Consider a situation where an asset consistently trades at a price exponentially above its actual worth. This continual increase in asset price due to its speculative demand ends abruptly and is followed by a panic sell-off.
Economic bubbles aren’t just economic theory
Following are some infamous historical instances(along with the asset which triggered the bubble.):
Tulip Mania-Dutch,1930(Tulip Flowers)
The Lost Decade-Japan, 1990(Real Estate)
Dot Com Bubble-The United States, the Early 2000s(Tesch Stocks)
How to spot an economic bubble?
Economists identify 5 steps of a bubble:
- Displacement: Arrival of a New Paradigm-eg. New Tech/Low Interest rate
- Boom: Prices rise slow at first and then gain momentum gradually
- Euphoria: Extreme valuation level observed, and are relentlesly justified
- Profit-taking: Signs of bubble bursting, selling positions and taking profits.
- Panic: Asset prices reverse course and decend as rapidly as they are ascended
What happens when it bursts?
The effects can be small as causing losses to only a few, and/or it could be short-lived. In other instances, it can trigger a stock market crash(like that of 2008), or it can be as drastic as an economic recession or worse-a depression.
Overall, it depends on the asset/asset class involved in the bubble frenzy: a particular stock/real estate/gold or cryptocurrency.