Definition of bubble

When the prices of securities or other assets rise so sharply and at such a sustained rate that they exceed valuations justified by fundamentals, making a sudden collapse likely (at which point the bubble "bursts").

For example, the housing market value booms, in Spain and Ireland, prior to the 2007/8 financial crisis, were fuelled by low borrowing costs. Their bursting strained banking systems.

In theory, at least, it should be relatively straightforward to detect the formation of a bubble in any asset. However, outcomes of bubbles can sometimes be unpredictable, as Andrew Odlyzko of the University of Minnesota points out in his paper on the Victorian British railway manias in the 1800s.

In the 1830s a massive expansion of the railways took place and railway shares soared. However, good times did not last and shares collapsed during a general financial crisis in 1837. But although costs of expanding the network turned out to be much higher than imagined, demand had also been underestimated. By 1844 shareholders who had held their stock were looking at annualised gains of nearly 10 per cent and investors who bought at the trough quadrupled their money.

The success of the first railway mania led to a new railway mania. 4,500 miles of new lines were sanctioned by parliament and forecasters estimated that passenger traffic would be four times that which had previously travelled in horse-drawn vehicles – an estimate that was uncritically accepted by shareholders. In fact, forecast passenger numbers turned out to be over optimistic and railway stocks shed two thirds of their value and shareholders, including the Brontë sisters and Charles Darwin suffered painfully.

Although both bubbles burst, the favourable outcome for investors who didn't sell after the first one shows that not all bubbles are bad for investors.


bubble in the news

In January 2014, regulators were concerned that unsuspecting private individuals might be sucked into a bubble in Bitcoin which would be particularly damaging when it burst because there were no assets underpinning its price. Economist Gavyn Davies, writing for the FT drew attention to a theory put forward by Milton Friedman decades earlier, who established that should private currency creation be permitted then competing providers would emerge until the price of the currency was reduced to the marginal cost of its creation. (In Bitcoin's case this would be close to nil)