The term economic bubble is conversationally bandied about by economic authorities in spite of the fact that mainstream audiences might not be aware of what a bubble actually is. In the starkest terms possible, an economic bubble is an economic event that occurs when asset prices outpace what incomes can sustain.

Examples and Essential Ingredients for Bubbles

The subprime mortgage crisis and meltdown of the U.S. real estate market in 2008 illustrated what can happen when asset prices – e.g., the cost of homes – outpace incomes. In very recent history, home values in Orange County, California rose to more than nine times the median income of Orange County residents.

According to Ph.D. economist and author of The Crash Course, Chris Martenson, when asset prices rise to three times income, a bubble can easily be declared. When asset prices rise above four times yearly income, long-term instability and credit difficulties are sure to follow the dissolution of the bubble.

Rise and Possible Normalcy of Economic Instability

The subprime mortgage lending underwritten by Fannie Mae and Freddie Mac did not even meet each company’s own guidelines for prime mortgages. These same kind of lending antics were present around the United States immediately before the 2008 crash as lenders looked to capitalize on high-risk, high-interest prime mortgages.

The writing is truly on the wall when a reported 23% of US homeowners held mortgages worth more than the home value, according to data from 2010. The tendency for potential homeowners to be seduced by short-term market gains and easy initial loan terms has not ebbed.

That said, economic bubbles should be viewed through the lens of a sociocultural phenomena rather than a mischievous plot orchestrated by national banks, governments or the US Federal Reserve. Consumers are the ones taking out unsustainable loans with high interest in order to get the next hot gadget or seaside villa.

Fundamentally, economic bubbles refer back to individual consumers; even the definition of a bubble rests upon the difference between asset prices and the incomes of individuals.

Differentiating a Bubble from Market Exuberance

Sometimes differentiating a bubble from mania or market hype can be challenging. A speculative bubble can be spotted when the price of assets stimulates enthusiasm from investors; the enthusiasm spreads like wildfire and eventually the price of certain assets seems justified.

In some cases the hype alone spurs investment from other investors out of a sense of envy, gambler’s frenzy and one-ups-manship. At some point in the bubble’s trajectory, and as a rule bubbles based on larger credit have a more harrowing comedown, the fever around the bubble can make an investor’s decision almost seem rational. Yet, bubbles are inherently irrational.

As bubbles are sociocultural in essence, economic bubbles can also prove difficult to control or even effectively manipulate. Actually, the public unrest over the possibility of a bubble may itself fuel the bubble.

Regulatory controls could predict or curtail a bubble’s devastating effects on the economy if caught early enough. Part of the problem with bubbles is how the public conceptualizes them. A bubble is not necessarily one expansion and one deflation cycle.

A bubble can ebb and flow for a decade or more, as evidenced by the recent subprime mortgage crisis whose effects partly spurred a double-dip recession. In fact, a bubble often winds down mysteriously yet with noticeable economic ripples.

Economic bubbles are often harbingers of larger problems, such as predatory lending and unstable markets. Spotting the tell-tale signs of an economic bubble, especially the outpacing of asset prices in relation to incomes, can save consumers a lot of remorse down the road.