Bubbles are brief economic periods in which asset prices rise. In this case, everyone experiences the euphoria of wealth and follows the same road as everyone else. A housing bubble, for example, can form, as happened during the financial crisis. The financial sector made owning a home appear so appealing that they gave thousands of loans to people who could not afford the loan.Due to the high demand that was projected towards the property, the prices skyrocketed leading to a higher demand thus reflecting the bubbles. A bubble can also be in the form of an invention in the economic world. For instance, people may discover a particular chicken breed and hence find the incentive of breeding it for some cash. In this case, anyone across the globe follows suit and buys the same kind. In the end, the prices of the chicken go up, and more people buy since they view it as a lucrative venture. Eventually, everyone owns the chicken, and the price of the chicken goes down meaning people are at a loss.
Why they occur
In most cases, the bubble occurs because people are always willing to follow others. The nation is crammed with a herd mentality that limits people’s rational thinking. People only want to follow what the rest are doing without focusing on the consequences at the end. In an economic view, whatever the public sees to be good is certainly good, and what is perceived as bad is hence bad. Therefore, if everyone is doing it, then it must be lucrative. On the other hand, if everyone else is running away from it, then it must be disastrous and hence should be avoided. Bubbles also occur because people are lazy and they do not want to work to get rich.
Why people ever learn
People never learn from the economic bubbles because they believe in a free and rational economy to make the right decision. The public is always ready to adopt a method that would make them effortlessly wealthy at the lowest effort possible. It is hence possible to see people buying a stock that they cannot afford using loans because they imagine that the company’s worth will go high and they shall eventually reap the benefits. Such people do not consider the economic uncertainty in the market but instead, focus on the profits that they would probably get. It is indeed possible that the investors would make so much money at the beginning, but that fades away with time because the market becomes crowded and the assets hence lose value. In this case, everyone desires to own the profit share and hopes that at the end, they will not possess the asset when its value goes down.
2. Why do bubbles always burst and cause financial crises? Pay particular attention to the role of leverage
Bubbles always burst and cause a financial crisis because people have failed to learn from their history. Most people follow others when it comes to investment decisions without making consideration for the consequences that would occur if the financial economy failed. Busts happen because the intrinsic value of assets has been exaggerated and everyone, therefore, seeks to own them. Most people are hence driven by their desire to get rich quickly as the rest and they look for leverage to acquire the assets. The banks are also willing to lend the funds to anyone without making the consideration of their financial standing. Economics professors also fail to divulge the information regarding the causes if the financial crises to the students. Economic graduates, therefore, end up as other lay people because they cannot articulate what happens. People are also greedy, and they seek for instant gratification. People’s rational mind is also limited whenever they are a prospect of getting rich schemes making everyone go after the gold. The government has also failed in its initiative to stop the economy from further financial crisis. For instance, it is common to realize that the federal government comes in to rescue the economy in a depression by tightening the economic and lending policies. In this instance, the government imposes stringent regulations that limit the banks’ lending ability. In the end, the economies regain its stability, and everyone becomes optimistic about the future. The government afterward chooses to relax the regulations and allow the free economy to be in operation. People hence acquire the money from the banks quickly, and they make the same mistakes done in the past.
3. Use your answers above to explain housing bubble and financial crisis of 2008
During the financial crisis, banks had no qualms issuing mortgages to people. The main idea was to make people homeowners and possibly make everyone seem to be financially independent. There was an upward surge in demand for the house mortgages since everyone viewed the mortgages as the prime things to do. With the increased demand, the price of mortgages shot high with some homes selling at a hundred grants, bans in effect asked people to present their pay slips and list of assets which they never even confirmed existed. In the end, most people applied for the bank mortgage while sending fake employment notification and property to the banks. The bank later realized that there was a low payout rate from the customers which sent them into a panic. It now became evident that the banks were lending to the wrong people, people that would not afford the loans, to begin with. The banks hence rushed to seek for funds from another bank which also froze their loans to other financial institutions thus leading to a financial crisis.
4. Why were the traditional economists unable to explain bubbles and their instigation of the financial crisis?
The traditional economists were unable to explain bubbles and the implication of the financial crisis because they never thought they would go through the same cycles. The professors went into a blame game and stated that the predecessors simply made the wrong decision that they simply could not make themselves. In this case, the economists failed to establish the effects of having a free economy with very little government interference. The economists also failed to evaluate the herd mentality among people and why people simply seek to follow what other people are doing without looking at the financial implications. When history is repeated with very few learned lessons, the country is bound to go through the same phase of a financial depression. Neoclassical economics can hence be linked to the bubbles. Neoclassical economists assume that every human being is rational and hence will make decisions that will give them maximum utility. However, in the real world, that may never be the case, and the government may hence need to come in and save the people from their mistakes and predicaments. The government should hence always participate in the market and make firm policies that would be followed by all.
5. What was Hyman Minsky’s explanation of the financial crisis?
According to Hyman Minsky, the financial crisis occurred because people were unwilling to learn from their history and the mistakes that were made by their forefathers. Minsky notes that a financial crisis occurs through three stages. The first stage is called the saving stage. At this juncture, people are optimistic about saving and even repaying their bank loans with the interests that they acquire others may choose to use the benefits they get to make some investments in the economy. In this case, people do not withdraw their money from the banks because they believe that it has the potential to bring them profits. Other people choose to save their funds in the insurance market instead. For instance, an investor can decide to save in the market and wait to receive the interests over time. The second stage is the speculation stage. During this stage, everyone is interested in getting a share of the growing economy. Therefore people who have made it in various businesses become a positive reflection of what would occur, and hence everyone follows suit. It is hence at this stage where everyone borrows from the banks to finance their investments thus causing a bubble due to the high demand. A bubble is a situation where the prices of assets are exceptionally high, and people are even encouraged to buy more since they can always sell it to someone else at a higher price. Every investor at this stage hopes that he does not end up with the asset at the end and hence actively trades it. The third and the final stage is the crisis stage. It now becomes apparent at this juncture that the high prices failed to represent the intrinsic value of the assets. The prices of the properties hence go down, and people start suffering losses. A share that would, for instance, go for a hundred grand is bow sold for ten grand. People still have to pay back their loans, and it becomes a crisis because they do not have the funds.
