Financial Crisis, Panics, and Macroeconomic Policies

Asset Bubbles

Definition

  • Asset bubble: when the price of an asset goes irrationally high relative to other assets.
  • The underlying value of the asset is much smaller than its market price due to supply and demand.
  • Collapse of the bubble can be dangerous for the global economy.

Graphical Representation

  • Initially follows typical supply and demand curves.
  • Demand curve: As price goes up, quantity demanded goes down (and vice versa).
  • During a bubble, this principle is violated: as the price goes up, quantity demanded also goes up.
  • Higher prices lead to more demand, defying normal economic principles.

Causes of Asset Bubbles

1. Herding
  • Human behavior: following each other, like animals.
  • Driven by greed and fear: when people get greedy, they all rush in one direction; when scared, they run the other way.
  • This behavior can create a self-fulfilling reality.
  • Example: During COVID-19, people hoarded goods, creating shortages due to fear, not actual increased need.
2. Extrapolative Expectations
  • People look at past trends and expect them to continue.
  • If prices have been rising, they assume prices will keep rising.
  • ExtrapolationExtrapolation: extending the curve into the future and assuming it will continue the same way.
3. Leverage
  • Borrowing money to invest, which fuels the bubble.
  • The more you borrow, the more you are leveraging your money.
  • More leverage allows more people to afford the asset, increasing demand and pushing prices higher.
  • However, it also increases debt levels, which can be dangerous when the bubble bursts.
  • Leverage examples based on down payment percentage:
    • 100% Down Payment: Zero loan, no leverage.
    • 80% Down Payment: 20% loan, low leverage.
    • 10% Down Payment: 90% loan, high leverage (every $1 you put down borrows $9).
    • 0.5% Down Payment: 99.5% loan, extremely high leverage (every $0.50 you put down borrows $99.50).

Hypothetical Example: Flower Price

  • Initial Price: $1.

  • Price increase over time:

    • Time 1: $1
    • Time 2: $10
    • Time 3: $100
    • Time 4: $1,000
    • Time 5: $10,000
    • Time 6: $100,000

  • People see the trend and want to buy in to make money.

  • Trader Mentality: focus on the trend, not the underlying value.

  • People borrow money to participate, attracting more people and institutions.

The Cliff

  • At some point, the trend stops, and prices start to fall.
  • People panic and try to sell, but there are no buyers.
  • Prices plummet, and everyone loses money.

Damage Caused by Bubbles

  • Tulip Mania (Netherlands, 1636-1637): Tulip bulb prices soared and then crashed.
  • South Sea Bubble (UK, 1720): Stock prices of the South Sea Company crashed.
  • Stock Market Crash of 1929 (USA): Led to the Great Depression.
  • Housing Market Crash of 2008 (USA): Financial crisis and Great Recession.

Case Study: 2008 Financial Crisis

  • Asset bubble: housing market.
  • Leads to job losses, home foreclosures, and loss of savings.
  • Global impact due to interconnected economies.
Examples of Affected Companies
  • AIG (American International Group):
    • Stock price dropped from $1,676 to $20.
    • Required a government bailout.
  • Bank of America (BAC):
    • Stock price dropped from $53 to $3.
    • Required government intervention.
  • GM (General Motors):
    • Went bankrupt and was bailed out by the government.

Government Intervention

  • Governments and central banks intervene to prevent complete collapse.
  • US government bailed out AIG and GM.
  • Expansionary Fiscal Policies: increasing government expenditure and cutting taxes.
  • Expansionary Monetary Policies: reducing interest rates, increasing money supply, and buying assets.