In economic terms, a bubble is high volume levels of trade at prices that are significantly out of line with actual intrinsic values. A simpler definition is the trading of assets that have over inflated values. Bubbles are also called market bubbles, speculative bubbles, balloons, financial bubbles, and speculation mania. Prices within bubbles can vary wildly. At times, they are no longer predictable using the traditional market determining forces of only supply and demand.
There are countless explanations offered for the reasons that bubbles occur even when there is no speculation, uncertainty, or limited rationality in the market. Some have theorized that bubbles could be caused in the end by prices coordinating against each other and by changing social scenarios. Bubbles are generally identified with certainty after they have burst, in the light of drastic drops in prices. This results from the difficulty of ascertaining real intrinsic values in actual trading markets. Bubbles burst, sometimes violently, in what is known as a crash or a bursting bubble.
Mainstream economics holds that you can not predict or call bubbles before they happen or while they are forming. It argues that you can not stop bubbles from developing, and that attempting to gently prick the bubbles leads to financial crises. This school of economic thought favors authorities waiting vigilantly for bubbles to burst by themselves, so that they can handle the aftermath of the bursting bubble with fiscal and monetary policy tools.
The Austrian school of economics argues that such economic bubbles are most always negative in their impacts on economies. This is because bubbles lead to misappropriation of economic resources to inefficient and wasteful uses. The Austrian business cycle theory is based on this argument concerning bubbles.
Examples of economic bubbles abound within the U.S. economy. In the 1970’s, as the United States departed from the gold standard, American monetary expansion led to enormous bubbles in commodities. Such bubbles finally ended after the Federal Reserve tightened up massively on the excess money supply by increasing the interest rates to in excess of 14%. This led to the bursting of the commodities bubble that caused gold and oil to fall down to more historically normal levels.
Another example of price bubbles proved to be the rising housing and stock market bubbles created by the extended period of low interest rates that the Federal Reserve enacted from 2001 to 2004. These bubbles burst once the interest rates returned to more normal levels.
An enormous amount of dislocation occurred in the following years as this bubble burst rippled over to the financial system and the entire economy in 2007 and 2008. The Great Recession and financial collapse were created in the wake of this bursting bubble. This example demonstrates how the larger bubbles grow before they finally pop, the more dangerous and damaging they become when they finally do burst.