An economic cycle known as a bubble is characterized by a sharp increase in market value, notably in asset prices. This rapid inflation is followed by a rapid decline in value, or contraction, which is occasionally referred to as a “crash” or “bubble burst.”

A bubble typically develops as a result of an increase in asset prices that is fueled by irrational market behavior. Assets often trade at a price during a bubble, or within a price range, that is significantly higher than the asset’s intrinsic worth (the price is not in line with the asset’s fundamentals).

The cause of bubbles is disputed by economists; some economists even disagree that bubbles occur at all (on the basis that asset prices frequently deviate from their intrinsic value). However, bubbles are usually only identified and studied in retrospect, after a massive drop in prices occurs.

An economic bubble occurs any time that the price of a good rises far above the item’s real value. Bubbles are typically attributed to a change in investor behavior, although what causes this change in behavior is debated. Bubbles in equities markets and economies cause resources to be transferred to areas of rapid growth. At the end of a bubble, resources are moved again, causing prices to deflate.

The Japanese economy experienced a bubble in the 1980s after the country’s banks were partially deregulated. This caused a huge surge in the prices of real estate and stock prices. The dot-com boom, also called the dot-com bubble, was a stock market bubble in the late 1990s. It was characterized by excessive speculation in Internet-related companies. During the dot-com boom, people bought technology stocks at high prices—believing they could sell them at a higher price—until confidence was lost and a large market correction occurred.

The research of American economist Hyman P. Minsky helps to explain the development of financial instability and provides one explanation of the characteristics of financial crises. Through his research, Minsky identified five stages in a typical credit cycle. While his theories went largely under the radar for many decades, the subprime mortgage crisis of 2008 renewed interest in his formulations, which also helped to explain some of the patterns of a bubble.

• Displacement

This stage takes place when investors start to notice a new paradigm, like a new product or technology, or historically low interest rates. This can be basically anything that gets their attention. 

• Boom

Prices start to rise. Then, they get even more momentum as more investors enter the market. This sets up the stage for the boom. There is an overall sense of failing to jump in, causing even more people to start buying assets. 

• Euphoria

When euphoria hits and asset prices skyrocket, it could be said that caution on the part of investors is mostly thrown out the window. 

• Profit-Taking

Figuring out when the bubble will burst isn’t easy; once a bubble has burst, it will not inflate again. But anyone who can identify the early warning signs will make money by selling off positions. 

• Panic

Asset prices change course and drop (sometimes as rapidly as they rose). Investors want to liquidate them at any price. Asset prices decline as supply outshines demand. 

Examples of Bubbles

Recent history includes two very consequential bubbles: the dot-com bubble of the 1990s and the housing bubble between 2007 and 2008. However, the first recorded speculative bubble, which occurred in Holland from 1634 to 1637, provides an illustrative lesson that applies to the modern-day.

• Tulip Mania

While it may seem absurd to suggest that a flower could bring down a whole economy, that is exactly what happened in Holland in the early 1600s. The tulip bulb trade initially started by accident. A botanist brought tulip bulbs from Constantinople and planted them for his own scientific research. Neighbors then stole the bulbs and began selling them. The wealthy began to collect some of the rarer varieties as a luxury good. As their demand increased, the prices of bulbs surged. Some rare varieties of tulips commanded astronomical prices.

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Bulbs were traded for anything with a store of value, including homes and acreage. At its peak, tulip mania had created such a frenzy that fortunes were made overnight. The creation of a futures exchange, where tulips were bought and sold through contracts with no actual delivery, fueled the speculative pricing.

The bubble burst when a seller arranged a big purchase with a buyer, and the buyer failed to show. At this point, it was clear that price increases were unsustainable. This created a panic that spiraled throughout Europe, driving the worth of any tulip bulb down to a tiny fraction of its recent price. Dutch authorities stepped in to calm the panic by allowing contract holders to be freed from their contracts for 10% of the contract value. In the end, fortunes were lost by noblemen and laymen alike.

• Dot-Com Bubble

The dot-com bubble was characterized by a rise in equity markets that was fueled by investments in internet and technology-based companies. It grew out of a combination of speculative investing and the overabundance of venture capital going into startup companies. Investors started to pour money into internet startups in the 1990s, with the express hope that they would be profitable. 

As technology advanced and the internet started to be commercialized, startup companies in the Internet and technology sector helped fuel the surge in the stock market that began in 1995. The subsequent bubble was formed by cheap money and easy capital. Many of these companies barely generated any profits or even a significant product. Regardless, they were able to offer initial public offerings (IPOs). Their stock prices saw incredible highs, creating a frenzy among interested investors. 

But as the market peaked, panic among investors ensued. This led to about a 10% loss in the stock market. The capital that was once easy to obtain started to dry up; companies with millions in market capitalization became worthless in a very short amount of time. As the year 2001 ended, a good portion of the public dot-com companies had folded.

• U.S. Housing Bubble 

The U.S. housing bubble was a real estate bubble that affected more than half of the United States in the mid-2000s. It was partially the result of the dot-com bubble. As the markets began to crash, values in real estate started to rise. At the same time, the demand for homeownership started to grow at almost alarming levels. Interest rates started to decline. A concurrent force was a lenient approach on the part of lenders; this meant that almost anyone could become a homeowner.

Banks reduced their requirements to borrow and started to lower their interest rates. Adjustable-rate mortgages (ARMs) became a favorite, with low introductory rates and refinancing options within three to five years. Many people started to buy homes, and some people flipped them for profit. But when the stock market began to rise again, interest rates also started to rise.

For homeowners with ARMs, their mortgages started to refinance at higher rates. The value of these homes took a nosedive, which triggered a sell-off in mortgage-backed securities (MBSs). This eventually led to an environment that resulted in millions of dollars in mortgage defaults. 

Stages of a Financial Bubble

The term “bubble,” in an economic context, generally refers to a situation where the price for something—an individual stock, a financial asset, or even an entire sector, market, or asset class—exceeds its fundamental value by a large margin. Because speculative demand, rather than intrinsic worth, fuels the inflated prices, the bubble eventually but inevitably pops, and massive sell-offs cause prices to decline, often quite dramatically. In most cases, in fact, a speculative bubble is followed by a spectacular crash in the securities in question.

The damage caused by the bursting of a bubble depends on the economic sector(s) involved, and also whether the extent of participation is widespread or localized. For example, the bursting of the equity and real estate bubbles in Japan in 1989–1992 led to a prolonged period of stagnation for the Japanese economy—so long that the 1990s are referred to as the Lost Decade. In the U.S., the burst of the dotcom bubble in 2000 and the residential real estate bubble in 2008 led to severe recessions.

Theoretically, there are an endless amount of asset bubbles; after all, a speculative frenzy can occur over anything, from home prices to tulip bulbs (to name a few real-world examples) to cryptocurrencies like Bitcoin and Dogecoin. However, asset bubbles can be broadly divided into four categories:

• Stock market bubbles involve equities—shares of stocks that rise rapidly in price, often out of proportion to their companies’ fundamental value (their earnings, assets, etc.). These bubbles can include the overall stock market, exchange-traded funds (ETFs), or equities in a particular field or market sector—like Internet-based businesses, which fueled the dotcom bubble of the late 1990s.
• Asset Market bubbles involve other industries or sections of the economy, outside of the equities market. Real estate is a classic example. Run-ups in currencies, either traditional ones like the US dollar or euro or cryptocurrencies like Bitcoin or Litecoin, could also fall into this bubble category.
• Credit bubbles involve a sudden surge in consumer or business loans, debt instruments, and other forms of credit. Specific examples of assets include corporate bonds or government bonds (like US Treasuries), student loans, or mortgages.
• Commodity bubbles involve an increase in the price of traded commodities, “hard”—that is, tangible—materials and resources, such as gold, oil, industrial metals, or agricultural crops.

Stock market and market bubbles, in particular, can lead to a more general economic bubble, in which a regional or national economy overall inflates at a dangerously fast clip. Many historians feel the U.S. was overheating in this way in the 1920s, aka “The Roaring Twenties”—leading to the meltdown of the Crash of 1929 and the subsequent Great Depression.

5 Stages of a Bubble

Economist Hyman P. Minsky was one of the first to explain the development of financial instability and the relationship it has with the economy. In his pioneering book Stabilizing an Unstable Economy (1986), he identified five stages in a typical credit cycle, one of several recurrent economic cycles.

These stages also outline the basic pattern of a bubble.

• 1. Displacement

A displacement occurs when investors get enamored by a new paradigm, such as an innovative new technology or interest rates that are historically low. A classic example of displacement is the decline in the federal funds rate from 6.5% in July 2000, to 1.2% in June 2003. Over this three-year period, the interest rate on 30-year fixed-rate mortgages fell by 2.5 percentage points to a then-historic low of 5.23%, sowing the seeds for the subsequent housing bubble.

• 2. Boom

Prices rise slowly at first, following a displacement, but then gain momentum as more and more participants enter the market, setting the stage for the boom phase. During this phase, the asset in question attracts widespread media coverage. Fear of missing out on what could be a once-in-a-lifetime opportunity spurs more speculation, drawing an increasing number of investors and traders into the fold.

• 3. Euphoria

During this phase, caution is thrown to the wind, as asset prices skyrocket. Valuations reach extreme levels during this phase as new valuation measures and metrics are touted to justify the relentless rise, and the “greater fool” theory—the idea that no matter how prices go, there will always be a market of buyers willing to pay more—plays out everywhere.

For example, at the peak of the Japanese real estate bubble in 1989, prime office space in Tokyo sold for as much as $139,000 per square foot. Similarly, at the height of the Internet bubble in March 2000, the combined value of all technology stocks on the Nasdaq was higher than the GDP of most nations.

• 4. Profit-Taking

In this phase, the smart money—heeding the warning signs that the bubble is about at its bursting point—starts selling positions and taking profits. But estimating the exact time when a bubble is due to collapse can be a difficult exercise because, as economist John Maynard Keynes put it, “the markets can stay irrational longer than you can stay solvent.”

In Aug. 2007, for example, French bank BNP Paribas halted withdrawals from three investment funds with substantial exposure to U.S. subprime mortgages because it could not value its holdings. While this development initially rattled financial markets, it was brushed aside over the next couple of months, as global equity markets reached new highs. In retrospect, Paribas had the right idea, and this relatively minor event was indeed a warning sign of the turbulent times to come.

• 5. Panic

It only takes a relatively minor event to prick a bubble, but once it is pricked, the bubble cannot inflate again. In the panic stage, asset prices reverse course and descend as rapidly as they had ascended. Investors and speculators, faced with margin calls and plunging values of their holdings, now want to liquidate at any price. As supply overwhelms demand, asset prices slide sharply.

One of the most vivid examples of global panic in financial markets occurred in Oct. 2008, weeks after Lehman Brothers declared bankruptcy and Fannie Mae, Freddie Mac, and AIG almost collapsed. The S&P 500 plunged almost 17% that month, its ninth-worst monthly performance.