What’s a “Bubble”?

The Federal Reserve’s Most Important Product
[courtesy Google Images]

For example, if the housing market goes into a “bubble,” most homes in that market will be selling for prices that seem unreasonably high.   If tech stocks go into a “bubble,” virtually all of the individual stocks in that particular market will be selling for unreasonably high prices.

Bubbles can occur in a particular nation’s bond, stock, housing, and commodity markets.  All bubbles share a single common denominator:  they’re significantly over-priced.

But when we say “over-priced,” we necessarily mean “over-priced” in relation to something else.  What’s that “something else”?  It’s the free market.  Bubbles are over-priced in relation to the prices that would normally exist in the free market.

For example, suppose the real estate market is in a “bubble”.  Prices for homes could be ridiculously high.  A house that should sell for $250,000 on the free market, is nevertheless selling for $1 million.  That’s a bubble.  Motivated by greed, people nevertheless buy that home for $1 million believing that the bubble will continue to expand and  the price of the $1 million home will soon go even higher to, $1.5 or even $2 million.

The important point to grasp is that when stock, bond, commodity and home markets become “bubbles” they’re over-priced in relation to a true, free market.

Any free market is capable of over-reacting so as to produce excessively high or low prices.  But generally speaking, when a particular free market produces irrationally high or low prices, the more astute members of that market will sense the irrational price and reverse course so as to produce a good profit.  Free markets tend to correct their excesses in a more-or-less timely manner.

But a true “bubble” will persist long after the free market might’ve cause a price correction.

Why?

Because a true “bubble” isn’t caused by mere forces of supply and demand in a free market.  A “bubble” is caused by influences from outside of the free market.  These outside forces cause a market to be artificially stimulated, manipulated and controlled in way that defy and overcome the true forces supply or demand.

What’s the source of outside forces?

It might be a very wealthy corporation.  It might be conspiracy of individuals bent on cornering a market.  But in this day and age, when you see a “bubble,” you see the result of legislation, policies and/or regulations that’ve been imposed by government and/or the central bank.

Bubbles exist in the un-free, manipulated markets.  Manipulated by whom?  Government and central banks like the Federal Reserve.

How long will “bubbles” last and continue to grow?  Until the government and/or Federal Reserve change policy or run out of sufficient fiat currency to continue to inflate the “bubble”.

(What’s the Federal Reserve’s favorite song?  “I’m Forever Blowing Bubbles.”)