Can efficient markets create bubbles? Regardless of the industry, market cycles and asset bubbles seem to be quit regular occurrences. The causes of booms and busts usually cannot be narrowed down to one factor, but human nature consistently impacts the severity. Market bubbles are usually capricious and unidentifiable until after they burst. These crashes often lead to enthralling circles of market depression and unemployment across economies. From the recent housing market crash to tulip mania in the seventeenth century, inefficient pricing and crowd hysteria has led to adverse price bubbles time and time again. In attempt to speculate the underpinnings of the bubble phenomenon and derive preventative measures, the following analysis will cover both recent and past events to provide a greater context for understanding of market behavior.
Real estate accounts about half of the worlds’ wealth and about twenty eight percent of US gross domestic product. The housing market crash of the recent decade has impacted both local and global economies significantly. A bubble is created when, “the price of an asset differs from its fundamental market value” (Mishkin). Originating in the late nineties and early two thousands, fueled by the decrease in credit requirements, the US housing market started to see drastic increases in demand for homes which pushed prices higher. As more people could afford to qualify for larger mortgages with less money down, more homes where purchased. The bubble grew for close to a decade, peaking in 2006, and finally crashed in 2007.
Charles Mackay, in his book Extraordinary Popular Delusions and the Madness of Crowds stated that men often, “think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one” (Mackay). Human nature, specifically crowd hysteria, often misguides investor’s in allocating wealth and usually leads to asset bubbles. The housing market experienced an injection of capital, increasing market prices above intrinsic values, which caused it to grow at an unsustainable pace.
The unpredictability of bubbles eludes even the brightest of scholars. In 2005, Ben Bernanke, chairman of the Federal Reserve, predicted that there was no concern of a housing bubble and asset values, “largely reflect(ed) strong economic fundamentals” (Henderson). As the market growth continued through 2006, most economic leaders held similar beliefs as Bernanke. Bull markets often lead to crowd hysteria and the common belief that the growth cannot end.
Many people have referred to real estate as the safest asset to invest in. This mentality, along with easily attainable credit, led to housing bubble and ultimate crash. Throughout the bubble growth phase some might have called you a fool not to invest in a home, all upside potential and no downside risk. This notion is why market bubbles and human nature are often intertwined. Relaxed credit standards led to increased housing demand, which drove home prices up, creating crowd hysteria and the idea of infinite sustainable growth. Although the effects of the crash are long lasting, the US housing market is not unique in its behavior.
Unique and diverse markets, such as that for tulips, even fall prey to asset bubbles resulting from inflated values. Throughout the seventeenth century the Dutch experienced a large demand for tulip bulbs. Due to the rarity of flower and limited supply, the prices for bulbs soared. The belief that tulips held great value spread through the land causing crowd hysteria and increased demand. As people started to understand the true asset value of a tulip bulb, the market collapsed. Similar to the housing market, unsustainable growth on the basis of asset prices which do not reflect true intrinsic values led to economic depression and hardships.
Asset bubbles can be avoided in perfectly efficient markets. As exhibited through all market bubbles in the past, human nature detracts from the efficiency of rational investment decisions. This false demand drives up asset prices beyond there intrinsic values. In the moment, regardless of the market, it is extremely difficult to analyze and predict growing bubbles. In an age of technology and regulation that increases market efficiency, bubbles are perhaps one of the greatest uncontrollable failures we are faced with overcoming. When the perceived return of an investment is large and the risk is minimal, it is the greatest challenge to all investors not to partake.
Henderson, Nell. “Bernanke: There’s No Housing Bubble to Go Bust.” The Washington Post: National, World & D.C. Area News and Headlines – The Washington Post. The Washington Post, 27 Oct. 2005. Web. 19 Oct. 2011.<http://www.washingtonpost.com/wpdyn/content/article/2005/10/26/A205102602255.html>.
“Mackay, Charles, Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, Front Matter and Chapter 1.” Library of Economics and Liberty. Web. 19 Oct. 2011 <http://www.econlib.org/library/Mackay/macEx1.html>.
Mishkin, Frederic S., and Stanley G. Eakins. Financial Markets and Institutions. Boston: Prentice Hall, 2012. Print.