Cause Of Bubble Essay

Causes of Financial Bubbles
People usually know what bubbles are, if they have ever blown a gum, taken a bubble bath or popped a blister. Financial bubbles work in much the same way. They are defined as a period of surge in the market caused by speculation regarding a commodity which results in vastly overinflated prices. However, these prices are not sustainable and the bubble is usually followed by a crash in prices in the affected sector. A prime example is the recent housing bubble which led to the financial crisis of 2008; however, we have limited knowledge of how bubbles arise and how they can be prevented. A bubble burst can have a devastating effect on the economy by plunging it into a recession. Some of the iconic historical bubbles are Tulip mania, dot-com bubble and housing bubble (2006). The three main causes of a bubble are government policies, greater fool theory and technological innovation.
One of the main causes of a bubble is government policy, specifically

This theory portrays bubbles as driven by the behavior of optimistic market participants (the fools) who buy overvalued assets in anticipation of selling it to other speculators (the greater fools) at a much higher price. The 19th century economist, Keynes, coined the term “animal spirits” for it-- “a spontaneous urge to action rather than inaction” (Keynes, 1936, p. 161) . Therefore, the bubble grows as long as fools can find greater fools to buy the overvalued assets. This psychological factor has been the cause of many bubbles in the past. For instance, during the “Tulip Mania” in the 17th century, prices of Tulip flowers reached unimaginable levels being priced at more than 3000 guilders, an amount that was equal to the annual income of a wealthy merchant (Dash, 2000). Moreover, the bubble will end when the greatest fool pays the highest price for the overvalued asset and can no longer sell it at an even higher