Today I read the book Manias, Panics and Crashes. And I think the following outline of a financial bubble is very insightful to understand the past and the future.
Rise of the Bubble
1. An outside shock to the macroeconomic system. A displacement is an outside event or shock that changes horizons, expectations, anticipated profit opportunities, behavior—‘some sudden advice many times unexpected’
2. The economic outlook and the anticipated profit opportunities would improve in at least one important sector of the economy.
3. Businesses and individuals would borrow to take advantage of the increase in anticipated profits in related investments.
4. The rate of economic growth would accelerate and in turn there might be a feedback to even greater optimism.
5. Economic growth leads to expansion of credit, which fuels the bubble and introduces instability.
6. Increase in effective demand presses against capacity, raising prices and profit. Positive feedback develops as the increase in investments leads to increases in the rate of growth of national income that induces additional investment.
7. Euphoria develops. Investors buy goods and securities to profit from the capital gains associated with the anticipated increases in the prices of these goods and securities.
8. The authorities recognize that something exceptional ishappening in the economy and while they are mindful of earlier manias, ‘this time it’s different,’ and they have extensive explanations for the difference.
9. More and more firms and households that previously had been aloof from these speculative ventures begin to participate in the scramble for high rates of return. Making money never seemed easier.
Burst of the Bubble
10. As the buyers become less eager and the sellers become more eager an uneasy period of ‘financial distress’ follows.
11. Price drops sharply and highly leveraged investors go bankrupt.
12. Some bear rallies will happen as some investors believe the drop is temporary, and other believe the price has dropped too far.
13. As the decline in prices continues,more and more investors realize that prices are unlikely to increase and that they should sell before prices decline further; in some cases this realization occurs gradually and in others suddenly.
14. The rush is on—prices decline and bankruptcies increase.
15. The decline in investor optimism might lead to panic, which feeds on itself until prices have declined so far and have become so low that investors are tempted to buy the less liquid assets, or until trade in the assets is stopped by setting limits on price declines, shutting down exchanges or otherwise closing trading, or a lender of last resort succeeds in convincing investors that money will be made available in the amounts needed to meet the demand for cash and that hence security prices will no longer decline because of a shortage of liquidity.