Economic bubbles are not easy to spot and are often identified only after they are burst. Otherwise known as asset bubbles, these occur when the price of an asset skyrockets due to unrealistic expectations regarding its future. Such a rise in their value is not sustainable for long periods and the result is a sudden and steep price drop. Past centuries have seen many bubbles and its effect on the world economy has been harsh. Here are some of the biggest economic bubbles you should know about.
During the 17th Century, the Dutch Republic led the world with its thriving socio and economic societies. This was also the time Europe witnessed the introduction of future's market for commodities.
Tulips were introduced in the Netherlands in the middle of the 16th century. These exotic flowers were brought to the country from Turkey and commercial production started by the end of the century. The flower grew in popularity over the years and with speculative traders entering the market, the price of Tulip bulbs went through the roof. Tulip mania had reached its peak and by 1637, the prices crashed as there were no more buyers. Though there are no proper records to analyze the extent and impact of this bubble, the term 'tulip mania' has come to associate with any economic bubble in the later centuries.
In the early 18th century, France went through a financial crisis. The French government was battered by wars and large amounts of debt had piled up. The standard norm in this situation would be to reduce government spending. But unfortunately for France, the monarchy devised another scheme, along with a Scottish exile named John Law. Law was a brilliant economist who believed that paper money was preferable than gold and silver coins, which were used widely during those times.
As the French government grappled with enormous national debt, Law proposed to replace coins with paper money. Production of new coins had stopped due to the shortage of raw materials and there was a huge shortage of coins in circulation. In 1716, Law proposed to open a private bank named 'Banque Royale' which will take up all of France's debt but in return, the country should allow him the sole privilege to develop land in Louisiana. He brought in two companies, the Company of the West and the Company of the Indies, which together were known as the Mississippi Company. The proposal was accepted and soon Law's business in the Mississippi valleys flourished. But the fact was that John Law purposefully exaggerated the wealth his companies were generating. Soon, the value of the shares went north and hence people needed more money, banks began printing more paper currency. But not long after in 1720, the shares came crashing down since the infusion of paper money triggered inflation and people realized that this was all orchestrated by John Law. Removed from all official positions, Law fled to Brussels and lived there until his death.
In the early 18th century, Britain's economic situation was battered by waging two wars simultaneously, the Great Northern War and a war with France. The government became more and more dissatisfied with the service it received from the Bank of England, which had the authority to arrange loans to the government. So, the newly appointed exchequer to the government, David Harley, made a suggestion to create a new company called the South Sea Company. The debt will be transferred to the company and in return, the company will issue shares. Also, the government shall pay a fixed amount annually which the company will use to distribute as the dividend. The company's operations involved trade to South America, which was under the control of Spain at the time.
Despite its efforts, the company remained largely unprofitable. But the founders decided to keep it a secret and between 1711 and 1720 and issued stocks several times for consolidating its debt. Also, they spread rumors about the company's profitability to make the share price boom. Meanwhile, seeing the success of the South Sea Company, several other companies were being floated and stocks were being offered to the public. But it all came crashing down in 1720 and an investigation into the matter revealed that the founders committed fraud and several high-ranking officials have fallen into corruption. As the markets crashed, thousands of people lost their money, making it one of the biggest bubbles in history.
The Dotcom bubble was one of the biggest stock market crashes in the history of United States. It started in 1997 when the widespread usage of internet paved way for many internet start-up companies to float IPOs.The share price of several established technology companies began climbing up in the first few years. Later, as the prices of these companies who were doing well in many areas of computer technologies, including hardware and software, were trading high, many investors chose to lap up new stock issues and penny tech stocks commonly known as 'dotcoms'. As the prices soared, more investors as well as speculators entered the market. By 2000, the NASDAQ stock exchange, which comprises of mostly technological companies, touched the peak. But, by mid-2001 panic selling started, which brought down almost all technology stocks with the new and penny stocks whose valuations were inflated to unrealistic numbers bearing the brunt. Many established companies lost huge portions of their valuations while several smaller ones had to face complete shutdown.
Real estate prices as well as the Japanese stock market shot up considerably during the Japanese asset price bubble that happened between 1987 and 1991. Bank of Japan's reluctance in tightening money supply along with speculative buying made overconfident investors put more money into real estate and stocks. The crash began in 1990 when the Nikkei stock exchange descended to halfway mark. In 1991, asset prices followed suit. The aftermath of the crash, which saw the Japanese economy stagnating for years, is known as the 'lost decade'.
Economic bubbles make investors rich. At the same time, it also makes a lot of people poor when they burst. As there is no single system to identify bubbles, past experiences should provide the necessary wisdom for investors to know when to stay away from an overheated market.