Markets + FOMO = Bubble Trouble
Bhakti Rupika Anand
When you think of bubbles, your mind might conjure images of childhood laughter, long showers with tons of soap, well we can go on forever. But why are we even talking about bubbles? Economics and bubbles might seem worlds apart, but they share some common ground. Let’s find out how bubbles are a perfect metaphor for the world of finance.
Economic bubbles are a fascinating but equally perilous aspect of financial markets. While they create economic growth and wealth in the short term, bubbles often end in tears when they pop. So, what exactly are bubbles? Economists define them as periods of rapid and unstable increase in prices of an asset: essentially, the asset is highly overvalued and soon after is followed by a rapid decline in prices. NFTs are the most recent example of bubbles, although they’ve been around for quite some time in the economy. The oldest one being the Dutch Tulip Mania of 1630s. Bubbles are not merely incidents written in an economist’s history book but also serve as cautionary tales, to remind us of the consequences of unchecked overvaluation, speculation and investor optimism.
Let’s rewind to 2021: NFTs– digital pieces of art were sold for millions of dollars driven by the belief that these will have a long-term value. Well, look at how that turned out. By the end of 2022, the market value of these assets reduced by 98%. Just like you need the right soap solution and technique to blow bubbles, certain conditions need to be present for an economic bubble to form. The combination of speculation, low interest rates, positive feedback loops and the belief that the prices will keep rising make the perfect bubble in the economy: promising a lot of profit but quite delicate.
The Internet Boom and the Dot-Com Bubble: in the late 1990s the dot- com bubble grew due to the rapid growth of internet related companies. Investors bought shares of companies with little to no profit history. The bubble inflated and so did the stock prices. When these companies failed to deliver profits, the bubble burst, leading to collapse of many tech companies and steep decline in the stock market.
The only quality both soap bubbles and bubbles in the economy share? They burst, easily. When a factor weakens, the bubble pops, wiping out millions in market value. Bubbles can cause economic and financial instability which can lead to job losses and even recession in the economy.
According to Hyman Minsky, American economist who introduced the instability hypothesis, bubbles are attributed to change in investor behavior. What changes the investor behavior? It is only human to want what others have, and be a part of what’s trending. The FOMO (Fear Of Missing Out) that is induced by the slight rise in prices and profits received by others pushes people to invest rapidly. Vernon Smith ,Nobel Laureate, awarded the prize for his work in the field of economics (market mechanisms), conducted an experiment by giving students an asset to trade in a market simulation. Even knowing that by the end of the given time period the asset value turns to zero, the players keep on trading for higher prices. As the time passes the prices increase: the players want to earn profits. Nearing the end, the assets are trading way above their value and when the investors want to back out, no one is willing to buy. This is a classic example of a bubble.
What’s another classic example? The South Sea Bubble of 1720: The South Sea Company, granted a monopoly to trade with South America, became the focus of speculation in England. Investors bought shares in the company at inflated prices, driven by rumors of untold riches. When the company’s value was revealed to be vastly inflated, the bubble burst, causing significant financial losses.
Everyone wants profit, and even knowing that the assets will have no value the next day, everyone wants a piece of cake. So how to mitigate the risk? Economic bubbles can be deflated by a few ways: Regulation by the government to curb the growth of bubbles to dangerous levels, transparency in financial markets to help investors make informed choices and of course a trader’s mantra: diversification of portfolio.
But why should it even come down to mitigating profits? Why not predict a bubble? Well, it isn’t that easy. Just like you can’t know for sure when a bubble is going to burst, economic bubbles can’t be timed either. Prices of stocks move up and down regularly and sometimes even exponentially. Although generally markets are efficient and prices reflect the available information, the Efficient Market Hypothesis is challenged when bubbles come into the picture. So, for now the only way for us to predict a bubble is the disconnect between the asset prices and the underlying fundamentals.
The Crypto Craze of 2017: The rise of cryptocurrencies, particularly Bitcoin, has sparked a speculative frenzy reminiscent of past bubbles. In 2017, Bitcoin’s price skyrocketed, drawing investors and media attention. However, its value subsequently experienced significant fluctuations, underlining the volatile nature of the cryptocurrency market. It’s hard to say if cryptocurrencies were actually a bubble or not. The volatility of the market and speculation sent the prices through the roof and also resulted in some losses. Instead of bringing the economy down, crypto did prove to be beneficial, promoting innovation and investment into a decentralized financial system. Although sometimes bubbles can have such benefits, the risks definitely outweigh them.
Bubbles, both soap and economic, are vastly different but offer intriguing parallels. Demonstrating the fragility of unstable growth and challenges of predicting their (inevitable) demise they do give us valuable insight in the world of economics. Maybe next time FOMO comes around, we’ll find ourselves blowing bubbles, not money in the market.