The Bubble And Bust Cycle

In macroeconomics, one of the dominant forces is what’s referred to as the “Bubble and Bust” cycle, also called “boom and bust.” The idea is that demand, and thus value, for certain goods or services will rise until the market cannot bear the price and then the value of that commodity crashes, which can leave devastation in its wake.

Most recent recession due to a bubble and bust cycle

The bubble and bust cycle is exactly what George Santayana had in mind when he posited that those who don’t study history are “doomed to repeat it.” Each follows a similar pattern, though the minutiae will vary.

A commodity, be it a good or service, rises in price, which investors and consumers flock to. Eventually, a fatal flaw is exposed in the system of business that props up the market for the commodity. A “pin” of some sort pricks the bubble. Prices then drop.

The most recent recession was a prime example, the commodity being housing and housing debt. Financial institutions developed complicated methods of re-selling mortgages as dividend-paying assets, as well as being less-than-scrupulous with lending, to get more people to buy houses which they wanted more of. It also didn’t help that Federal Reserve policies favored the banks with very easy terms on lending capital.

Eventually, some people stopped paying those mortgages, which the whole scheme depended on to work. Since consumers, investors and banks had all borrowed too much money or exposed themselves to too much risk, it practically paralyzed the global financial system when the margin call came.

Bubbles are nothing new

The bubble and bust cycle has been a repeating theme for centuries. There are occasionally periods with only moderate recessive cycles, but the bubble-then-burst dynamic keeps occurring.

A classic example is the Dutch Tulip Craze, also called Tulip Mania, from the early 1600s. The background is that tulips aren’t native to Europe. Additionally, tulips grow very slowly; it takes years to produce a quality bulb. As the flower was introduced to Europeans, it was naturally prized for it’s beauty and became valuable due their scarcity. The Dutch grew the bulk of European tulips, so the harvests and crops were naturally of great interest for the commodity.

Speculators entered the market and began trading on tulip futures, much as is done today with other commodities. Trading drove the market value further and further beyond the intrinsic value and prices rose until single tulip bulbs commanded ridiculous prices. Investors stopped buying and everyone who had invested in them lost a fortune.

Granted, the above narrative is an extremely curt gloss; there was much more to the Dutch tulip craze and to other bubbles, but that’s the gist of it. Other examples include the South Sea bubble of the early 1700s in England, the stock market craze of the late 1920s and the subsequent Great Depression, the real estate crash in 2007/2008, and so on and so forth.

The point is that it keeps happening.

Intrinsic versus perceived

The bubble and bust cycle is a vast topic; a truly comprehensive overview would be lengthy to say the least, especially if reviewing all the different proposed causes and mechanisms by which bubbles and busts occur.

Any commodity has an inherent price, relative to a number of things, but still an amount of currency that a unit of it is worth. A diamond, for instance, is rarer and thus more valuable than a pound of fertilizer. (Which seems stupid when you think about it; fertilizer grows food.)

Some person or group finds a way to make an item more valuable than its intrinsic worth suggests. Other people buy into the idea, because they want to make money from selling the commodity – be it a physical object, a stock share or a future (or a unit of a commodity that will be produced in the future) – for more money than it commands at present. The price continues to go up as the increased revenue from the activity creates a positive feedback loop and there are few methods of positive feedback that work as well as cash.

There are a lot of people disposed to the opinion that a second tech bubble is happening now. The glut of “journalism” extolling valuations and IPOs would certainly lend credence to that idea; continually rising prices and commodity values are a hallmark of bubbles.

The next disastrous bubble is merely a question of “when.”