Economic bubble made easy

A Bubble begins when the price of an asset rises far higher than can be explained by fundamentals, such as the income likely to derive from holding the asset.

The Chicago Tribune of April 13th 1890, writing about the then mania in real-estate prices, described “men who bought property at prices they knew perfectly well were fictitious, but who were prepared to pay such prices simply because they knew that some still greater fool could be depended on to take the property off their hands and leave them with a profit”. Such behavior is a feature of all bubbles.

Famous bubbles include tulip mania in Holland during the 16th century, and the South Sea Bubble in Britain a century later, although there have been many others since, including the dotcom bubble in internet company shares that burst in 2000 and the housing market in 2007-2008.

To give you  a better understanding of bubble , an example of the Tulip bubble will be used which happened in Holland near the turn of the 16th century.

The tulip bulb trade started inadvertently when a botanist brought tulip bulbs from Constantinople and planted them for his own scientific research. Neighbors then stole the bulbs and began selling them. The wealthy began to collect some of the rarer varieties as a luxury good. As their demand increased, the prices of the  bulb surged to ridiculously high prices.

Holland’s upper classes soon competed for the rarest bulbs as tulips became a status symbol.

By 1636, tulip bulbs were traded on the stock exchanges of numerous Dutch towns and cities, encouraging all members of society to speculate in the markets. Many people traded houses to participate in the tulip market mania.

Like any bubble, it all came to an end in 1637,when someone decided to not pay. Some people decided to capitalize on their investments and started selling. Demand started decreasing as more and more people wanted to sell .This started a panic throughout Europe, driving the price of any tulip bulb down to a tiny fraction. Dutch authorities stepped in to calm the panic by allowing contract holders to be freed from their contracts for 10% of the contract value. In the end, fortunes were lost by noblemen and laymen alike.

Economists argue about whether bubbles are the result of irrational crowd behavior perhaps coupled with exploitation of the gullible masses by some savvy speculators or, instead, are the result of rational decisions by people who have only limited information about the fundamental value of an asset and thus for whom it may be quite sensible to assume the market price is sound.

Whatever their cause, bubbles do not last forever and often end not with a pop but with a crash.