What is an Economic Bubble?

Professor Charles Kindleberger, from the Massachusetts Institute of Technology, defined a bubble in the New Palgrave: A Dictionary of Economics as:

“A bubble may be defined loosely as a sharp rise in the price of an asset or a range of assets in a continuous process, with the initial rise generating expectations of further rises and attracting new buyers – generally speculators interested in profits from trading in the asset rather than its use of earnings capacity.” (Eatwell et al, 1987)

What Kindleberger is implying with this definition is that asset bubbles are created when assets are valued higher than what they are intrinsically worth. 

A warning pamphlet printed by the Dutch
government, warning of the dangers of
investing in Tulips

There have been many examples of such asset price bubbles, with the first real being the “Tulipmania” of the 1630’s when the price of tulip bulbs reached astronomic levels, with some estimating that prices reached approximately 10 times the annual wage of a skilled worker. Tulips were seen as the “sure-thing investment” of the day, and this confidence that they would always make an investor money lead to a severe case of hubris in the market. Then, in February 1637 it was considered that tulips weren't as valuable as their price indicated, and from February to May 1637 bulbs which were once very valuable became basically worthless. Other notable asset bubbles since Tulipmania have included the South Sea Bubble of 1720, “Railway Mania” in the 1840’s and the Great Crash of 1929.

The Dot-Com bubble was caused mainly by excess speculation on internet start-up companies, which saw stock markets grow very quickly for approximately 5 years, from 1995-2000. The boom and bust of the dot-com bubble draws very clear parallels with many previous asset bubbles throughout history. Clearly lessons were not learned from these bubbles though, as history went on to repeat itself during this bubble. Over the next few posts I will consider what happened during the dot-com bubble and what happened when it burst?