Financial market bubbles and crashes under magnifying glass: what causes financial and economic booms and collapses
Bubbles will always be
In the hub I want to explore the reasons for different financial and economic bubbles and to see how they are connected with the recent crisis. If you find the article useful I would appreciate if you liked it on Facebook, tweeted and shared on other social platforms.
We still feel the consequences of global economic crisis that hit the world in 2008. Crisis will be the next topic I am going to cover in my hubs. Now let me concentrate on its’ predecessor – economic expansion. There have always been ups and downs in the markets and they will always be. We should not be too much concerned about that. What should interest us are reasons for repetitive market bubbles and crises that follow those bubbles. There are very many people who say that it is impossible to state why exactly those things happen, but I have a different opinion. If you have studied financial markets for a longer period of time and looked thoroughly through the history of various stock markets you must have noticed that there are certain tendencies that cause bubbles to be formed and those tendencies are repetitive. Unfortunately, financial ‘experts’ do not seem to know them as at the very end of the last boom most of them were talking about the continuation of economic expansion and never saw the coming collapse. So, I encourage you to study history for yourself and make your own conclusion. Now, let me go to the major reasons for formation of financial bubbles.
Low interest rates – a solid foundation for any financial bubble
Ben Bernanke would definitely oppose the idea and when asked he always does. But is he right? We should not look at the graduation certificate to judge whether a person is right or wrong. Allan Greenspan once considered a ‘financial god’ admitted publicly that he was wrong about the coming crisis. When warned about chaos in derivatives market he would say everything was ok there and markets will regulate themselves. They did and ordinary people as well as investors lost trillions of dollars during the collapse. If you study how economy expansion works you will notice that economic growth in our world is based on borrowing. Companies borrow money for working capital to run their businesses; they also borrow for bigger projects. People borrow money to buy houses, cars and almost every possible thing. Low interest rates create big opportunities to borrow in very good conditions. In such a way a lot of capital is released from banks into various economic activities and economy starts expanding. People start looking where to put their money and finally they start to invest in stocks, commodities, currencies, real estate and etc. Due to large quantities of money coming to economy inflation starts picking up and banks start raising interest rates bit by bit. Finally economy is overheated and the bubble explodes. Everything starts going to ‘the toilet’. That’s how any bubble is created and exploded.
Inappropriate lending causes economic bubbles
If you look how banks were lending money to businesses and private individuals before crisis hit the world you would not be surprised that the crisis came. Everybody could take a loan for a house, a car or anything else. People could take loans without any down payment. Even students could buy houses. That is ridiculous! Money was given to those who would have never been able to repay it unless they won a lottery. Money was also lent for speculation and this flooded financial markets with big amounts of money and caused securities to rise across the board. This kind of lending also caused unprecedented rise of prices in construction sector across the world. As you know, rise in the sector pushed other sectors up as well. As the world has become a global village, the result of this was a huge international financial bubble in the entire world.
Excessive leverage and large liquidity contribute to market bubble formation
If we take as an example currency market or Forex a private investor and speculator could operate up to 400 times larger amount of capital than he puts into the market. This is due to the fact that brokers, banks, funds provided speculators and investors with that extra amount and in this way a small guy with a deposit of one thousand bucks could operate with the sum of one hundred thousand. Furthermore, he would have a tremendous liquidity. One could open a position for ten million bucks and close it after a few seconds. Who would not want to trade under such conditions? Of course, people were warned about excessive leverage, but still brokers and banks were also playing with fire, not only investors and speculators. Why give such huge amounts of money to anybody willing to try his luck in financial markets? Well, nice commissions, spreads and etc. tempted most of capital providers. So, some gave, others took and they all participated in market bubbles creation.
Over supply of inflated money from central banks accelerate growth of bubbles
When central banks lower interest rates they create very favorable borrowing conditions for huge banks. They can borrow from their central bank at very low interest rates and then lend the money at bigger interest rates to smaller banks, businesses and private individuals. When this happens inflation starts picking up and money starts losing value. As time passes by, you are not able to buy the same thing for the same price you used to buy. It costs more. Unfortunately salaries do not rise so fast and if you do not know how to increase your earnings, your wealth is ‘eaten up’ by inflation. People try to save their capital by investing into various securities and in this way flood financial markets with money. A bubble is the usual outcome.
Greed is the biggest human flaw that creates all possible financial bubbles
If people weren’t greedy no other factors would be able to create financial and economic bubbles in the markets. Nobody forces you to take a loan if you do not think you will not be able to pay it off. You are greedy and not willing to live according to your possibilities. You want to live beyond them and in this way participate in bubble creation. Nobody forces a trader to leverage his trade so much as to wipe out his account at the smallest swing. He chooses to do it himself. If we were not greedy there would never be market bubbles in the world. Maybe bankers would be sitting without a job as well. I do not think that is a big problem. They are not doing anything good anyway. Economy that grows on borrowed money will always end up in some sort of bubble and crisis. I think we need more financial and economic education now as never before. We cannot believe what we are told by ‘financial experts’ any more. They are almost always dead wrong. Do not be greedy, use your head and you will find out how to make more money.
Jim Rogers on bond market bubble (video)
Some TIPS on what to do when economy is in a bubble
1. Save money. When market bubbles develop it creates unique opportunities to save as salaries are usually higher, governments gather more taxes, businesses booming, and a lot of jobs are created. Do not waste your money at these times. Save it. When the bubble explodes money becomes scarce and you will enjoy the cash that you saved up.
2. Get rid of debts. If you do this they will not give you any trouble when crisis comes. Presently very many acquaintances of mine regret that they did the opposite. When the bubble exploded, some of them experienced 80 percent salary decrease. Some others lost their jobs. What do you think happened to their loans? So be wise and get rid of debts.
In this part of the article I want to briefly go through some of the most famous historical bubbles in the world. I hope you will find it useful.
Tulipomania bubble (1634-1638)
It is one of the first known market bubbles that happened in the modern history. It happened in Holland. Although it may be surprising, but the bubble did not form in some stock market or other financial market (stock market as we know it was not yet in Amsterdam yet). The object of trade and speculation became tulip bulbs. It might sound very irrational to a modern person, but people would sell their wealth in order to buy a few tulip bulbs. There was something special about tulips that attracted people throughout centuries. Rulers of Persia and Ottoman Empire were amazed by the beauty of the flower. However, who could have said that at the peak of Tulipomania bubble one could sell a tavern just to get three tulip bulbs. In those times Holland had just got its’ independence from freedom and was commercially blossoming. The Dutch were seeking for opportunities to do big business and tulip bulbs appeared to be the answer. Everything seemed ok, till bulbs became an object of speculation. As the supply was not able to meet the demand, the price of bulbs skyrocketed. Everybody started buying and selling bulbs. At the end of the peak the same bulbs were changing hands ten times a day. One day a greater fool failed to appear and prices collapsed. This led to a great recession in Holland.
A useful resource on Tulipomania bubble: http://www.businessweek.com/2000/00_17/b3678084.htm
So, I hope I was pretty clear on the reasons that cause financial and economic bubbles in the world today. There could be more of them and you should study for yourself the history of various markets crashes to see that what happened in 2008 was nothing new. It has been happening for centuries, but most people have never learned anything from history and that’s why they are doomed to repeat the same mistakes their forefathers had done. Be responsible, learn to live according to your possibilities and find out ways how to make more money. It will take time, but you will know that the things you have are yours and you will not have to give it back to somebody else (bank).
Other useful hubs:
- Economic bubble - Wikipedia, the free encyclopedia
An economic bubble (sometimes referred to as a speculative bubble, a market bubble, a price bubble, a financial bubble, a speculative mania or a balloon) is trade in high volumes at prices that are considerably at variance with intrinsic values.
Useful material on various financial and economic bubbles.
Historical study of financial bubbles
- Financial Bubbles - Historical Returns
Financial Bubbles explores some of the extraordinary similarities between the South Sea Bubble of 1720 and the recent technology bubble.
- PBS: Think Tank: Economic Bubbles
From the Railroad boom to the dot.com crazy economic bubbles have shaped and shaken our Economy. But, are these always a bad thing?
- Economic Bubbles: What They Are, Why They Happen, and Why You Should Care
You dont need a Ph.D. in economics to know that economic bubbles---and their ensuing POPS!---can take us all for a wild ride. Bubbles occur anytime asset