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Old 29th September 2008, 16:08   #1
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Lightbulb Economic Bubbles - Why they form and why they burst ?

I have never studies Economics in detail, but always fascinated by the "Bubbles". For example, the Real Estate bubble, which, some might say, has burst. Skyrocketing and unrealistic prices of 2004-2007 looks like a thing of the past. Ditto for stock market and equity. Overpriced shares down to rock bottom prices, and there is more turmoil going on. Home loan interest rates on an upward swing. Same for Inflation figures.


So my question is, what makes these bubbles form in an economy?

- Is it un-equal growth? (geographical/social)
- Rapid globalization ?
- Speculation ?

P.S. A wonderful depiction:
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Old 29th September 2008, 16:17   #2
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The only thing in economics that I know is that when money goes out to someone else it expense and when it goes to your bank it is savings!!

But IMO, psychology too plays a role in forming these bubbles. Many people start having faith in an industry/stock/product because someone else they know has trust in the same industry/stock/product. This kind of social mob behavior generally drives up value of that industry/stock/product to unrealistic heights. There are a lot of other repercussions that happen during this process go to a point where all it takes is some event or just some time beforecommon sense prevails causing the bubble to burst.

It would be very interesting to know how an expert may explain these bubble burst though.
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Old 29th September 2008, 16:19   #3
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I think a bubble always has "easy money" as the trigger. This easy money could be :

1.DEBT
Easy availability of loans such as the current subprime bubble and our very own real estate bubble.

2.EQUITY
Lots of Venture Capital money floating about like in the case of the DOT COM bubble.
Easy IPO conditions where we saw companies like Roman Tarmat get listed at crazy prices!
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Old 29th September 2008, 16:32   #4
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I think you have more or less answered the question yourself, the economic bubble seems to form from rapid globalization, a fair bit of unrealistic expectation which leads to speculation, and all of this results in an un-equal growth pattern.
Very interesting thread, and i can't wait for some of the experts to post.

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Old 29th September 2008, 17:07   #5
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While i am no expert, here is my take on this, from the housing bubble that burst in US recently.

This was a bubble driven mainly by political will and financial greed. The politicians wanted to persue their agenda of home ownership for everyone, and the companies wanted to cash-in on these securitised loans. The banks were not doing enough background checks before giving loans because they were converting these loans into securities (Mortgage Backed Securities and Collateralised Mortgage Obligations) and selling them off in the market. The financial institutions were buying these securities because they had the implicit backing of the US government, and hence posed very less risk of default. The problem started to surface when NINJA (No Income No Jobs or Assets) loans and Sub prime loans (loans given to people with not enough documentation or not a steady flow of income) became a major part of these securities that the institutes were buying. Initially, the demand for housing increased because banks were giving loans at dirt cheap rates. Hence the cost of real estate started increasing. Once it crossed a critical mass, it started heading down.
Also, many of these loans started off with low interest rate, and then the rates shot up like crazy but people didnt realise this. So, when the time came to pay high interest, they wanted to prepay their loans or sell off the property. But by then, the interest rate everywhere had increased and the real estate prices dropped. So, now they cant sell off their property to repay the loan, nor can they continue paying the high interest.
As a result, banks that issued loans started suffering defaults. Bear Stearns used such assets as collateral for running their day to day business using repos. When the value of collateral collapsed, it just ran out of money to run their business.
Similarly, the govt backed agencies, Fannie Mae and Freddie Mac had to be bailed out because they carried govt backing.
And the financial institutions that had bought these securities, suddenly saw their inflow drying up.

All in all, it was a combination of corporate greed and lack of regulation that brought the market down.

Some time back there was talk of breaking the agencies into smaller ones and imposing stricter regulations. But rumour has it that these agencies lobbied hard with their dollars to prevent that from happening.

Its ironic how a US president had warned about exactly such things:
"I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs."
This was way back in 1802, made by Thomas Jefferson
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Old 29th September 2008, 18:08   #6
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I don't want to sound like a know-it-all but I would highly recommend a book by John Kenneth Galbraith called "A Brief History of Financial Euphoria". It's a fascinating read meant for people with zero background in economics but an interest in such things - like you and me.
It starts with various stages in history when such booms and bursts happened. The first chapter is on the tulip speculation in Holland in the 15th century. So globalisation is not the basic reason for such booms and busts and speculative activities.
This book is thin, easy read and offers fantastic depth of analysis. Available from Penguin. It does not intimidate ordinary mortals like you and me with any jargon.

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Old 29th September 2008, 22:27   #7
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Here is a forward I got, which give some inteersting perspectives on the same:
Once there was a little island country. The land of this country was the
tiny island itself. The total money in circulation was 2 dollar as there
were only two pieces of 1 dollar coins circulating around.

1) There were 3 citizens living on this island country. A owned the land. B
and C each owned 1 dollar.

2) B decided to purchase the land from A for 1 dollar. So, A and C now each
own 1 dollar while B owned a piece of land that is worth 1 dollar.

The net asset of the country = 3 dollar.

3) C thought that since there is only one piece of land in the country and
land is non produceable asset, its value must definitely go up. So, he
borrowed 1 dollar from A and together with his own 1 dollar, he bought the
land from B for 2 dollar.

A has a loan to C of 1 dollar, so his net asset is 1 dollar.

B sold his land and got 2 dollar, so his net asset is 2 dollar.

C owned the piece of land worth 2 dollar but with his 1 dollar debt to A,
his net asset is 1 dollar.

The net asset of the country = 4 dollar.

4) A saw that the land he once owned has risen in value. He regretted
selling it. Luckily, he has a 1 dollar loan to C. He then borrowed 2 dollar
from B and and acquired the land back from C for 3 dollar. The payment is by

2 dollar cash (which he borrowed) and cancellation of the 1 dollar loan to
C. As a result, A now owned a piece of land that is worth 3 dollar. But
since he owed B 2 dollar, his net asset is 1 dollar.

B loaned 2 dollar to A. So his net asset is 2 dollar.

C now has the 2 coins. His net asset is also 2 dollar.

The net asset of the country = 5 dollar. A bubble is building up.

(5) B saw that the value of land kept rising. He also wanted to own the
land. So he bought the land from A for 4 dollar. The payment is by borrowing

2 dollar from C and cancellation of his 2 dollar loan to A.

As a result, A has got his debt cleared and he got the 2 coins. His net
asset is 2 dollar. B owned a piece of land that is worth 4 dollar but since
he has a debt of 2 dollar with C, his net Asset is 2 dollar.

C loaned 2 dollar to B, so his net asset is 2 dollar.

The net asset of the country = 6 dollar. Even though, the country has only
one piece of land and 2 Dollar in circulation.

(6) Everybody has made money and everybody felt happy and prosperous.

(7) One day an evil wind blowed. An evil thought came to C's mind. "Hey,
what if the land price stop going up, how could B repay my loan. There is
only 2 dollar in circulation, I think after all the land that B owns is
worth at most 1 dollar only."

A also thought the same.

(8) Nobody wanted to buy land anymore. In the end, A owns the 2 dollar
coins, his net asset is 2 dollar. B owed C 2 dollar and the land he owned
which he thought worth 4 dollar is now 1 dollar. His net asset become -1
dollar.

C has a loan of 2 dollar to B. But it is a bad debt. Although his net asset
is still 2 dollar, his Heart is palpitating.

The net asset of the country = 3 dollar again.

Who has stolen the 3 dollar from the country ?

Of course, before the bubble burst B thought his land worth 4 dollar.

Actually, right before the collapse, the net asset of the country was 6
dollar in paper. his net asset is still 2 dollar, his heart is palpitating.

The net asset of the country = 3 dollar again.

(9) B had no choice but to declare bankruptcy. C as to relinquish his 2
dollar bad debt to B but in return he acquired the land which is worth 1
dollar now.

A owns the 2 coins, his net asset is 2 dollar. B is bankrupt, his net asset
is 0 dollar. ( B lost everything ) C got no choice but end up with a land
worth only 1 dollar (C lost one dollar) The net asset of the country = 3
dollar.

****************End of the story***************************

There is however a redistribution of wealth.

A is the winner, B is the loser, C is lucky that he is spared.

A few points worth noting -

(1) When a bubble is building up, the debt of individual in a country to one
another is also building up.

(2) This story of the island is a close system whereby there is no other
country and hence no foreign debt. The worth of the asset can only be
calculated using the island's own currency. Hence, there is no net loss.

(3) An overdamped system is assumed when the bubble burst, meaning the
land's value did not go down to below 1 dollar.

(4) When the bubble burst, the fellow with cash is the winner. The fellows
having the land or extending loan to others are the loser. The asset could
shrink or in worst case, they go bankrupt.

(5) If there is another citizen D either holding a dollar or another piece
of land but refrain to take part in the game. At the end of the day, he will
neither win nor lose. But he will see the value of his money or land go up
and down like a see saw.

(6) When the bubble was in the growing phase, everybody made money.

(7) If you are smart and know that you are living in a growing bubble, it is
worthwhile to borrow money (like A ) and take part in the game. But you must
know when you should change everything back to cash.

(8) Instead of land, the above applies to stocks as well.

(9) The actual worth of land or stocks depend largely on psychology.
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Old 30th September 2008, 10:31   #8
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That was quite an innovative story to explain the crisis. Good work phamilyman
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Old 30th September 2008, 14:11   #9
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It may be surprising, but these bubbles existed in 1720s - one of the most earlier ones was named the "South sea bubble". The reaction to that bubble burst was same as we have nowadays - more legislation.

Thankfully, that legislation went on give us the earliest precussors of the Company Law.
Some links:-
Stock Market Crash
Crashes: The South Sea Bubble
The South Sea Bubble
The South Sea Company - Wikipedia, the free encyclopedia
The days before the great depression of 1989 had seen several Mutual Funds in the US of A buying units in each other - and when value of MF "A" went down, value of MF "B" also went down because "B" held a sizeable portion of "A"; but because "A" held units in "B", lowering value of "A" further reduced value of "A". This caused a severe spiral.
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Old 30th September 2008, 14:33   #10
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Harward School of Business and Stanford school of business are to be blame. I say so because most bit Investment Bankers come from these institutes. There is something seriously wrong with top Business Schools.
I mean, look at top engineering institutes. you have stuff like google/Touch screens/Microprocessors being designed by the guys from these schools, however top people of Business schools are producing bubbles, scams and Meltdowns.
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Old 30th September 2008, 14:35   #11
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Damn Interesting The Dutch Tulip Bubble of 1637

beats that by a solid time
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Old 30th September 2008, 14:37   #12
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Quote:
Originally Posted by tsk1979 View Post
Harward School of Business and Stanford school of business are to be blame. I say so because most bit Investment Bankers come from these institutes. There is something seriously wrong with top Business Schools.
I mean, look at top engineering institutes. you have stuff like google/Touch screens/Microprocessors being designed by the guys from these schools, however top people of Business schools are producing bubbles, scams and Meltdowns.
I will add our IIM's and IIT's too because most of the MNCs like Lehman Bro has hired top performers from IIMs. See where they are now.
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Old 30th September 2008, 15:15   #13
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I will just say two things to tsk/naronikar ji:
a. Your posts are complete fantasy. Greed had nothing to do with any institute. Please think before you post.
b. No IIM/Harvard was part of the Tulip bubble - sorry to bust your theory bubble. Bubbles have been around courtesy greed, not courtesy institutions of excellence.

And i fully expect these two posts to be deleted. Just like I've had so many posts of mine deleted in threads for chatter or for going OT.

Last edited by phamilyman : 30th September 2008 at 15:17.
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Old 30th September 2008, 15:18   #14
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I never used the word greed in my post. All I said was that the economic Investment Banking etc., is controlled by people from top B schools, so what is taught there must be wrong in some way,
Nothing OT about it, I feel this is the reason for the current economic bubble.
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Old 30th September 2008, 15:30   #15
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bubbles , baloons, spirals , gyres & meltdowns.

Excess Greed & Poor regulation is the cause.

Masking of sub prime loans as assets and trading them across the planet is main cause of this one. Once it started the slide it exposed all the other flaws such as pure speculation and low liquidity with very high exposure and its all downhill for a while
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