Why do bubbles happen?

Date posted: January 27, 2011

The recession began with the so-called bursting of the investment bubble in residential housing. But what exactly is an investment bubble? And what causes it? N.C. State University economist Mike Walden answers.

“Well, your first question, the answer to that is that an investment bubble occurs … when the price of some asset rises to levels that in many cases in hindsight we can say were not supported by the fundamentals of that asset. A good example, obviously, is the housing market that we saw in the 2000s. Housing prices rose to levels we had never seen before — double digit appreciation rates three times, four times the average. And those were just not being supported; the fundamentals were not supporting those price levels when you looked at people’s incomes and rent.

“Now your second question is what causes this, and you might extend that and say, ‘Well, why don’t people see these bubbles?’ Well, I think this is where psychology has a big impact. People, for example, looking at the housing market of the 2000s — many people said, ‘Well, gosh, this can’t last. These housing prices can’t keep going up like they are, but I’m going to take advantage of it while I can. I am going to get in and make money before it falls.’ And I think that became the attitude of many people, and that just perpetuated and prolonged the bubble. And then it usually takes something external to burst that bubble. And in this case it was the Federal Reserve actually increasing interest rates, which made buying a house less affordable. It also hurt those people who had adjustable rate mortgages. And then, of course, we had the collapse of the housing market, which led I think to the great recession.”

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