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Introduction of Economic Bubbles

An economic bubble is the commonly used term for an economic cycle that is characterized by a rapid expansion followed by a contraction, often times in a dramatic fashion. A phenomenon in economics in which too much loose cash finds its way into an area of the market, e.g., stocks, housing, dot-com, etc., resulting in a buying frenzy that leads to wildly inflated prices. Economic activity in those areas affected is not sustainable in the long run, so large numbers of late investors eventually go bankrupt. The concept is also posited as a theory which holds that security prices will always rise above their real value and will continue to do so until prices drop and the bubble bursts. While some bubbles happen naturally as a part of the economic cycle, some also occur as a result of investor exuberance and serve as correctives. These typically happen in securities, stock markets, real estate and various other business sectors because of certain changes in the way key players conduct business. The popping of a bubble can often have significant economic repercussions.

Causes of Economic Bubbles


The exact cause of economic bubbles has been disputed by many economists. Some experts think that bubbles are related to inflation and therefore believe that the factors which cause inflation could also be the same factors that cause bubbles to occur. Other experts are of the opinion that there is a basic fundamental value to every asset and the bubbles represent an increase or rise over that fundamental value. This rising movement must eventually return to that fundamental value, which is its natural state. There are also chaotic theories regarding the formation of bubbles. These theories maintain that bubbles come from certain critical states in the market that originate from the communication of economic players. Still a few others see bubbles as a necessary effect of unreasonably valuing assets based solely on their returns in the recent past without really thinking from a macro perspective or regard for economic fundamentals. There are some economists who also theorize that a bubble is an imbalance in the way people perceive opportunities, because they try to chase the prices of assets instead of making purchases based on the intrinsic value of the assets (this could also be called a speculators mentality). It is also maintained that bubbles are a manifestation of the basic tenet that a market is very efficient in the long-term but not very efficient in the short-term. Greater fool theory A theory that states it is possible to make money by buying securities, whether overvalued or not, and later selling them at a profit because there will always be someone (a bigger or greater fool) who is willing to pay the higher price.

When acting in accordance with the greater fool theory, an investor buys questionable securities without any regard to their quality, but with the hope of quickly selling them off to another investor (the greater fool), who might also be hoping to flip them quickly. Unfortunately, speculative bubbles always burst eventually, leading to a rapid depreciation in share price due to the selloff. Extrapolation Extrapolation is projecting historical data into the future on the same basis; if prices have risen at a certain rate in the past, they will continue to rise at that rate forever. The argument
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is that investors tend to extrapolate past extraordinary returns on investment of certain assets into the future, causing them to overbid those risky assets in order to attempt to continue to capture those same rates of return. Overbidding on certain assets will at some point result in uneconomic rates of return for investors; only then the asset price deflation will begin. When investors feel that they are no longer well compensated for holding those risky assets, they will start to demand higher rates of return on their investments. Herding Another related explanation used in behavioural finance lies in herd behaviour, the fact that investors tend to buy or sell in the direction of the market trend. This is sometimes helped by technical analysis that tries precisely to detect those trends and follow them, which creates a self-fulfilling prophecy. Investment managers, such as stock mutual fund managers, are compensated and retained in part due to their performance relative to peers. Taking a conservative or contrarian position as a bubble builds results in performance unfavorable to peers. This may cause customers to go elsewhere and can affect the investment manager's own employment or compensation. The typical short-term focus of U.S. equity markets exacerbates the risk for investment managers that do not participate during the building phase of a bubble, particularly one that builds over a longer period of time. In attempting to maximize returns for clients and maintain their employment, they may rationally participate in a bubble they believe to be forming, as the risks of not doing so outweigh the benefits. Short selling Short selling means when you purchase shares of stock for a small period of time to earn immediate profits. When the number of such investors increase the price of stock start rising and general investors starts following them at that time the stock holder having motive of immediate profit sell the stock and price go down suddenly and bubble burst. Insider trading Insider trading means when the material information is still nonpublic--trading while having special knowledge is unfair to other investors who don't have access to such knowledge. Insider trading therefore includes tipping others when you have any sort of
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nonpublic information. Directors are not the only ones who have the potential to be convicted of insider trading. People such as brokers and even family members can be guilty. when investors invest on the basis of insider trading a sudden hype in the price can be noticed, which creates bubble and bubble burst when information becomes public and investor who have purchased the shares start selling very quickly.

Liquidity One possible cause of bubbles is excessive monetary liquidity in the financial system, inducing lax or inappropriate lending standards by the banks, which asset markets are then caused to be vulnerable to volatile hyperinflation caused by short-term, leveraged speculation.For example, Axel A. Weber, the former president of the Deutsche Bundes bank, has argued that "The past has shown that an overly generous provision of liquidity in global financial markets in connection with a very low level of interest rates promotes the formation of asset-price bubbles.According to the explanation, excessive monetary liquidity (easy credit, large disposable incomes) potentially occurs while fractional reserve banks are implementing expansionary monetary policy (i.e. lowering of interest rates and flushing the financial system with money supply). When interest rates are going down, investors tend to avoid putting their capital into savings accounts. Instead, investors tend to leverage their capital by borrowing from banks and invest the leveraged capital in financial assets such as equities and real estate. Simply put, economic bubbles often occur when too much money is chasing too few assets, causing both good assets and bad assets to appreciate excessively beyond their fundamentals to an unsustainable level. Once the bubble bursts the central bank will be forced to reverse its monetary accommodation policy and soak up the liquidity in the financial system or risk a collapse of its currency. Inflation The rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling. Central banks attempt to stop severe inflation, along with severe deflation, in an attempt to keep the excessive growth of prices to a minimum.
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When the price of the product start going up, investor having bull characteristics assume that price will rise more and start purchasing the stock or the commodity at large scale for future, then price rises and when the market become stagnant they start selling and prices go down, which cause bursting of bubble again.

Major Economic Bubbles


Tulip Mania Long before anyone ever heard of Qualcomm, CMGI, Cisco Systems, or the other high-tech stocks that have soared during the current bull market, there was Semper Augustus. Both more prosaic and more sublime than any stock or bond, it was a tulip of extraordinary beauty, its midnight-blue petals topped by a band of pure white and accented with crimson flares. To denizens of 17th century Holland, little was as desirable. Around 1624, the Amsterdam man who owned the only dozen specimens was offered 3,000 guilders for one bulb. While there's no accurate way to render that in today's greenbacks, the sum was roughly equal to the annual income of a wealthy merchant.

The Dutch were not the first to go gaga over the tulip. Long before the first tulip bloomed in Europe--in Bavaria, it turns out, in 1559--the flower had enchanted the Persians and bewitched the rulers of the Ottoman Empire. It was in Holland, however, that the passion for tulips found its most fertile ground, for reasons that had little to do with horticulture. Holland in the early 17th century was embarking on its Golden Age. Resources that had just a few years earlier gone toward fighting for independence from Spain now flowed into commerce. Amsterdam merchants were at the center of the lucrative East Indies trade, where a single voyage could yield profits of 400%. They displayed their success by erecting grand estates surrounded by flower gardens. The Dutch population seemed torn by two contradictory impulses: a horror of living beyond one's means and the love of a long shot. Enter the tulip. ''It is impossible to comprehend the tulip mania without understanding just how different tulips were from every other flower known to horticulturists in the 17th century,'' says Dash. ''The colors they exhibited were more intense and more concentrated than those of ordinary plants.'' Despite the outlandish prices commanded by rare bulbs, ordinary tulips were sold by the pound. Around 1630, however, a new type of tulip fancier appeared, lured by tales of fat profits. These ''florists,'' or professional tulip traders, sought out flower lovers and speculators alike. But if the supply of tulip buyers grew quickly, the supply of bulbs did not. The tulip was a conspirator in the supply squeeze: It takes seven years to grow one from seed. And while bulbs can produce two or three clones, or ''offsets,'' annually, the mother bulb only lasts a few years.
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Bulb prices rose steadily throughout the 1630s, as ever more speculators wedged into the market. Weavers and farmers mortgaged whatever they could to raise cash to begin trading. In 1633, a farmhouse in Hoorn changed hands for three rare bulbs. By 1636 any tulip--even bulbs recently considered garbage--could be sold off, often for hundreds of guilders. A futures market for bulbs existed, and tulip traders could be found conducting their business in hundreds of Dutch taverns. Tulip mania reached its peak during the winter of 1636-37, when some bulbs were changing hands ten times in a day. The zenith came early that winter, at an auction to benefit seven orphans whose only asset was 70 fine tulips left by their father. One, a rare Violetten Admirael van Enkhuizen bulb that was about to split in two, sold for 5,200 guilders, the all-time record. All told, the flowers brought in nearly 53,000 guilders.

Soon after, the tulip market crashed utterly, spectacularly. It began in Haarlem, at a routine bulb auction when, for the first time, the greater fool refused to show up and pay. Within days, the panic had spread across the country. Despite the efforts of traders to prop up demand, the market for tulips evaporated. Flowers that had commanded 5,000 guilders a few weeks before now fetched one-hundredth that amount.
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Tulip mania is not without flaws. Dash dwells too long on the tulip's migration from Asia to Holland. But he does a service with this illuminating, accessible account of incredible financial folly.

Japanese asset price bubble In the decades following World War II, Japan implemented stringent tariffs and policies to encourage people to save their income. With more money in banks, loans and credit became easier to obtain, and with Japan running large trade surpluses, the yen appreciated against foreign currencies. This allowed local companies to invest in capital resources much more easily than their competitors overseas, which reduced the price of Japanese-made goods and widened the trade surplus further. And, with the yen appreciating, financial assets became very lucrative. One of the major reasons for the sudden appreciation of the yen was the Plaza Accord. So much money readily available for investment, combined with financial deregulation, overconfidence and euphoria about the economic prospects, and monetary easing implemented by the Bank of Japan in late 1980s resulted in aggressive speculation, particularly in the Tokyo Stock Exchange and the real estate market. The Nikkei stock index hit its all-time high on December 29, 1989 when it reached an intra-day high of 38,957.44 before closing at 38,915.87. Additionally, banks granted increasingly risky loans. Prices were highest in Tokyo's Ginza district in 1989, with choice properties fetching over 100 million yen (approximately $1 million US dollars) per square meter ($93,000 per square foot). Prices were only marginally less in other large business districts of Tokyo. By 2004, prime "A" property in Tokyo's financial districts had slumped to less than 1 percent of its peak, and Tokyo's residential homes were less than a tenth of their peak, but still managed to be listed as the most expensive in the world until being surpassed in the late 2000s by Moscow and other cities. Tens of trillions of dollars worth were wiped out with the combined collapse of the Tokyo stock and real estate markets. Only in 2007 had property prices begun to rise; however, they began to fall in late 2008 due to the financial crisis.

With the economy driven by its high rates of reinvestment, this crash hit particularly hard. Investments were increasingly directed out of the country, and manufacturing firms lost some degree of their technological edge and Japanese products became less competitive overseas. The Japanese Central Bank set interest rates at approximately zero. When that failed to stop deflation some economists, such as Paul Krugman, and some Japanese politicians, advocated inflation targeting. The easily obtainable credit that had helped create and engorge the real estate bubble continued to be a problem for several years to come, and as late as 1997, banks were still making loans that had a low probability of being repaid. Loan Officers and Investment staff had a hard time finding anything to invest in that would return a profit. They would sometimes resort to depositing their block of investment cash, as ordinary deposits, in a competing bank, which would bring howls of complaint from that bank's Loan Officers and Investment staff. Correcting the credit problem became even more difficult as the government began to subsidize failing banks and businesses, creating many so-called "zombie businesses". Eventually a carry trade developed in which money was borrowed from Japan, invested for returns elsewhere and then the Japanese were paid back, with a nice profit for the trader. The time after the bubble's collapse, which occurred gradually rather than catastrophically, is known as the "lost decade or end of the century" in Japan. On March 10, 2009, the Nikkei 225 stock index reached a 27-year low of 7054.98. The Dot com bubble The dot-com bubble was a stock market bubble which popped to near-devastating effect in 2001. It was powered by the rise of Internet sites and the tech industry in general, and many of these companies went under or learned some valuable lessons when the bubble finally burst. Many investors lost substantial sums of money on the dot-com bubble, helping to trigger a mild economic recession in the early 2000s. Analysts noted that some companies did not seem to be sobered by the burst of the bubble when web 2.0 sparked a fresh round of investing and speculation around 2004. Several factors combined to cause the dot-com bubble, which is usually defined as the period of investment and speculation in Internet firms which occurred between 1995 and 2001. 1995
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marked the beginning of a major jump in growth of Internet users, who were seen by companies as potential consumers. As a result, numerous Internet start-ups were birthed in the mid to late 1990s. These companies came to be referred to as dot-coms, after the .com in many web addresses. Many of these companies engaged in unusual and daring business practices with the hopes of dominating the market. Most engaged in a policy of growth over profit, assuming that if they built up their customer base, their profits would rise as well. Many dot-coms also expended a great deal of energy in market domination, attempting to corner the bulk of customers for a particular need. Investors responded to daring business practices with money; lots of it. The American stock market rose dramatically during the dot-com bubble, with hundreds of companies being founded weekly, especially in tech hot spots like the Silicon Valley near San Francisco. Many people associate lavish lifestyles with the dot-com bubble, since companies regularly sponsored exclusive events filled with fine food and entertainers. At conferences and events focusing on the tech industry, the combined entertainment costs were sometimes counted in hundreds of thousands of dollars. Unfortunately for many companies and investors, the growth of the tech sector proved to be illusory. Numerous high profile court cases targeted tech companies for unscrupulous business practices including borderline monopolies, and the stock market began to tumble down in a serious correction. A decline in business spending combined with market correction to deal a serious financial blow to many dot-coms, and tech companies began to fold, one by one. The issues of the dot-com bubble were also compounded by outside factors, like a rise in outsourcing which led to widespread unemployment among computer developers and programmers. The market also took a major downturn in the wake of terrorist attacks in the United States in 2001, and companies who had engaged in shoddy or questionable bookkeeping were essentially caught with their pants down in a series of government investigations. The loss of consumer faith in the tech industry also depressed earnings for dot-coms.

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The rise of broadband in developed nations only a few years after the collapse of the dot-com bubble has been an issue of concern to some financial analysts, who recognize a recurring pattern. The growing number of high-speed users led to a new proliferation of dot-coms, especially social networking sites, and some investors fear that the tech industry may be facing a bubble 2.0. Uranium Bubble The uranium bubble of 2007 was a period of nearly exponential growth in the price of natural uranium, starting in 2005 and peaking at roughly 300$/kg (or ~135$/lb) in mid-2007. This coincided with significant rises of stock price of uranium mining and exploration companies. After mid-2007, the price began to fall again and at end 2010 was relatively stable at around 100$/kg. The upward trend for the prices of uranium was already apparent since 2003. This prompted increases in mining activity. A possible direct cause for the bubble is the flooding of the Cigar Lake Mine, Saskatchewan, which has the largest undeveloped high-grade uranium ore deposits in the world. This created uncertainty about short-term future of the uranium supply. The impact of the bubble on nuclear power generation was small, as most power plants have long-term uranium delivery contracts,and the price of natural uranium makes up only a small fraction of their operating cost. However, the sharp fall in prices after mid-2007 caused a lot of new companies focused on exploration and mining to lose their viability and go out of business.Due to increased prospecting, known and inferred reserves of uranium have increased by 15% between 2005 and 2007. Indian property bubble The origins of Indian Property Market Bubble can be traced to the interest rate reductions made by the NDA coalition government in the years following 2001. Home Loan Rates fell to a historical lows of 7.5% in early 2004. This prepared the basis for the increase in real estate property prices across India. Low interest rates triggered interest in individuals to borrow to own their own homes and this triggered an increase in demand for real estate across India. The Indian Property Market has been growing fast since March 2005, when the current UPA government decided to open FDI in Real Estate.
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The price increase is mostly happens due to two reason - one primarily in most cases the developers create false claims of overbooking and increase the demand and price and the other reason most of time properties are bought sold within 6-12 months from one buyer to other. There is no system available to the public to track these sells or buys. The other factor to consider is cost-to-facility ratio, in Mumbai a 2 bedroom apartment with living space of 1,200 square feet (110 m2) or 1,400 square feet (130 m2) of build up area will cost about 60 Lakhs to 1 Crore or even more, same for other major Indian cities Chennai, Bengaluru, Hyderabad, Pune , Gurgaon,etc.. . Where as in US, Australia, UK or France a 3 bedroom/2.5 bath townhouse which is at least 2,000 square feet (190 m2) around most of metros( other than Manhattan and Los Angeles ) will cost between 250,000 USD to 500,000USD which is between 1 Crore to 2 Crore Rs. This houses have parking garage, back yard and with basic Kitchen setup including cabinets, refrigerators, washer and dryer and for higher range may include a private swim pool, basement, front yard. In these western countries average salaries are almost 8 times the Indian salaries but cost of house (For a much better house) is only double. Also the Interest rate paid by Indians is almost double that of there developed country pears makes the EMI paid on par with developed countries in many cases. By its very definition a bubble is a short term phenomenon while Indian real estate market has continued on a secular upward trend, apart from periodic adjustments, in the last 10 years. Bear in mind that there are almost 400 million Indians waiting to hit the middle class group and they will exert additional pressure on the system. Affordability is the most important factor when it comes to housing prices and middle class housing is much levels of affordability in most of the major cities in India. People who compare India with developed European cities, forget the huge difference in affordability in both areas. Of course there is a huge demand for housing but they can only buy what they can afford. One of the big problem of real-estate market is that supply lags behind demand by about 5 years (Plan-Approve-Finance-Construct time). Lack of efficient signals to market participants means that there will be periods of mismatch between suppliers and buyers hence leading to cycles of booms and busts.

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Impact of economic bubbles


Financial crisis The country of industry facing problem of economic bubble mostly face financial crisis because all the late investors suffer losses, the money gets blocked or vanished away when number of companies go bankrupt. It also affects the related industries because there work also gets hampered. Continuing economic malaise Economic bubble leaves the impact for the longer period of time because once the investors face losses from such bubble; they do not wish to invest again so easily or early which keep the investors away. Low investment impact negatively on liquidity situation and financial sector of the economy. Market participants with overvalued assets tend to spend more because they "feel" richer When the trend of rising price is there and liquidity is more, investors feel richer and positive about the situation which leads them to invest more and face the losses. Hindering economic growth Crisis in the industry poor economy have poor impact on finances, liquidity, investment, FDIs. So all the source of income to economy decrease which hinder economic growth because there left less funds with government and other associations. Moreover the foreign companies also do not invest. All this decrease the value of the currency, which means all the trades would be more costlier and this cycle continues. Increased interest rates To control liquidity and inflation banks have to take corrective action that is increase interest rates on the borrowing so that people borrow less and they possess less amount of extra money.

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Prevention
Most of the economist believes that bubbles cannot be prevented Most of the analysts believe that economic bubbles are the natural phenomenon that they cannot be prevented, they have occurred and they would occur according to the trends of the market. Increase investment opportunities When investors have access money they have limited options to invest in, major are stock, gold, real estate, financial. There should be increased options to invest in which should give the similar or better returns so that the investment gets scattered and do not create bubble in one industry. Curious observation Government should have a curious observation over the activities happening in all the major industry of the economy and whenever they feel that a bubble might rise they should intervene by having new policies to stop the bubble or to minimize the losses. Deregulate in a systematic way Its a good sign that the economy is deregulating. This means that people will be having more leverage, there would be more liquidity, and people would be having more purchasing power which improves the standard of living. But deregulation should be rational than emotional, it should take place step by step. Sudden inflows of money force the people to spend more, which increase inflation and create bubble. This was one of the reasons of subprime crisis in U.S. because government flooded the nation with liquidity and reduce the cost of borrowing. People borrowed but were unable to payback which impact in crisis in economy of U.S as well as world economy.

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Reference
http://www.businessweek.com/2000/00_17/b3678084.htm http://www.investopedia.com/terms/g/greaterfooltheory.asp#axzz1Xx014ToE http://www.doctorhousingbubble.com/japanese-asset-bubble-lessons-from-the-economic-assetbubble-of-japan-the-heisei-boom-what-parallels-exist-between-the-japanese-asset-bubble-and-ourcurrent-financial-environment/ http://www.nethistory.info/History%20of%20the%20Internet/dotcom.html http://www.joneslanglasalleblog.com/realestatecompass/real-estate/2010/09/indian-real-estateheading-bubble/ http://www.investopedia.com/terms/i/inflation.asp#axzz1YKBgxMif

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