how does an economic bubble\speculative bubble work?
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This is actually a subject of some debate among economists, but here are the absolute basics. All assets, to some degree, are traded because they are expected to return some value in the future (If they did not, you’d be buying them solely for what they’d offer you now, and they wouldn’t be assets, they would be commodities). However, it is impossible to perfectly know what will happen in the future, so there is some guesswork involved in evaluating assets. Most of the time, some people are a little optimistic, others pessimistic, and the end result is that the future value of the asset is accurately represented in the price of the asset. However, in a speculative bubble, whether by chance or due to some popular misconception, there are more optimists than pessimists, and this causes the price of the asset to be overvalued. In some cases, since this initially pushes the price up, it can be self reinforcing, and people will see the current rise in price as validating the asset’s worth, and they start buying, further feeding into the problem. This can only go on for so long though, as eventually the future becomes the present, and the asset’s true worth is revealed. At this point, the price is far higher than what the asset is worth, and the bubble pops, as no one is willing to buy at the inflated prices of before.
Economic bubbles generally occur when there’s a disconnect between the intrinsic value and the price of something.
*Usually* it’s due to some piece of information being inaccurate that starts it, either mistakenly or deliberately, and then it feeds off of itself.
Sometimes it is because the market is overly optimistic about something–the Dot Com bubble is an example, as people threw a lot of money at a lot of internet companies. It made sense–the internet was just beginning to be a commercial force in the 90s, so anyone on the ground floor was due to make a *lot* of money. And a lot of people did! But there were also a *lot* of companies people threw money at, hoping to be the next eBay or Amazon. The disconnect in information began–“dot com business means money” started off true, but as more and more companies with less and less justification were created, that statement was more often untrue than true.
It could be speculation, which is basically assuming a good will increase in price *because* people think it will increase in price. There’s no *inherent* change in value; it’s the same good with the same utility, the only think that has changed is that for whatever reason people *think* it’s going to be more valuable in the future. This happens with land, raw resources, or collectables.
It could be misinformation. The housing crisis in 2008 is a prime example; the mortgages were being sold as having a high rating, but in reality were not. (Some people wouldn’t consider this a bubble but just regular fraud, but people continued to ride it out even after this became obvious, which classifies it as a bubble.)
(There are other reasons, but these are the big three.)
The main thing about all of them is that the bubble feeds on itself. After a certain point, something is increasing in price *only because* it increased in price in the past, and there doesn’t seem to be any reason it would stop. It’s super easy to make a quick buck buying some and then selling it off…right up until the point where it doesn’t. While *some* of it is psychological, a lot of it is perfectly standard risk-taking. A lot of people with a lot of charts and econometrics might still buy into a bubble because they’ve done the math, and even if they lose it was worth the risk.
The last thing that that people call a lot of things speculation/bubble that really aren’t. The defining feature is that towards the end, the reason for the price increase is the price increase itself, not any change in supply or the intrinsic value of the good. A lot of people just look at the normal flow of supply and demand and call it a “bubble” but that’s just reflecting reality.
Like, we’re not in a housing bubble right now; house prices are crazy because we stopped building houses during the pandemic and only started to rebuild them relatively recently (and houses take a while to build), but also the price of lumber tripled at one point so the intrinsic value is, indeed, higher. Now, at some point, it *might* become a bubble, and maybe already is in certain areas, but that’s the thing about bubbles–there’s no immediate way to tell if it’s a bubble or just the normal price change due to supply and demand.
Not really an ELI5. There is a lot of research and even today, not everyone (among economists) agree on the various mechanisms.
One common idea is that there is excessive optimism, overconfidence, lack of proper risk management policies, sustained excess liquidity etc. And I may have explained this with too much jargon.
When Dune came out, there was a ton of hype about Zendaya. All the commercials featured her and her appearance helped sell a lot of tickets. When you watch the movie, it turns out she’s only in the last 10 minutes. All the hype was way over the top of what actually was there.
In a bubble, different kinds of assets get over-hyped what they actually could produce. The value of them skyrockets clear up until people realize what actually is going on. Whereas Zendaya fans only suffered mild disappointment after the movie was over, investors suffer significant losses when they realize they bought hype rather than an asset providing reasonable returns
Imagine there is a high demand for houses, and prices start to rise a bit.
You notice a trend, buy a house, wait for a year, then sell it at a higher price. Everybody notices there is an opportunity to earn some easy money, and more people start doing the same. Prices start to skyrocket, more and more houses are being built, and more people buys and sells houses just to earn money
But many of those houses are empty, because in reality, there are not that many people who need a house. The value of a house is no longer determined by the needs of the people who might inhabit it, but the perceived benefit of buying it then selling it later.
Real explain like I’m five: people overvalue some commodity for _____ reason. They basically are playing optimistic hot potato with this commodity until the market self adjusts the value back down to where it should be.
The person (or people) holding that commodity at the time of the correct gets burned by the proverbial hot potato.
NFTs are a great example.
Bubbles are when the market value of an asset decouples from the intrinsic value of the asset and becomes overvalued. The specifics of why this happens depend on the bubble in question, but one common idea is what’s called the Greater Fool Theory. The idea is that a lot of people buying an asset know it’s overvalued, thus making them a fool. But they do so anyway because they believe that they’ll be able to sell the asset to a greater fool who is willing to pay even more. This chain keeps going until you eventually arrive at the greatest fool, the one who pays more than anyone else is able or willing to pay. At that point, the price has nowhere to go but down, and since the price appreciation was entirely driven by speculation rather than intrinsic worth, a dip in the price tends to cause a panic that then leads to the collapse of that price.
Now, there are a lot of other factors at play that are more about the mechanics of how markets work like excess liquidity as well as other psychological factors like overconfidence in the future value. But for speculative assets that have little intrinsic value (e.g. cryptocurrencies, NFTs, Beanie Babies, etc.), it’s usually a greater fool scenario.
The misguided or false belief that a commodity will have a high demand in the future is the “speculation”, the growing number of investors who latch onto this belief in hopes of earning a profit is the “bubble”, the sharp decline in price as reality sets in and everybody starts dumping their worthless commodity is the “pop”.
The price only goes up on a speculated commodity for as long as there are investors entering the market on it, but there are not an infinite number of investors in the world, hence why the bubble can only grow to a certain point before it collapses.
It is kind of like Tulip Mania that happened some time ago. When everyone thinks things are going up, eventually everyone starts pulling out their money and things go back to “normal”.
https://en.m.wikipedia.org/wiki/Tulip_mania
All these ELI50 answers…..
I have some apples. I’m selling them for $1 each. Some guy comes along and he thinks they are worth more, so he gives me $2 each. Then some other guy comes along and thinks the apples are worth even more, and pays him $3 each. Then more people get hyped about these apples because the prices are soaring, and now there are 6 new guys each trying to offer more than the other for the apples. Eventually, this drives the price of the apple up to $100 each. It’s still the same $1 apple.
The bubble was inflated by a combination of hype and demand, and all it takes is enough people to remember these $100 apples are really just $1 apple for it the bubble to pop.
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