Over the past few years, we have heard certain concepts, products and /or services being described as a “Bubble” with many financial experts debating on how certain changes in their characteristics will impact the economy, and in which specific manner. But what really is this figurative “bubble” really about?
An Economic Bubble is any product and/or service is characterised by a rapid increase in the value of assets driven by exuberant market behaviour, and an equally sharp fall in the value of that particular asset sometime in the future. This is when it is said, “The bubble has burst.”
During its initial stages, the price of the asset trades at a high value, which makes investors to further increase their investments within that particular asset, hoping that there shall be a consequent rise in prices once again, which they can they sell at a higher price sometime in the future. It is this large-scale inflation that enables the asset to be traded at higher values.
Another indicator is that when the economy gains momentum, companies report higher profits, prompting an increase the salary of the people they have employed. Instead of saving more, individuals increase their levels of consumption, and buy things that may be out of their price range by leveraging debt that is now available at cheaper rates and hence leveraging their capital and investing in sectors like real estate.
This particular trend is termed as the Cantillon Effect, wherein early recipients of newly minted money invest in assets causing the value of that particular asset to rise, and also its relative value as compared to other good and/or services present in the economy.
To summarise, the rise in price is primarily due to consumer exuberance without any proper fundamental analyses of underlying factors, facilitated by amounts of inflation in its price caused by an increase in the supply of money and credit flow in the economy.
The real trouble commences when the asset picks up so much momentum that the last recipients of the newly-minted money (thanks to the effects of the Trickle Down Economy) decide that they too, should invest in that particular asset to make a quick buck off of it. And since this money has now entirely circulated within the economy, its ability to pushes prices further diminishes with each new investment.
The earlier investors have already maximised their profits after having sold their stake to those who are the last receivers of the newly minted money, and the final recipients would now only experience marginal profits since the price of that particular security cannot be driven up further.
Now, real trouble starts brewing. As the other products in the economy rise with respect to their prices, it causes the value of money to dampen since there is no new supply of money in the economy to drive up the price of that particular asset. As a result, the price of that particular asset begins to fall over a period of time, prompting it to return to the market fundamentals.
Therefore, when the flow of money falters, halts or completely stops, it causes the asset bubble to burst, wreaking havoc on the economy and especially on the latecomers who invested in that particular price during the final stages of the price rise since they were the ones who now held the majority amounts of investments in that particular stock.
This particular phenomenon is the culminating event of the Cantillon Effect, since it is not only the relative prices that had risen in order to accommodate the relativity of that particular asset, but also a massive shift of wealth from the latecomers to the early initial investors of the asset, thereby further increasing the income gap between the rich and the poor.
Since the economy is now left with little or no money, with the working class almost bankrupt due to it being late to the game, the plight of whom is further enhanced by the rise in prices of other products to accommodate the relativity of the asset and since there are no profits for companies and organizations to earn, they would lay off several thousand employees causing widespread unemployment in the economy, causing a severe cash crunch in the economy.
This is when the Central Bank of the country will have to step in for a Bailout. A Bailout typically takes place when the Central Bank of the country induces provides a cash injection within the economy to provide it with a kickstart of the credit cycle once again. It might be in the form of stimulus cheques, Social Security benefits or direct injection of credit into the bank accounts of people, with essentials being subsidised so that they can be afforded by those who lost their fortunes when the bubble burst.
The existence of bubbles is an inherent concept every economic composition; there shall always be investor exuberance in products and/or services as long as the human mind will continue towards being creative of financial instruments that will make them more money than they had ever before. As long there shall be greed in this world, the continuance of bubbles will go on, regardless of how rich or poor there are in the world.