Currency bubbles which affect fundamentals

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Purchase Subscription prices and ordering for this journal Short-term Access To purchase short term access, please sign in to your Oxford Academic account above. This article is also available for rental through DeepDyve. View Metrics. Email alerts Article activity alert. Advance article alerts. Sometimes a real economic shock, such as a spike in oil prices, helps trigger a cut back in monetary injections. When the flow of new money stops, or even slows substantially, this can cause the asset bubble to burst.

This sends prices falling precipitously and wreaks havoc for latecomers to the game, most of whom lose a large percentage of their investments. The bursting of the bubble is also the final realization of the Cantillon Effect, as not just a change in relative prices on paper during the rise of the bubble, but a large scale transfer of real wealth and income from the late comers to the early recipients of the newly created money who started the bubble.

This redistribution of wealth and income from late investors to the early recipients of newly created money and credit who got in on the ground floor is what makes the formation and collapse of asset price bubbles very much like a pyramid or Ponzi scheme.

When this process is driven by money in its modern form of a fiat currency mostly made of fractional reserve credit created by the central bank and the banking system, then the bursting of the bubble not only induces losses to the then current holders of the bubble assets, but it can also lead to a process of debt deflation that spread beyond those exposed directly to the bubble assets but to all other debtors as well. This means that any sufficiently large bubble can crash the entire economy into recession under the right monetary conditions.

The biggest asset bubbles in recent history have been followed by deep recessions. The reverse is equally true: the largest and most high-profile economic crises in the U.

While the correlation between asset bubbles and recessions is irrefutable, economists debate the strength of the cause-and-effect relationship. Some economists even dispute the existence of bubbles at all, and argue that large real economic shocks randomly knock the economy into recession from time to time, independent of financial factors, that price bubbles and crashes are simply the optimal market response to changing real fundamentals.

Broader agreement exists, however, that the bursting of an asset bubble has played at least some role in each of the following economic recessions. The s began with a deep but short recession that gave way to a prolonged period of economic expansion. Lavish wealth, the kind depicted in F. The bubble started when the Fed eased credit requirements and lowered interest rates in the second half of through , hoping to spur borrowing, increase the money supply, and stimulate the economy.

It worked, but too well. Consumers and businesses began taking on more debt than ever. Steady expansion of the supply of money and credit through the 's fueled a massive bubble in stock prices. Widespread adoption of the telephone and the shift from a majority rural to a majority urban population increased the appeal of more sophisticated savings and investment strategies like stock ownership compared traditionally popular savings accounts and life insurance policies.

The excess of the s was fun while it lasted but far from sustainable. By , cracks began to appear in the facade. The problem was debt had fueled too much of the decade's extravagance. The investors, the general public, and the banks eventually became skeptical that the continuous extension of new credit could go on forever, and began to cut back to protect themselves from the eventual speculative losses.

Savvy investors, the ones tuned in to the idea the good times were about to end, began profit-taking. They locked in their gains, anticipating a coming market decline. Before too long, a massive sell-off took hold. People and businesses began withdrawing their money at such a rate that the banks didn't have the available capital to meet the requests.

Debt deflation set in despite Fed attempts to reinflate. The rapidly worsening situation culminated with the crash of , which witnessed the insolvency of several large banks due to bank runs.

The crash touched off The Great Depression , still known as the worst economic crisis in modern American history. While the official years of the Depression were from to , the economy did not regain footing on a long-term basis until World War II ended in In the year , the words Internet, Web and online did not even exist in the common lexicon.

By , they dominated the economy. The Nasdaq index, which tracks mostly tech-based stocks, hovered below at the beginning of the s.

By the turn of the century, it had soared past 5, In , the Fed began easing monetary policy in order to support the government bailout of the holders of Mexican bonds in response to the Mexican debt crisis. The new liquid credit that the Fed added to the economy began to flow into the emerging tech sector.

As the Fed dropped interest rates starting in , the Nasdaq began to really take off, Netscape launched its IPO, and the dot-com bubble began. The hype of new technologies can attract the flow of new money investment that leads to a bubble. The Internet changed the way the world lives and does business.

Many robust companies launched during the dot-com bubble , such as Google, Yahoo, and Amazon. Dwarfing the number of these companies, however, was the number of fly-by-night companies with no long-term vision, no innovation and often no product at all. Because investors were swept up in dot-com mania, these companies still attracted millions of investment dollars, many even managing to go public without ever releasing a product to the market.

As wage and consumer price pressures mounted amid a flood of liquidity meant to combat the underwhelming effects of the Y2K bug , the Fed began cutting back money supply growth and raising interest rates in early This pulled the run out from under the Fed fueled mania of the tech boom. A Nasdaq sell-off in March marked the end of the dot-com bubble. The recession that followed was relatively shallow for the broader economy but devastating for the tech industry.

The Bay Area in California, home to tech-heavy Silicon Valley, saw unemployment rates reach their highest levels in decades. Many factors coalesced to produce the s real estate bubble. The biggest were monetary expansion leading to low interest rates and significantly relaxed lending standards. The Fed dropped its target interest rate to successive historic lows from to mid and the M2 money supply grew an average of 6.

Government policies that try to shape economic trends are almost bound to guide the growth of bubbles in the presence of the expansion of money and credit. As house fever spread like a drought-fueled conflagration, lenders, particularly those in the high-risk arena known as subprime, began competing with each other on who could relax standards the most and attract the riskiest buyers.

One loan product that best embodies the level of insanity reached by subprime lenders in the mids is the NINJA loan; no income, no job, or asset verification were required for approval. For much of the s, getting a mortgage was easier than getting approved to rent an apartment.

As a result, demand for real estate surged.