Economic Bubbles

A bubble is an economic phenomenon that features a significant rise in the market value of assets. The price of the asset greatly exceeds its intrinsic value. It can be related to commodities such as agri-commodities, metals, precious metals, etc. It can also relate to stocks, currency, or debt.
The cause of bubbles can be excessive monetary easing, huge debt, excessive speculation, irrational exuberance, etc. Due to excessive monetary easing, the supply of money increases. This money chases assets, which leads to rising in asset prices. When debt levels rise significantly, this debt is utilized for carrying out excessive economic activity, excessive infrastructure, real estate, or irrational capital expenditure. Excessive speculation occurs when many institutions and people chase assets because of herd mentality. Due to irrational exuberance, people assume the high valuations will continue forever and prices will never fall.
After bubbles are formed for some time, they burst. When they burst, it leads to a contagion effect in turn leading to economic recession or depression, stock market crashes, reduction in employment, etc. Here is a history of some bubbles in the last few decades.
Dutch Tulip mania (1634-1638)
This bubble is one of the earliest recorded instances of an economic bubble.  Research is difficult as it took place many decades back and hence we get different data from different sources. During the tulip bubble, tulip bulb prices jumped around 20 times in a short span of time. The prices jumped so much that even some houses cost less than tulips. At the peak of the bubble, some bulb contracts were changing hands 10 times in a day. People imagined that the passion for tulips would last forever.
It is reported that the bubble burst when buyers refused to show up at a routine bulb auction in Harlem as Haarlem was suffering from an outcome of bubonic plague. When the bubble burst, tulips lost most of their value at their peak, plunging by 99% by May 1637. Many people made and lost fortunes in quick time.

Mississippi Bubble (1719-20)
France suffered huge macroeconomic problems and they called upon a person who was known to be a financial wizard and close to the government, known as John Law. A scheme was engineered by him. In 1716 Law established a bank called Banque Generale. This bank was unique because it had the authority to issue notes. It took deposits in coins but issued loans and withdrawals in the paper. He later established another company known as Mississippi Company which monopolized various industries including trade.  The shares of the company showed a meteoric rise from 500 to 18,000 livres. There was a general stock market boom across Europe. Law then merged this company with the bank. The activities later resulted in removing France’s paper currency from the gold and silver standard and putting it on the Mississippi Company share price standard.
This led to hyperinflation. Law depreciated the currency and the shares by half. However, the decision backfired. It triggered a selling frenzy that drove the share price down sharply. When the Mississippi bubble ended, it led to a general stock market crash in France and other countries. Law was compelled to run away from France in December 1720. The humongous debts of the company and bank had to be taken over by the State. The State had to raise taxes to retire this debt. The Mississippi bubble was as much a currency blunder as a stock market bubble. 
South Sea Bubble (1720)
The South Sea Company was a company created to reduce the cost of the national debt. It was given a monopoly to trade in South America for Britain. It also carried out slave trading. The company was significantly dependent on the goodwill of the government. People developed a herd behavior resulting in a humongous rise in South Sea stock from 100 pounds to 1000 pounds in a matter of one year. Then the stock crashed from nearly 1000. As a stock price crashed, it triggered bankruptcies among people who had bought the shares on credit. This led to further selling and this coincided with the burst of the Mississippi bubble, leading to stock prices crashing to 100 pounds in a short span of time.
Upon investigations, it was found that huge bribes were given to politicians to support the workings of the South Sea Company. This led to many politicians being disgraced. Also, the founders of the company had indulged in insider trading. The bursting of the South Sea Bubble significantly diminished the national economy. Then, the company was restructured and it continued its operations for more than a century.
Panic of 1819
This was the first financial crisis in the United States. The Napoleonic Wars ended in 1815. This led to the price of land, commodities like cotton, tobacco, wheat, and slaves growing by leaps and bounds. The speculative land bubble ended when the Second Bank of the US called in loans for species in August 1818. From 1819 to 1821, the prices of these agricultural commodities fell by around 50%.
Panic of 1837
This was another financial crisis that happened in the USA. Many people attribute this bubble to the economic expansion that happened between mid-1834 to mid-1836. This led to a significant rise in the price of land and cotton.
But, due to better transportation systems, the prices of cotton declined. The security for loans was cotton prices. USA’s cotton kings defaulted. Wheat crops suffered in 1836 and 1837 from winter kill and Hessian fly. This caused the prices of wheat to increase. This in turn led American labor to starve. In May 1827, banks in New York ran out of gold and silver. This led to the suspension of special payments. When the bubble burst, unemployment went up and prices and wages went down. An economic depression hit the United States up to around the mid-1840s. Nearly half the banks failed during this period. There was a contraction in currency in the US by around 34%. 
Roaring 20’s stock market bubble
The Roaring 20’s started as people wanted to break the shackles of trauma and deprivation caused by World War 1 (1914 – 18). There was widespread economic prosperity in the 1920s and consumer demand accelerated. The period saw high levels of technological development with millions of lives being positively impacted due to the widespread use of electronic appliances, telephones, automobiles, radio, and films.
The stock market became 4x from 1920 until 1929. People assumed that there was a new paradigm of economic prosperity. People assumed the boom would last forever. Many experts including economists also assumed the same thing. In fact, in 1927, the economist John Meynard Keynes said that we will not have any more crashes in our time.
However, there was one element that came into society in the Roaring ’20s that perhaps played a role in causing the bubble – greed. A ‘get quick rich’ mentality had set in among people. Many people had taken excessive loans from brokers and banks to buy stocks. Stock prices had gone far above their intrinsic values. The era of the Roaring 20’sended with the Wall Street crash of 1929. Wall Street collapsed by 12% on October 29, 1929, known as Black Tuesday.  The Dow Jones crashed by 88% from a high of 353 on October 10, 1929, to 41 on July 8, 1933. It climbed to 353 only after 2 decades in 1954. There were many bank runs and closures from 1932 to early 1933.
In the aftermath of the crash, the Securities and Exchange Commission (SEC), which is the regulator for stocks, was set up. In 1933, a series of programs called the ‘The New Deal’ was introduced to improve the lives of Americans.

Japanese Asset Price Bubble (1986-1991)
The cause of the Japanese Asset Price Bubble was excessive monetary easing. In this bubble, stock and real estate prices zoomed. The madness in land prices was so much that at one point in time, the Tokyo Imperial Palance grounds were estimated to be worth more than all the land in the entire state of California. There was excessive economic activity.
The bubble burst due to the tightening of monetary policy. Stock prices crashed by more than 60% from December 1989 to August 1992. The Non-Performing Assets (NPA’s) of lending institutions rose and land prices also declined significantly. The economic decline of Japan continued for a decade, leading it to be called The Lost Decade and later the Lost 20 years where average GDP growth was only 0.13% per annum for 20 years. The benchmark Nikkei 225 index is still at lower levels than the highs it made during the bubble.
1997 Asian Financial Crises
East Asian economies followed the policy of export-led growth prior to the crisis. This strategy involved subsidies and favorable financial deals. Also, currency was pegged to the US dollar to ensure a favorable exchange rate for exporters. However, this economic policy involved certain risks which were ignored.  One of the risks was that there were guarantees, direct or indirect, to bail out banks and domestic industries.
A key event occurred when due to the implications of the reversal of the Plaza Accord in 1995, governments of the US, Japan, and Germany agreed to let the US dollar appreciate against the Deutsche mark and yen. This meant an appreciation of East Asian currencies that were pegged to the US dollar. This led to the breaking of the model of export-led growth, which required weak currencies in East Asia. German and Japanese exports became more competitive as compared to East Asian exports. Due to this, exports of East Asian countries significantly reduced and profits of companies declined.
In order to tide over the problem, one after another East Asian currencies removed their pegging to the US dollar and devalued their currencies. This caused stock market declines and government upheavals. International stocks crashed by up to 60% and some East Asian currencies fell as much as 35%. The IMF intervened to provide loans to East Asian countries by imposing certain conditions.
Dot Com Bubble (1995-2000)
This was also known as the tech bubble or dot com boom. There was a massive growth in the adoption of the internet and computers during this period. A decline in interest rates led to more capital being available, which fueled the boom. Nasdaq Composite showed a stupendous rise of more than 600% from July 1, 1994, to mid-March 2000. Towards the end of this period, people were willing to invest in technology companies at any valuation. If a company had ‘.com’ suffix to its name, people used to blindly invest in them.  There were a number of IPO’s of technology companies. At its peak, NASDAQ reached a price-earnings ratio of 200.

When the bubble burst, Nasdaq crashed by more than 75% from mid-March 2000 to mid-October 2002. Several technology companies failed or shut down. However, some technology companies like Amazon went on to become multi-baggers in the next 2 decades, even after crashing post-bubble.
US Housing Bubble (2002-2006)
There was a rapid growth in housing prices during this period caused by inflows of money into the housing market and the construction of a lot of new houses. Loans were given to sub-prime high-risk borrowers and the lending conditions were very loose. Many of these loans were sold off to other institutions. Since many of these loans were sold off, there was little incentive to carry out prudent risk management practices to ensure that these loans don’t turn into NPA’s.  
Another aspect was the credit crisis resulting from the bursting of the housing bubble. This led to a recession in the United States. Dow Jones crashed by 54% from mid-October 2007 to mid-March 2009. The impact on the stock market was felt the world over with Sensex also crashing by more than 60%. Housing prices collapsed with them reaching new lows in 2012. A limited bailout of the US housing market for homeowners was announced.

2000’s Commodities bubble (2002-2008)
It was also known as the commodities super-cycle. During the boom, prices of many commodities such as crude oil, food, oil, metals rose significantly. The cause of the boom was a rise in demand mainly from China and to some extent, from other emerging markets known as BRICS nations (Brazil, Russia, India, and South Africa including China. For instance, crude oil rose stupendously to reach a peak of $147 in July 2008 from $30 in 2003. During the boom, many people believed that commodity prices could be predicted better than stocks as they were based on actual demand and supply. Commodity prices reduced significantly due to the financial crisis of 2008. However, commodity prices began to recover in late 2009.
Bubbles and bursting of bubbles are economic phenomena that have been there in the past and will continue in the future. 
The lesson is that you should not buy stocks at peak valuation like Warren Buffett did in this case. Also, since oil prices were too high, the mean reversion was on the cards. Mean reversion is an important concept in investing. One of the other lessons to learn is that even great investors make mistakes and are not infallible. 
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