Most of us have witnessed and suffered from the consequences of economic bubbles in our lives. The most notable recent example is the housing market bubble of 2007, which ultimately led to the Great Recession of 2008 and 2009. In hindsight, there were plenty of economic signals that should have warned us what was happening – but most mainstream economists didn’t see it coming.
Are economic bubbles functionally impossible to predict? And if not, how can we predict the next one?
The Basics of Economic Bubbles
Let’s start with a high-level explanation of what economic bubbles are.
An economic bubble is a set of conditions where the price of a given type of asset increases irrationally and quickly. For example, if there’s a bubble in the housing market, the prices of houses might skyrocket in the span of a few years, and if there’s a bubble in the stock market, the prices of stocks in a given sector might explode seemingly overnight.
This price increase isn’t due to a realistic motivating factor; for example, there’s no sudden increase in company revenues leading to stock increases. Instead, the growth in a bubble is largely due to consumer excitement; people develop an inflated sense of what an asset is worth or get caught up in public hype, ultimately driving prices higher.
The rising prices tend to accelerate, since more excited consumers jump in to benefit from the continued growth. But eventually, the bubble hits a peak. At its zenith, the bubble “pops,” with a sudden decrease in prices.
Why It’s Hard to Predict Bubbles
In theory, bubbles shouldn’t be hard to predict or spot forming. We just need to look for an unusual rising action in the prices of a given asset, right?
Unfortunately, it’s more common than that.
- Hindsight bias and ambiguity. Hindsight bias and ambiguity make it extremely hard to tell when you’re seeing a bubble and when you’re simply seeing a rational price increase. If housing prices increase by 20 percent in the span of a year, is it because the area has exploded in popularity? Or is it the beginning of a bubble? In a few years, prices will likely increase further or sharply decrease; in light of the new information, it’s easy to tell whether it was a bubble or not. But in the moment, it’s nearly impossible.
- Timing the peak. Let’s say there is a bubble forming. It’s never entirely clear where a bubble will begin or end. Some bubbles begin with totally rational price increases. Some continue growing even when they’ve reached absurd heights. Even if you can spot a bubble, there’s almost no way to time it correctly.
- The investor paradox. Investors are the driving force responsible for increasing prices. With a rental property and a property management company to help you, you can make a lot of money in the real estate market. If prices in an area are going up, it makes sense to capitalize on that momentum and make even more money. But your investing action plays a role in increasing prices further since you’re increasing market demand. This results in a complex relationship between investor attitudes and prices – and one that’s very hard to model or predict.
The Defining Features of Bubbles
Of course, there are some key defining features of bubbles that can help you spot them as they’re forming:
- Consumer greed. Are consumers acting in a greedy way? For example, are they investing because they think it’s a reliable long-term play or because they want to get rich quick? The “get rich” greedy mentality was a large part of bubbles like the 2017-2018 cryptocurrency bubble.
- Cultural optimism. How optimistic do people seem to be? If opinions are overwhelmingly or blindingly positive, you should be concerned. Attitude like “this asset will keep going up forever” are a bad sign.
- Rising prices. There’s nothing inherently wrong with rising prices. It’s often the hallmark of a solid investment. But rapidly or unusually escalating prices can be a warning sign.
- New attention. Are your non-investor friends suddenly talking about investing in a specific asset? It could be a sign that the hype has exceeded the practical reasons for investing.
- Limited factors for long-term sustainability. With little to no foundation for long-term growth, rising prices could be a problem.
Is It Impossible?
So is it truly impossible to predict an economic bubble? In some ways, yes. It’s definitely possible to scrutinize rapidly rising prices – and it’s very easy to observe questionable economic conditions. But can you ever be certain where the “peak” of the bubble will be? Or when the bubble will collapse? Economic effects are incredibly complex, and even with perfect information, you wouldn’t be able to call the next bubble with any degree of reasonable certainty.