Economic bubble
The metaphor indicated that the prices of the stock were inflated and fragile – expanded based on nothing but air, and vulnerable to a sudden burst, as in fact occurred.
An equity bubble[4] is characterised by tangible investments and the unsustainable desire to satisfy a legitimate market in high demand.
These kind of bubbles are characterised by easy liquidity, tangible and real assets, and an actual innovation that boosts confidence.
[citation needed] A debt bubble[8] is characterised by intangible or credit based investments with little ability to satisfy growing demand in a non-existent market.
A protracted period of low risk premiums can simply prolong the downturn in asset price deflation, as was the case of the Great Depression in the 1930s for much of the world and the 1990s for Japan.
Investor George Soros, influenced by ideas put forward by his tutor, Karl Popper (1957),[11] has been an active promoter of the relevance of reflexivity to economics, first propounding it publicly in his 1987 book The alchemy of finance.
Sooner or later they reach a point where the sentiment is reversed and negative expectations become self-reinforcing in the downward direction, thereby explaining the familiar pattern of boom and bust cycles.
For several decades there was little sign of the principle being accepted in mainstream economic circles, but there has been an increase of interest following the crash of 2008, with academic journals, economists, and investors discussing his theories.
[14] Economist and former columnist of the Financial Times, Anatole Kaletsky, argued that Soros' concept of reflexivity is useful in understanding China's economy and how the Chinese government manages it.
[22] Recent computer-generated agency models suggest excessive leverage could be a key factor in causing financial bubbles.
[26] More recent theories of asset bubble formation suggest that they are likely sociologically-driven events, thus explanations that merely involve fundamental factors or snippets of human behavior are incomplete at best.
For instance, qualitative researchers Preston Teeter and Jorgen Sandberg argue that market speculation is driven by culturally-situated narratives[clarification needed] that are deeply embedded in and supported by the prevailing institutions of the time.
[23] For example, Axel A. Weber, the former president of the Deutsche Bundesbank, has argued that "The past has shown that an overly generous provision of liquidity in global financial markets in connection with a very low level of interest rates promotes the formation of asset-price bubbles.
"[28] According to the explanation, excessive monetary liquidity (easy credit, large disposable incomes) potentially occurs while fractional reserve banks are implementing expansionary monetary policy (i.e. lowering of interest rates and flushing the financial system with money supply); this explanation may differ in certain details according to economic philosophy.
Risky leveraged behavior like speculation and Ponzi schemes can lead to an increasingly fragile economy, and may also be part of what pushes asset prices artificially upward until the bubble pops.
If there is a monetary authority like a central bank, it may take measures to soak up the liquidity in the financial system in an attempt to prevent a collapse of its currency.
These measures may include raising interest rates, which tends to make investors become more risk averse and thus avoid leveraged capital because the costs of borrowing may become too expensive.
There may also be countermeasures taken pre-emptively during periods of strong economic growth, such as increasing capital reserve requirements and implementing regulation that checks and/or prevents processes leading to over-expansion and excessive leveraging of debt.
When investors feel that they are no longer well compensated for holding those risky assets, they will start to demand higher rates of return on their investments.
In attempting to maximize returns for clients and maintain their employment, they may rationally participate in a bubble they believe to be forming, as the likely shorter-term benefits of doing so outweigh the likely longer-term risks.
A recent example is the Troubled Asset Relief Program (TARP), signed into law by U.S. President George W. Bush on 3 October 2008 to provide a government bailout for many financial and non-financial institutions who speculated in high-risk financial instruments during the housing boom condemned by a 2005 story in The Economist titled "The worldwide rise in house prices is the biggest bubble in history".
However, in relation to the party instigating the bubble, these smaller competitors are insufficiently leveraged to withstand a similarly rapid decline in the asset's price.
If the bubble-instigating party is itself a lending institution, it can combine its knowledge of its borrowers' leveraging positions with publicly available information on their stock holdings, and strategically shield or expose them to default.
