by Sithambaranathan Prithiviraj

Created on: September 05, 2008

In market economy the economy move up and down. It is called a business cycle. In history the asset bubble happened in 1960, 1970 and recently the tech-stock asset bubble. In simplistic terms asset bubble is where the asset is over valued because of mis -perception of investors and the different investment avenues and returns. In effect, it is caused by the credit cycle by the financial system and animal spirit of investors. Asset bubbles create a sudden clymate of panic and causes people to react with an animal spirit and it may increase the pain if the asset bubble burst because of unpredictable economic shock.

In downturn the banks only lend to credit worthy businesses and individuals. When the economy move up words the due to competition and excessive profit motive these banks and other financial institution give credit to customers and companies who are not credit worthy like the other companies. This occurs because the investors over value the investment and the prices tend to rise and even the banks give credit to customers who cannot afford or not credit worthy.

Then a shock occurs in the market and deflationary process come it to effect. In this perid the prices tend to fall sharply and people loose money and the asset price plunges ina short period of time. The animal spirit of investors also causes this to some extent. That means the asset bubble burst sometimes and people suffer financially and economy also some times goes in to recession depending on the degree of the impact of the shock and the investors reaction.

Asset bubbles are unpredictable and can happen any time. However prudent financial regulations and sound financial system may reduce the frequency of asset bubble happening and asset bubble bursting and if it burst it can cope well and to some extent avoid deeper recessions and depressions. However, in a market economy no body can assure asset bubbles will never occur again because humans can act irrationally some times and some investors are speculative by nature. Asset bubble has also devastating effect on the confidence of customers to recover and it is also a social cost in the short-term for the government as they have to provide social security to a large number of people suddenly. It is better to have sound banking practice and reduce the possibility of asset bubbles happening and educating the investment bubbles to act rationally in most situations.

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