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Economic Bubbles

Emily Walters. Economic Bubbles. Other names: speculative bubble, market bubble, price bubble, financial bubble or balloon Occurs when there is trade in high volumes at prices that are considerably at variance with intrinsic values

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Economic Bubbles

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  1. Emily Walters Economic Bubbles

  2. Other names: speculative bubble, market bubble, price bubble, financial bubble or balloon Occurs when there is trade in high volumes at prices that are considerably at variance with intrinsic values Bubble metaphor – prices of stock or item were inflated, expand on speculation (air), and fragile – can burst anytime Goes back to 1600’s – Tulip mania in 1630s Economic bubbles - Overview

  3. Have a good (something “new”) The price goes up This increase in price attracts new buyers The new buyers assure a further increase More attraction so more keep buying Speculation builds upon itself Bubble eventually bursts How it works

  4. Those who buy in and expect the market to go up and stay up for the particular good • Those who buy in intending to ride the upward wave and get out before the eventual fall • Decide when its time to get out • Both are attracted to the increase in wealth participants

  5. “And thus the rule, supported by the experience of centuries: the speculative episode always ends not with a whimper but with a bang.” – John Kenneth Galbraith in A Short History of Financial Euphoria (pg. 4)

  6. A negative impact results from the bursting of the bubble Usually a recession or depression results, but the severity varies This is because there is thought to be a misallocation of resources into non-optimal uses Liquidity holding Reaction: fiscal and monetary policies Aftermath

  7. 1630s - Tulipomania Bubble 1720 – The Mississippi Company Bubble 1922 - Roaring 20’s Stock Market Bubble 1995 – Dot-com Bubble 2007 – United States Housing Bubble Historical bubbles

  8. Tulipomania • 1630s • Holland • Speculation on tulip bulbs – beautiful and rare • Tulips arrived in Western Europe in 16th century • High prestige was attached to the possession on this flower • Many grew very rich, and everyone wanted a part of the tulip industry

  9. A single bulb could be traded for a new carriage, 2 horses, or even a house Other countries got involved in the mania and money poured into Holland Code of laws was drawn up to regulate the tulip market Money was borrowed to purchase the flower and small bulbs leveraged large loans 1637 – the fall. Some began to sell - as others saw them go there was a panic to sell Those who used the bulbs as leverage or pledged property were left poor Holland went into an economic depression Tulip0mania Cont’d

  10. The mississippi company • John Law • Paris had a bankrupt treasury and numerous debts • Law given right to establish a bank –Bank Royale • Bank authorized to give notes to pay expenses and debts of the government • In principle the notes could be exchanged for hard coin • These were well received so more were issued • The Mississippi Company – source of earning to support the notes • The company worked to find gold deposits in Louisiana • Led to speculation

  11. The mississippi company cont’d • Shares of the company were sold • Money didn’t go to the company – went to paying off government debts • The notes that went towards the debt came back to buy more stock • More stock was issued as demand increased • Not enough coin to back the volume of notes in circulation - inflation • This leverage reversed in 1720 when people started to demand their notes be turned in for gold • Notes declared no longer convertible • Values plummeted • Millionaires became impoverished and the French economy went into a depression

  12. The 1920s was a time of great economic growth and prosperity Post-war economy. New industries, more jobs, greater consumer spending led to a national feeling of optimism about the economy This confidence that the economy would continue to flourish fed the speculative bubble October 29, 1929 the stock market crashed and the bubble burst This resulted in The Great Depression that took the U.S. years to recover from Roaring 20’s stock market bubble

  13. 1995-2000 Popularity of the internet grew creating the founding of numerous new internet based companies know as dot-coms Stock values for these companies rose and continued to rise Many bought into the trend which resulted in the over-inflation of the stocks intrinsic value Investors willing to overlook P/E ratio because they were confident in technological advances Dot – com bubble

  14. Dot-com bubble bursts • Between 1999-2000 the Federal Reserve increased interest rates six times, and the economy began to slow down • March 10, 2000 – NASDAQ index peaked at 5,048.62 and dropped to 4,580 on March 15,2000 • Causes: multi-billion dollar sell orders for high-tech stock (IBM, Dell, CISCO) – this triggered selling and liquidation • Many internet companies that were started in order to get-rich-quick failed • January 2000 – America Online acquired Time Warner (world’s largest media company) • The transaction – “the worst in history” • Numerous communication companies filed for bankruptcy • Technology stocks plummeted • U.S. entered into an economic recession

  15. NASDAQ Composite Index Notice: peaked in 2000

  16. u.s. housing bubble • The U.S. housing market flourishing • Causes: Low-interest mortgage rates, lowered lending standards, and speculation caused people to take on mortgages that they realistically could not afford • When the value of real property reaches unsustainable levels relative to income, home prices decrease • This left many home owners with a mortgage debt higher than the value of the property – negative equity • This led to the bursting of the bubble

  17. u.s. housing bubble cont’d • December 2008 – the Case-Shiller home price index reported a largest drop in history • This led to a crisis in the debt, mortgage, credit, hedge-fund, and foreign bank markets • President Bush and Federal Reserve chairman Ben Bernanke announced a bailout plan • In 2008, the U.S. government allocated over $900 billion to bailout homeowners • In December 2009, the Treasury Department announced it would provide financial support to Fannie Mae and Freddie Mac – despite losses of $400 billion so far • The burst of the housing bubble resulted in an economic recession in the U.S. • The U.S economy is still recovering

  18. “All life is speculation” – 19th century American trader James R. Keene What history has taught us

  19. Galbraith, John Kenneth. A short History of Financial Euphoria. New York: Penguin Books, 1990. Chancellor, Edward. Devil Take the Hindmost: A History of Financial Speculation. New York: Penguin Books, 1999. http://en.wikipedia.org/wiki/United_States_housing_bubble http://en.wikipedia.org/wiki/Economic_bubble sources

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