What do bubbles mean?
A bubble requires an asset price to be above its fundamental value. This is difficult to define because investors will argue about what fundamental value is. Economists still argue passionately about the fundamental value in Dutch tulip bulb prices during the early 17th century (economists do not get out very much).
A bubble generally involves novelty. Dutch tulips, 18th century canals, 19th century railways, 20th century radios and turn of the century Internet stocks were all new.
Cryptocurrencies today are new. Alternatively it can be financial innovation that is the novelty. Cash-settled futures contracts on Dutch tulip bulbs were new.
Novelty matters because it makes valuing future fundamentals difficult. Novelty allows the dread phrase 'this time it is different' to be spoken. There has to be a reason investors forget the rational lessons of history. Novelty helps.
A bubble must promise real-world returns at some distant date. If real-world returns are expected quickly, the failure to realize those returns quickly will be obvious quickly. The gap between selling financial assets and achieving the real-world returns lets irrationality build. The asset price continues to rise because bubble buyers believe that returns will come pouring in if only they wait long enough.
The final characteristic of a bubble is that a bubble bursts. It is the bursting of a bubble that is of most interest to the economist. This conclusive signal comes too late for the bubble buyer, of course.
Bubbles in financial assets make for exciting media headlines, but what do they mean for the real economy?
A bubble transfers money from one group in society (asset buyers) to another group in society (asset sellers). Wealth is redistributed.
Bubbles often involve a large numbers of buyers giving wealth to a smaller number of sellers. The 1929 equity-market bubble sucked in the general population as buyers. A smaller group sold out in time. Cryptocurrency buyers are larger in number than cryptocurrency miners today. The large number of losers and the small number of winners from a bubble concentrates wealth in an economy.
If building and bursting a bubble concentrates wealth, consumption patterns change. Wealthy people buy different things from less wealthy people. It is also generally true that wealthy people spend less of their income than less wealthy people. Shifting spending power from the losers of a bubble to the winners will probably reduce overall consumer spending.
Bubble buyers will experience a negative wealth effect when a bubble bursts. The decline in the value of their assets will cause bubble buyers to increase their savings. This is a negative impact for the economy.
The loss of wealth is made worse by a behavioral economic concept, called 'loss aversion.' People dislike the loss of something more than they like gaining something. It is a very ancient survival mechanism, forcing people to run away from danger. Research suggests a loss is twice as important as a gain. We run away from the sabre tooth tiger twice as fast as we run towards a potential meal. Even though the size of bubble losers' losses will equal the size of bubble winners' gains when a bubble bursts, the losses will be more important economically.
Direct experience of building and bursting a bubble may make investors more risk averse in the future. Rising risk aversion can change an economy's future investment and innovation. This hurts the trend rate of growth.
While a bubble builds, money is diverted from useful economic activity into less useful economic activity. Because asset prices exceed fundamental value, investing in a bubble is 'bad' investment (economically speaking). That means that parts of the economy that should be getting investment ('good' investment) lose out. Bursting the bubble may help restore the balance-but risk aversion may lower investment (and growth) overall.
Does a bursting bubble have to have negative economic consequences? It is likely, but not certain. If a small group of people in a country participate in a bubble, then the economic consequences of the bubble and of the bubble bursting are limited. This is particularly true if the financial sector has remained aloof from the bubble.
Policy-makers can limit the damage. Seventeenth century Dutch officials allowed tulip futures contracts to be terminated by bubble buyers at a fraction of the cost-limiting the worst of the wealth transfers. The United States Federal Reserve offered help after the 1987 equity correction.
Clearly, bubbles are unlikely to disappear from financial markets. The changes of the fourth industrial revolution may produce more of the novelty that can fuel bubble creation. Looking for signs that a bubble is building and understanding the real-world consequences are likely to matter more.