Rick Kelo – Bubbles

As a tax expert with a degree in economics, Rick Kelo knows (and has written more than one article) about economic bubbles. A bubble, to put it one way, occurs when any asset is traded for a price that far exceeds that item’s intrinsic value. A bubble is far from a new phenomenon; as a matter of fact, the first bubbles occurred in the 17^th century, well before real-time information on any asset was available.

Bubbles, of course, lead to economic crashes, which lead either to recessions (bad enough), or outright depressions (far worse). The British South Sea Bubble, which occurred in the years 1711 to 1720, gave us the term we use so often today. Previous bubbles (including the Dutch tulip bubble, which caused widespread economic devastation) were known as “manias”.

Some economists are of the opinion that a bubble cannot be identified before it begins, and thus, that a bubble cannot be prevented from starting. They believe that any measures taken to prevent the formation of a bubble will create a crisis; therefore, it is best to let a bubble form and burst – which, also, will cause a crisis. Not only that, but the subsequent crash can cause long-term economic problems, as shown by the Great Depression of the 1930s, and the housing bubble of earlier this century.

When a bubble has formed, owners of the assets that are the subject of the bubble have the tendency to spend more. Given that their assets are seriously overvalued, these owners feel that they are richer. The housing bubble is one such example. Then, when the bubble bursts, spending is cut and economic growth slows considerably.

Economists have yet to agree on what causes bubbles in the first place. One theory puts forth the idea that they are driven by sociological factors. Another theory is that excessive monetary liquidity creates banks to lend money under unfavorable terms. This, in turn, creates markets that are vulnerable to inflated asset prices driven by speculation. To quote Axel A. Weber, formerly the president of Deutsche Bundesbank, “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.”

In other words, when assets are highly appreciated, economic bubbles tend to occur. When the bubble bursts, as it must, assets fall in price and confidence sinks, which may lead to a financial crisis.