a large extent outside of its borders as the Japanese economy was the focus of the world, with an annual growth rate of 3.89%, compared with the United States of America, which had a growth rate of 3.07%. However, it faced several problems in the early 1990s, with the annual growth rate falling to 1.14% Much less than the Other industrial nations, noting that the bubbles of property rights and real estate in Japan have been exploded at the beginning of the autumn of 1989, leading to severe decline in equity value by 60% between the end of the year 1989, and August 1992, at the same time the value of lands were decreased as it lost 70% of its value by the year 2001.
Another negative consequence of the economic bubble is the increase in consumer spending to buy goods at high prices, such as the real estate market in England, Spain and parts of the United States. Consumers spend more money because they feel they are wealthier financially.
Speculation occurs here only for that the traders and investors predict or speculate that the stock will rise, pushing them to buy in order to get a bigger share of profits.

Therefore, the volume of the purchase starts to increase excessively, regardless of the intrinsic value of the share. Those who participate in the purchase of the stock are convinced that it is a good idea or seek to share the potential profits. However, the bubble is not completed until the price returns to its normal position. This sharp rise is normally followed by a sharp decline that ensures things are back to its normal position.

In the 1920s, airplanes, cars, radio and electricity were invented. In the 1990s, the world became connected to the Internet and broadband communications. These bubbles were”burst” and thousands of investors lost their capital because the bubble does not cover a huge market, and it is limited to a certain event or field and It can be short-term and lead to the loss of a lot of investors of much money when the market trend changes suddenly.

In recent years, the emergence and exacerbation of economic bubbles have increased in many Arab countries due to the tendency to speculate in the markets of land, real estate and stock Exchange markets.
Including the so-called “Windfall Profits,” which are earned without effort or actual tangible production. This is linked to additional spending cycles that lead to more consumer spending, fueling a new cycle of spending that contributes to the boom of the bubble economy, resulting in inflation in some economic assets due to frantic speculation, which in turn leads to successive spikes in stock, land and real estate prices. , Without real economic performance.

Economists believe that the “bubble” represents an excess in the basic value, and that the current value does not fully reflect what can be paid for acquisition because of excessive pricing due to hectic speculation, and therefore the current value will fall back to the point of equilibrium, which is the basic value where investment is useless of paying large sums of money in an asset that he does not deserve.

They also see that the relationship between the bubble and the stock collapse is interlinked. Over the course of the historical pursuit of stock market, it is observed that it was born from the womb of bubbles, and the bigger the bubble, the bigger the collapse.

There is some evidence that convinced economists of the “efficiency” in the movement of assets, but not always ideal, where speculators are convinced to make small gains to avoid any irrational “bubbles” that will be sweep markets with them, but eventually, the overtaking happens and then appear bubbles.
In the stock market, it is not difficult to predict a bubble in a stock, when there is no transparency in the disclosures and the company is not making profits, yet the rise of its share is accelerating, simply because of rumors of investments or expansions.

We get to the conclusion that taking a sudden, extraordinary and unrealistic profits that are not based on the actual operation of capital through the economic cycle of a limited category is one of the most important disadvantages of the “bubble”, due to the insane rise in the price of the commodity or asset.

Because these profits contribute to fuel new bubbles by pumping them into other assets without real production within the structure of the economy in order to maximize the profit which is exhausting the economy.

Shatha Khalil
Economic Studies Unit
Rawabet Center for Research and Strategic Studies