What Is an Economic Bubble? Tulips, Railways, Houses and Why It Keeps Happening
By the BrainSnail editorial team. How these articles are written and checked, and how to tell us when one is wrong.
In February 1637 a single tulip bulb in the Netherlands changed hands for more than the price of a house, and three months later the same bulb was worth a tenth of that. Nothing about the flower had changed. What had changed was what buyers believed other buyers would pay, and that is the whole mechanism of a bubble: a price held up not by what the asset earns or does but by the expectation that someone will pay more for it later.
Price and value come apart
Every asset has some fundamental value: the rent a house can earn, the profits a company will make, the interest a bond pays. Prices wander around that value all the time, and a rise in price is not a bubble just because it is fast. The mark of a bubble is that buyers stop asking what the asset is worth and start asking only what the next buyer will pay. At that point the price feeds on itself. Rising prices attract buyers, more buyers raise prices, and the rising price becomes the only justification anyone needs.
Economists call this the greater fool theory: it is rational to buy an overpriced asset if you are confident a greater fool will take it off you at a higher price. It stays rational for each individual right up until the moment the supply of greater fools runs out, and nobody can see that moment coming.
How they inflate
Bubbles tend to follow a pattern first described by the economist Hyman Minsky. Something new appears, a technology, a market, a financial product, that genuinely justifies some rise in prices. Early investors make money. Credit gets easier, because lenders see the rising prices as security. The story spreads to people who do not normally invest, and it spreads through them as a story of others getting rich, which is more persuasive than any analysis. The price detaches from any calculation and becomes pure momentum.
The clever and the cautious are not immune. In the South Sea Bubble of 1720 Isaac Newton sold his shares early at a profit, watched the price keep rising, bought back in near the top and lost a fortune. He is reported to have said that he could calculate the motions of the heavenly bodies but not the madness of people, and the line captures why bubbles are so hard to avoid from inside: the price keeps proving the sceptics wrong until the day it does not.
The famous ones
Each bubble has had its own object, and the objects have been getting more abstract:
- •Tulip mania, 1636 to 1637: rare tulip bulbs in the Dutch Republic, the first well-documented case
- •The South Sea Bubble, 1720: shares in a company with a monopoly on trade that barely existed
- •Railway mania, 1840s Britain: thousands of miles of proposed lines, many never built
- •The 1920s American stock market: shares bought with borrowed money, ending in the 1929 crash
- •The dot-com bubble, 1995 to 2000: internet companies valued on visitors rather than revenue
- •The American housing bubble, 2002 to 2007: house prices and the mortgage securities built on them
How they end
A bubble does not need bad news to burst. It needs only a pause. Once prices stop rising, the sole reason for holding the asset is gone, and the buyers who came in for the momentum leave at once. Those who borrowed to buy are forced to sell as their collateral shrinks, which pushes prices down faster, and lenders who had treated the rising prices as security discover that the security was the bubble itself. The unwinding is usually faster than the inflation.
The damage depends on who was holding the debt. The dot-com collapse wiped out several trillion dollars of share value but caused only a mild recession, because most of the losses fell on investors who had bought with their own money. The housing bubble of 2007 was smaller as a percentage but had been financed by banks, so when it burst it took the banks with it and produced the deepest downturn since the 1930s. The lesson central banks drew is that a bubble in something bought with borrowed money is the dangerous kind.
Why nobody stops them
Bubbles are obvious in hindsight and genuinely uncertain at the time, because every one begins with something real. The railways were built and changed the country. The internet did transform commerce, and some dot-com companies became the largest in the world. A regulator who tries to deflate a bubble early risks stopping a real boom, and a price that looks absurd can keep rising for years, which ruins anyone who bets against it too soon. The signs worth watching for:
- •Buyers explaining the price by future price rises rather than by earnings or use
- •Rising prices being used as collateral for borrowing to buy more
- •A story of easy wealth reaching people who have never invested before
- •Sceptics being dismissed because they have been wrong so far
- •A claim that this time the old rules do not apply
The takeaway
An economic bubble is a price sustained by the expectation of selling to a later buyer rather than by what the asset is worth, inflated by credit and by stories of others getting rich, and ended by nothing more than the price ceasing to rise. Each one begins with something real, which is why they are hard to call in advance, and the ones financed by debt are the ones that wreck economies.