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How Do Asset Bubbles Cause Recessions?

Asset bubbles shoulder blame for some of the most devastating recessions ever faced by the United States. The stock market bubble of the 1920s, the dot-com bubble of the 1990s, and the real estate bubble of the 2000s were asset bubbles followed by sharp economic downturns. Asset bubbles are especially devastating for individuals and businesses who invest too late, meaning shortly before the bubble bursts. This unfortunate timing erodes net worth and causes businesses to fail, touching off a cascade effect of higher unemployment, lower productivity and financial panic.

Key Takeaways

  • Asset bubbles exist when market prices in some sector trade far higher than fundamentals would suggest.
  • Market psychology and emotions like greed and herding instincts are thought to provide fuel for bubbles.
  • When bubbles eventually pop, they tend to leave economic pain in their wake including recession or even depression.

How Asset Bubbles Work

An asset bubble occurs when the price of an asset, such as stocks, bonds, real estate or commodities, rises at a rapid pace without underlying fundamentals, such as equally fast-rising demand, to justify the price spike.

Like a snowball, an asset bubble feeds on itself. When an asset price begins rising at a rate appreciably higher than the broader market, opportunistic investors and speculators jump in and bid the price up even more. This leads to further speculation and further price increases not supported by market fundamentals.

The real trouble starts when the asset bubble picks up so much speed that everyday people, many of whom have little-to-no investing experience, take notice and decide they can profit from rising prices. The resulting flood of investment dollars into the asset pushes the price up to even more inflated and unsustainable levels.

Eventually, one of several triggers causes the asset bubble to burst. This sends prices falling precipitously and wreaks havoc for latecomers to the game, most of whom lose a large percentage of their investments. A common trigger is demand becomes exhausted. The resulting downward shift puts downward pressure on prices. Another possible trigger is a slowdown in another area of the economy. Without economic strength, fewer people have the disposable income to invest in high-priced assets. This also shifts the demand curve downward and sends prices plummeting.

Historical Examples of Asset Bubbles

The 1920s Stock Market Bubble/The Great Depression

The crash touched off The Great Depression, still known as the worst economic crisis in modern American history. While the official years of the Depression were from 1929 to 1939, the economy did not regain footing on a long-term basis until World War II ended in 1945.

The 1990s Dot-Com Bubble/Early 2000s Recession

The Internet changed the way the world lives and does business. Many robust companies launched during the dot-com bubble, such as Google, Yahoo, and Amazon. Dwarfing the number of these companies, however, was the number of fly-by-night companies with no long-term vision, no innovation and often no product at all. Because investors were swept up in dot-com mania, these companies still attracted millions of investment dollars, many even managing to go public without ever releasing a product to the market.

A Nasdaq sell-off in March 2000 marked the end of the dot-com bubble. The recession that followed was relatively shallow for the broader economy but devastating for the tech industry. The Bay Area in California, home to tech-heavy Silicon Valley, saw unemployment rates reach their highest levels in decades.

The 2000s Real Estate Bubble/The Great Recession

For much of the 2000s, getting a mortgage was easier than getting approved to rent an apartment. As a result, demand for real estate surged. Real estate agents, builders, bankers, and mortgage brokers frolicked in the excess, making piles of money as easily as the 1980s Masters of the Universe portrayed in Tom Wolfe’s “Bonfire of the Vanities.”

As one might expect, a bubble fueled in large part by the practice of loaning hundreds of thousands of dollars to people unable to prove they had assets or even jobs was unsustainable. In certain parts of the country, such as Florida and Las Vegas, home prices began to tumble as early as 2006. By 2008, the entire country was in full economic meltdown. Large banks, including the storied Lehman Brothers, became insolvent, a result of tying up too much money in securities backed by the aforementioned subprime mortgages. Housing prices tumbled by more than 50% in some areas. As of 2015, the majority of Americans feel the economy still has not fully recovered from the Great Recession.

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About Amy Harvey

Amy R. Harvey writes forStartUps Sections In AmericaRichest.

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