Financial Bubble

A Bubble begins when the price of an asset rises far higher than can be explained by fundamentals, such as the income likely to derive from holding the asset.

The Chicago Tribune of April 13th 1890, writing about the then mania in real-estate prices, described “men who bought property at prices they knew perfectly well were fictitious, but who were prepared to pay such prices simply because they knew that some still greater fool could be depended on to take the property off their hands and leave them with a profit”.

Such behavior is a feature of all bubbles. Famous bubbles include tulip mania in Holland during the 17th century, when the prices of tulip bulbs reached unheard of levels, and the South Sea Bubble in Britain a century later, although there have been many others since, including the dotcom bubble in internet company shares that burst in 2000.

The 17th century saw the Netherlands enter the Dutch golden age. By the 1630, Amsterdam was an important port and commercial center. Dutch ships imported spices from Asia in huge quantities to earn profits in Europe. So Amsterdam was brimming with wealthly, skilled merchants and traders who displayed their prosperity by living in mansions surrounded by flower gardens. And there was one flower in particularly high demand: the tulip. The tulip was brought to Europe on trading vessels that sailed from the East. Because of this, it was considered an exotic flower that was also difficult to grow, since it could take years for a single tulip to bloom. During the 1630s, an outbreak of tulip breaking virus made select  flowers even more beautiful by lining petals with multicolor, flame- like streaks. A tulip like this was scarcer than a normal tulip and as a result, prices for these flowers started to rise, and with them, the tulip’s popularity. It wasn’t long before the tulip became a nationwide sensation and tulip mania was born. A mania occurs when there is an upward movement of price combined with a willingness to pay large sums of money for something valued much lower in intrinsic value.

A recent example of this is dot-com mania of the 1990s.Stocks in new, exciting websites werw like the tulips of the 17th century.

Economists argue about whether bubbles are the result of irrational crowd behavior perhaps coupled with exploitation of the gullible masses by some savvy speculators or, instead, are the result of rational decisions by people who have only limited information about the fundamental value of an asset and thus for whom it may be quite sensible to assume the market price is sound. Whatever their cause, bubbles do not last forever and often end not with a pop but with a crash.