DEFINITION: An economic bubble occurs when the market price of some good increases rapidly in a way which, in hindsight, turns out to be unsustainable.
ETYMOLOGY: The word “bubble” derives from the Middle English word “bobel,” meaning “bubble.”
The word, which is first attested in the fourteenth century, is thought to derive by onomatopoeia from the sound made by water flowing over stones in a shallow stream bed.
USAGE: Famous examples of economic bubbles include the Dutch tulip mania of the 1660s, the French Mississippi Company bubble of 1720, and the British South Sea Company bubble of that same year.
Retrospectively, bubbles are obvious. Unfortunately, they are not so easy to discern beforehand.
The question is: What distinguishes an economic bubble from sustainable price increases due to the ordinary play of market forces of supply and demand?
It is sometimes said that bubbles are situations in which an asset’s market price “strongly exceed[s] the asset’s intrinsic value” (Wikipedia).
But this claim presupposes there is some way to determine an asset’s “intrinsic value” apart from its market value.
However, almost all reputable modern economists subscribe to the subjective theory of value, which teaches that this makes no sense.
If all prices are determined by the subjective preferences of consumers, then there is no such thing as “intrinsic value,” at least in the realm of economics.
One might think that the main difference between economic bubbles and normal asset price increases has to do with what psychologists call the “bandwagon effect,” that is, the tendency of people to want to “get on board” any promising or fashionable trend.
While there is no doubt that the bandwagon effect drives bubbles, the same might be said for many other successful new products which “take off” and become popular with the public. So, it is not clear how the bandwagon effect can be used to differentiate between bubbles and other breakout products.
One promising idea is to link bubbles to the velocity of the price increases. Another is to survey bubbles against the background of wide economic comment, much of which will typically be warning of a bubble forming.
However, none of these ideas is capable of really separating the wheat from the chaff when it comes to economic bubbles.
Probably the two best protections against becoming caught up by the bandwagon effect surrounding an economic bubble are having long experience with investing, in general, and informing oneself about the details of any investment one makes, in particular.