eli5 What is an economic bubble? What causes it?

481 views

E.G. the dot com bubble. The 2008 housing market bubble. And the recently talked about NFT bubble.

In: Economics

A bubble is when, basically, people start buying something solely because they believe someone else will buy it for more later on en masse without really having any reason for why it will be worth more.

This does, indeed, raise the price of the thing. I mean, lots of people are trying to buy it, so sellers raise prices in response. This attracts more buyers. The feedback loop continues and prices climb way out of proportion with any concept of the “fair value”* of the thing.

Eventually, people realize that, “hey, maybe paying $2000 for a thing that should really be worth $20 isn’t such a good call and I’m likely to lose a ton of money when the bubble bursts.” The pool of buyers dries up and, usually, everyone panics.

The people who bought hoping to sell later all try to sell at once before the price really crashes. This, obviously, crashes the price. The vast majority of people bought in well above fair value (which is likely where the price will settle in the long run) so most people lose a bunch of money trying to sell.

*Basically the price that reflects the actual value the thing creates for a buyer.

At it’s most basic, a bubble is when people buy assets not based on sound valuation but on the belief they’ll be able to find somebody who will pay even more than they did. They don’t care that the house should only be worth $500k, they’ll pay $700k because they’re “certain” they can sell it for $900k in a few months.

At some point, something snaps enough people back to reality that prices begin to fall, then panicked owners scramble to sell, causing a rapid price drop.

Everything is worth what it’s purchaser will pay for, but sometimes people value things based off of incorrect (or even irrational) views.

A bubble ends up being the result of a large amount of people overvaluing a particular thing (or group of interconnected things). When the degree of this overvaluation is exposed, it leads to a significant correction in the market, which can happen very very quickly.

So, for example, the 2008 financial crisis was, fundamentally, caused by people overvaluing Mortgage Backed Securities (MBS). When it started to be understood that MBS-based investment was horrifyingly flawed, everyone rushed to offload all of their suddenly-vulnerable investments, causing the bubble to pop and prices to crash.