What is a bubble? | CNBC Explains - YouTube

It was called Tulip Mania.

As the story goes, the prices of tulips skyrocketed here in the Netherlands in the 1600s, and then crashed.

It’s seen as the first example of an economic bubble.

So what are bubbles, and what causes them to burst?

Throughout the years, there have been all sorts of economic bubbles.

Tulips, real estate, dotcom companies, maybe even bitcoin.

But they all have one thing in common.

Investors pay more for an asset than may actually be justified, resulting in surging, sky-high prices.

Let's use Tulip Mania as an example to understand the anatomy of a bubble.

Economists have laid out five stages of an economic bubble.

Stage one?

Displacement.

It's when investors start to get very excited about a new or innovative product or technology.

That's what happened in the Netherlands in the 1600s.

The country was experiencing a surge in wealth thanks to booming international trade.

Tulips were seen as luxury items. They were rare, and they take a long time to grow.

By the mid-1630s, the Dutch had gone wild for tulips.

More and more buyers drove up the prices of tulips fast.

By some accounts, the price for a single rare type of tulip bulb was equivalent to $50,000.

That brings us to the second stage of an economic bubble: a price boom.

In recent years, we’ve seen this happen with the dotcom bubble

when shares of the NASDAQ, which tracks tech stocks, spiked in the late 1990s.

Or more recently, when the price of bitcoin roughly tripled in just one month at the end of 2017.

Price booms come back to the simple rules of economics.

Let’s say there’s a limited supply of a product.

If everybody wants a piece of it, there’s a lot of demand. That causes prices to go up.

There was only one tulip crop per year. So there was limited supply and a lot of demand.

Because tulips can only be harvested during certain months of the year,

the Dutch starting buying tulip futures contracts.

They were putting a bet on the future price of a bulb that they didn’t have in hand yet.

Even though it was impossible for Dutch buyers to completely predict the future price of a tulip,

they were confident they’d be able to sell it for a higher price than what they paid.

This is the third stage of an economic bubble: euphoria.

It creates a trading frenzy as more and more buyers try to get in on the market.

But then some investors begin to realize that the actual value of a product, like a tulip,

isn’t in line with what they paid, and so they cash out.

This is called the profit-taking phase or stage four.

I mean, could a single tulip bulb really be worth $50,000?

Buyers started to lose trust that they were worth that much, and so they started to sell.

By 1637, the prices of tulips plummeted.

Which brings us to the final stage of a bubble: panic.

This is when everyone realizes how crazy it is

that they had paid as much for a tulip bulb as, say, a house in Amsterdam.

That’s when they decide it’s time to get out of the market.

Selling, selling and more selling ultimately causes a bubble to burst.

We saw panic during the dotcom bubble,

as the NASDAQ tumbled around 40% in the second half of 2000.

Bitcoin’s plunge in early 2018 suggested that bubble had burst,

as the value of the cryptocurrency was roughly cut in half in just one month.

One takeaway from Tulip Mania or other more recent bubbles

is that prices are influenced by how much buyers are willing to pay.

When a group of buyers gets excited about a product, like a tulip, they might not act rationally about its price.

This can make predicting and preventing bubbles tough.

Traders, economists and central bankers all can get pretty obsessed with identifying the next bubble.

After all, the burst of the housing bubble in 2008

contributed to the worst financial crisis since the Great Depression.

It’s important to know that not all bubbles do burst.

Sometimes price swings are just part of supply and demand,

and don’t have spill over effects to other parts of the economy.

Here in Amsterdam, Tulip Mania did have one lasting effect.

The flowers are still a staple in the city nearly 400 years after the bubble.

Hey everyone, Elizabeth here. Thanks so much for watching.

Where do you see bubbles in the market? Let us know in the comments section.

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