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Economic Bubble Archives -

07 May

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What is an Economic Bubble

May 7, 2014 | By |

 

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 challengin