A financial bubble, aka economic bubble, occurs when the price of an asset rises to a level well above that at which it is normally valued. Eventually, the price drops, usually precipitously, to a point at or below its normal level. (The bubble “bursts.”) Those who bought the asset at an inflated price and failed to sell it before it crashed suffer an obvious financial loss, that loss being multiplied in the case of a highly leveraged purchase, such as a stock bought on margin or a house purchased with a small down payment.
Under normal conditions, market forces ensure that the prices of commodities remain at or close to their intrinsic values. In the case of a temporary shortage, such as one resulting from a crop failure, the demand for that product will temporarily exceed the supply, causing the buyers to bid up the price until the balance between supply and demand is restored. Buyers generally react to price increases by purchasing less of those products and substituting similar products that have not increased in price. Since the market smoothly adjusts to temporary shortages and surpluses, these occurrences rarely if ever precipitate a financial bubble.
Since financial bubbles harm individuals financially and can be disruptive to markets as a whole, it’s important to identify the factors associated with these bubbles in order to prevent them or at least mitigate the harm resulting therefrom. Furthermore, since government intervention in the economy, however well-intentioned, usually results in more harm than good, the proposed remedy or remedies should involve a minimum of restrictive or coercive legislation.
We can identify three stages in the life of a financial bubble: its inception, the maintenance phase, and the crash. Ideally, we would like to have the capability of recognizing when a financial bubble is about to develop and be able to take countermeasures to prevent its formation. Failing that, the next best option is to intervene as early as possible in the maintenance phase of the bubble in order to bring the affected market to a “controlled landing,” rather than a crash.
The free market is a homeostatic system. Under normal conditions, market forces provide a negative feedback mechanism that causes the price of a commodity to vary so that the supply closely approximates demand. However, just as the temperature of the human body can deviate from its normal narrow range during illness, pathological conditions in the economy can result in an imbalance between supply and demand.
A financial bubble can be triggered by a government action or policy that causes a disruption in the balance between the supply and demand of a commodity. An example is the housing bubble, which was caused in large measure by the government artificially increasing the demand for housing by mandating housing loans, as well as by the Federal Reserve (Fed) maintaining historically low interest rates. Thus, it is likely that the housing bubble as well as the recession that followed could have been averted had the government not intervened in the economy. Therefore, in order to prevent future financial bubbles, it is herein recommended that the government refrain from intervening in the economy, except in the case of a dire emergency and then only with the approval of two-thirds of both houses of Congress as well as the president.
To prevent the Fed from setting interest rates in a manner that distorts the economy, it is herein recommended that this agency be abolished and that interest rates be determined by the free market. Regarding the role of the Fed in adjusting the interest rate in order to steer the economy between the Scylla of high unemployment and the Charybdis of inflation, this wouldn’t be necessary if the minimum wage were abolished, as recommended in my article Solving the Unemployment Problem, which would result in jobs for those willing and able to work, and if the gold standard were adopted, as recommended in my article A Proposed Method of Eliminating Inflation, which would eliminate inflation.
A major factor contributing to the housing bubble and the resulting subprime mortgage crisis was the massive fraud committed by the banks. This included misrepresenting the financial status of those applying for mortgage loans by allowing and often encouraging the applicants to misstate their income in order to qualify for loans on which they were likely to default. These “liar loans” were then packaged into mortgage-backed securities, which were fraudulently sold to investors as low-risk investments. Aiding and abetting this fraud were rating agencies, which gave these securities the top AAA rating. When the housing bubble burst and housing prices plummeted, there was a sharp rise in the default rate of these liar loans, resulting in major losses by those who invested in these mortgage-backed securities.
Since the subprime mortgage crisis was caused in large measure by the fraudulent activity of banks described above, this suggests that similar crises may be averted, or at least mitigated, by the government being more aggressive in identifying and prosecuting fraud. It’s not sufficient to impose fines on banks and other corporations that engaged in illegal activities, since doing so only penalizes the innocent shareholders and has little if any effect in deterring future wrongdoing. Rather, the individuals responsible need to be prosecuted for their crimes and be required to pay restitution for the damage that they have done.
One positive feedback mechanism that tends to maintain a bubble is that when the price of an asset is steadily rising, there will be those that will buy that asset based on the expectation that the price will continue to rise, and that they will be able to later sell it at a profit. The increasing number of buyers of that asset will drive up its price, resulting in a self-fulfilling prophecy. As the number of new buyers eventually becomes depleted, the price will level off, causing the investors to rush to unload that asset before it crashes, which, in turn, will precipitate the crash. The best way to avert such speculative bubbles is to educate the public on the dangers of such speculation.