The Theory of Credit Boom Bubble - Essay Example

Running head: Bubbles Bubbles s Bubbles The word “bubble” in economics means the economic cycle which involves theboom and the recession periods over and over again. Broadly speaking, there are basically two types of bubbles that exist in the economy-the credit boom bubble and the irrational exuberance bubble. The theory of credit boom bubble says that the prices of assets and securities will keep rising above the real value till the time when prices falls and bubble bursts. However, there are certain other types of bubbles that do not occur due to the natural cycle but as a result of investor exuberance. Usually it takes place in securities, real estate and stock markets. The rising prices of stocks, securities or properties attract people to invest in them, believing that they will be able to sell them at even higher prices. Prices keep rising till the time when people start loosing confidence in the securities or stocks, and thus, a crash occurs which moves the prices back to the original level.” Asset bubbles can exist in an economy with endogenous growth provided that they are not too large and that the growth rate in the equilibrium without bubbles exceeds the interest rate” (Grossman & Yanagawa, 2002). A different perspective can be seen from the bubble effect. It is natural for the companies to revalue their assets or up rating the equity valuation. In order to remain in business and to compete with other business, they need to raise the equity .Since most of the big companies now a days are public limited companies, they require publishing their annual reports at the end of the financial period. Thus, if they do not revalue their assets, their financial statement would be badly affected. Since the real value of money is falling with time, taxes rising, and governments not able to meet the commitments, investors assets kept independent of government is completely rational. It is the excessive debt that has brought the crash which has been transfer by the governments. (Odey, 2009) Some economists believe that the bubble occurs due to inflation which causes the prices to rise but the others believe that there is a basic value of every asset and bubbles tend to rise the value of the asset, but eventually the value moves back to is original position after going through the economic fluctuations. Some of the theories regarding bubble state that there are economic players who play the key role. The bubble originates from the communication and coordination of the economic players. However, the basic concept of bubble suggests that people do not see the intrinsic or real value of the asset. They rather get attracted to the rising prices of assets which build a confidence of selling it at even a higher price later. “Buying assets in such circumstances requires investors to rely on the "greater fool" argument, to believe, mistakenly, that they will make money on the up and get out before the burst” (Odey, 2009). Bubbles can either be short term or long term. Short term economic bubbles, which are less than 10 years, occur due to artificial situations or mistakes and they tend to correct the market imbalances naturally. However, the long term bubbles result due to the system of misperception created in the value of goods and services and the manipulation of financial records by the strong governments and organizations. Long term bubbles create a heavy economic recession for a longer period of time. When the bubble is building up, the debt to the individual also increases as the money in circulation remains the same but the prices of assets keep increasing. The one who sells the asset before the bubble bursts, gains from it and the others get worse off since they owe to the financial institutions for taking loans. In 1980s prices of assets rapidly rose in Japan but suddenly declined in the early 1990s. A research was carried out to draw the relationship among stock and land prices in Japan, output and bank lending variables. In the first period, the bubbles brought an affect on each other (Basile & Joyce, 2001). Currently, the President of United States, Obama, has injected millions of dollars in to the economy, for the ‘recovery plan’, seeking to take the economy out of recession. A lot of investment has been made in the infrastructure and energy projects primarily for the sake of spending money, this is going to create a new bubble in the infrastructure and asset market, since too much money is chasing for the limited opportunities (Janszen). The word “Irrational exuberance” came into existence in the speech of Federal Reserve chairman Alan Greenspan in December 1996 which basically referred to the phenomenal gains in the stock market. The stock market was rising tremendously and Greenspan names it as irrational. The rise in the stock prices in 1996 was a bubble which burst as soon as the statement was made. The stock market dropped sharply right after the speech due to fact that people lost confidence in buying stocks because traders were afraid that the Federal Reserve might take action to reduce the so called irrational gains in the stock market. Federal Reserve could have raised the interest rate which could decrease investment. ”When an irrational exuberance bubble bursts, it stings -- but it doesnt level the economy” (McGugan, 2009). The dot com bubble in 2000 is the example of irrational exuberance. Irrational exuberance is not as crucial as the credit boom bubble because it causes a relatively mild recession compared to the credit boom bubble. The Wall Street crash is a perfect example of stock bubbling which brought USA into deep recession in the late 1920s. In the mid- 1920s, the American economy was growing at a very fast rate and the rates on returns were rising rapidly. The industrial output was increasing greatly and the New York Times index rose above 180 in December 1925 as compared to 1924 i.e. 106. However, in 1928, the agricultural prices were falling which gave an alarming signal that there was over production taking place which could have drastic effect later but the stock market still grew. In March 1928, the stock market rose by 25 points. The prices of the shares kept rising which attracted the potential investors to buy as many shares as possible to gain from the short term speculation .There could be many reasons for high investment but the important reason could be the low interest rates. Low interest rates means low cost of borrowing which allows people to borrow more in terms of loans .Perhaps, too much borrowing led to the increasing buying and selling of stocks. This is because the investors thought that they would get a higher return from trading stocks than the interest rate they have to pay on the loans. Thus, the increasing transactions led to the rise in prices of shares. Since investments are not measured by dividends, the rate of returns rose. Eventually the time came when the people thought that it was useless to buy shares as they might not be able to sell them at the higher price. That was the point where the market collapsed drastically! The prices of shares dropped back to their real value and the investors who bought the shares at a higher value lost their money. Banks went bankrupt since they made excessive lending in the period of boom which could not be recovered. (Sun 04, May 2008) According to the research, it is expected that 12 bubbles can burst in different markets. Firstly it is the guns sales. It has been anticipated that Americans are “snapping up guns to hoard, collect, or safe keep. Some are even stockpiling for investment purposes. This has led to an increase in the prices of guns which is creating a bubble. The second bubble which is popping up is ‘option Arms’. Option ARMs allow the owners of the home to pay the partial interest and the rest is added to the principal amount. With the falling property values, this scheme will attract people and, thus, eventually the bubble will burst. Similarly there are other expected bubbles that are expected to burst which includes Cap and Trade, Incandescent Light Bulbs (EU), China’s stock market, gold, higher education, Trustafarianism, Alternative Energy, Junk Bonds, ETFs, Food. (Drea, 2009) However, there is another perspective to see the effects of bubbles. The bubble leaves behind a new commercial and consumer infrastructure. Due to the massive production during the period bubbles are built up, new technology is brought in, that helps the economy in the long run. Even though ,in United States , the banks were bankrupt when the bubble burst in 1929 but the stuff that was built during infrastructure bubbles, for example, housing and telegraph wires, fibre optic cables and rail roads did not vanish. No doubt, the business men, after the burst, got bankrupt, but the infrastructure made during this time, actually helped the new entrepreneurs entering the same businesses. With low costs and better capital, businesses can provide even better services and enhance the economy of the country, Usually , the economies tend to get out of bubbles in a short period but the everlasting capital and technology helps for a longer period. Looking at the history of United States, many fast growing industries, which includes consumer goods, financial service sector, tourism, telecom, data services and mass media and most importantly the “internet space”, were found in those “hot house bubble environment” (Dubner, 2007). There are certain ways by which bubbles can be prevented. Policy makers should continue with their zero interest policies for the time period it takes for the economy to move back to the steady state. Increasing the interest rates is the only way to vanish asset bubbles. Steps that can be taken to pull down the bubbles include that the margin requirements to purchase securities can be increased, down payment for real asset can be increased. These measures can help preventing bubbles to create in the market. The recent housing bubble could have bee n prevented by using the scientific method. For a number of years, the housing values increased faster than ever which was an alarming signal. An average worker had to spend about 50% of his or her income for the monthly payments of the purchase of a house. There were lax requirements for obtaining a mortgage which were bundled into securities and they were sold at a high rating. This resulted in a bubble in mortgage and thus led to even a bigger economic bubble. Therefore, all the bubbles give an alarming signal .Government should take actions before time to avoid the painful results of the burst. References Basile A. & Joyce J. P. (2001). Asset bubbles, monetary policy and bank lending in Japan: an empirical investigation. Applied Economics, 33(13): 1737-1744(8). Drea. (2009). 12 Economic Bubbles That May Burst. [Online] Available at: http://www.businesspundit.com/12-economic-bubbles-that-may-burst/ [Accessed 17 November 2009] Duber, S. J. (2007). The benefits of a bubble, even when burst. [Online] Available at: http://freakonomics.blogs.nytimes.com/2007/06/26/the-benefits-of-a-bubble-even-when-burst/?pagemode=print [Accessed 17 November 2009] Odey, C. (2009). It may be a bubble but it’s completely rational. [Online] Available at: http://www.ft.com/cms/s/571555b8-a7da-11de-b0ee-00144feabdc0,Authorised=false.html?_i_location=http%3A%2F%2Fwww.ft.com%2Fcms%2Fs%2F0%2F571555b8-a7da-11de-b0ee-00144feabdc0.html%3Fnclick_check%3D1&_i_referer=&nclick_check=1 [Accessed 17 November 2009] Yanagawa, N., & Grossman, G. M. (1993). Asset bubbles and endogenous growth. Journal of Monetary Economics, 31: 3-19. Read More