Reading 1

Unit 6- Reading 1

Page 82

Economic bubbles

An economic bubble occurs when speculation in commodities (such as oil), securities (such as stocks and bonds), real estate, or collectibles drives up prices well beyond the item’s Intrinsic value. The end result of this boom in price is a crash or bust.

The price falls sharply once it becomes clear that it is far beyond the purchasing power of potential customers. Speculators risk money in such investments because they hope that the price of an asset they purchased will quickly increase. Since most speculators are nervous about where they invest their money, bubbles are by no means the norm. After all, speculators face the danger that the item is already overpriced.

They also know that rising prices will encourage either greater production of a commodity or greater willingness of current owners to sell. Either of these conditions can serve as a “negative feedback” mechanism that adjusts prices downward. In economic situations, negative feedback works a bit like your eyes do. As the light gets brighter, your pupils get smaller and let in less light.

But what if your eyes worked as a “positive feedback” mechanism? In sunlight, your pupils would open wide and damage the retina.

Economic bubbles occur when prices trending sharply upward serve as a positive, rather than a negative, feedback mechanism.

For whatever reason (fear of shortages, greed, an excessively optimistic attitude toward the future, or misinformation about an asset’s underlying value), buyers believe that the value of the asset will continue to rise well beyond the current price. If the price rises, exuberant speculators buy more, or those who missed out on the lower price want to buy before the price rises any higher.

Some economists offer the “greater fool theory” to explain this: Buyers justify the high price they pay by assuring themselves that they will find “a greater fool” who will pay even more. Or buyers assume that a rising trend has a momentum that will surely carry it higher. Under the right conditions, prices can reach dizzying heights before falling.

One famous example of this phenomenon is the tulip-buying bubble centered in Amsterdam in the 1630s when a single tulip bulb could cost a year’s salary (see Reading 2).

Most bubbles cause little or no economic damage. The losers (the “greater fools”) are a bit wiser, and the winners (the sellers) are a lot richer.

But the effects of a bubble might be felt more widely if the holders of the overpriced asset feel rich and spend foolishly. Imagine this: You buy a house for $200,000 for which you borrowed $160,000. At this point, you have $40,000 in equity in the house (the difference between the price of the house and what you owe). The market value rises to $500,000 over a 5-year period.

Now you have $340,000 in equity ($500,000 - $160.000). so you.borrow another $240,000 from a bank using this equity to secure the loan. You suddenly feet much wealthier. You control assets worth half a million dollars. You still have $100.000 in equity in your home, and you have $240.000 to spend.

And you do—a down payment on a vacation home, your daughter’s freshman year at an expensive private college, a new car, and luxurious home furnishings.

The market holds long enough for you to spend the money. Then it crashes and the value of your home falls to $325,000. Now you have negative equity and owe the bank almost $400,000.

You ask yourself why you should be paying $400,000 for a $325,000 house, so you stop paying your loan and give your house, car, and vacation home to the bank. Depending on how this plays out. the bank or you or both will take a huge loss. If this situation is widespread, banks can fail and less money is available for the investments and purchases necessary to “grow” the economy.

Besides real estate bubbles, there are stock market bubbles. In a normal market, investors buy stock in a company (also called “buying shares”) because they anticipate that future profits will be distributed to shareholders, or because they believe that the value of the company’s assets will increase.

The share price depends on how certain investors are that these gains will materialize—and uncertainty usually is enough to keep prices within reason. Sometimes, though, a “herd mentality” sets in and too many investors rush to buy. driving prices to levels that prove unrealistic. Eventually. the price collapses.

When this happens to many companies simultaneously, it is called a stock market crash, with panicked investors selling so much stock that the market can drop a staggering amount in a single day.

A famous stock market bubble was the “dot-com” bubble in the United States which lasted from the mid 1990s to 2001.

Excitement about the economic possibilities of the Internet encouraged investors to fund the creation of many dot-com companies—too many, it turns out. For several years, instant wealth seemed within reach of any business with a website. Dot-com companies used expensive TV commercials to attract investors, sometimes without indicating what product they were selling.

Many companies, to increase “market share,” purposely sold products at a loss, a scheme they believed would increase the company’s customer base and lead to future profits. Instead, on March 10, 2000, the dot-com boom reached its peak. Its dramatic decline can be seen by looking at numbers provided by the NASDAQ Composite Index.

This stock market index tracks the combined value of thousands of companies traded on the technology-heavy NASDAQ stock exchange. On that day the index hit 5,132.52. Over the next two and a half years, the index dropped to as low as 1.108. Most of the dot-coms were out of business, filing for bankruptcy or selling off their assets to healthier companies.

Particularly hard-hit were communication companies that invested heavily in a high- speed communications Infrastructure that greatly exceeded demand.

Bubbles are not limited to real eatate or glamorous “get rich” stock offerings. In 1996, a series of stuffed animal toys called Ty Beanie Babies™ became such a fad that speculators bought up large quantities, assuming that their value as collectibles would rise greatly in future years.

Did anyone make money on that fad? Maybe, but why not see for yourself? Check out the price of Beanie Babies in an online auction site and decide if any of these sellers have struck it rich.