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a blog from young economists at Nova SBE

Bubbles – a new economic reality

From the Dutch tulipmania (17th century), to the Mississippi Bubble (18th century) or the recent Dotcom Bubbles, bubbles have been around for a long time. This phenomenon can be characterize as an expansion in assets valuation that is not explained by present-value models, once the price of assets exceeds the discounted value of expected future cash flows. Consequently, this asset valuation is not related to macroeconomic conditions, but instead, can be explained by market expectations, or high volume trade.

Grossman and Yanagawa (1992), state that bubbles can reduce the welfare of generations born after the bubble appears. The reason that supports this theory is that bubbles draw capitals that can be allocated in more productive assets. Furthermore, we need to take in to consideration that if valuation occurs there will be a point where bubble bursts is bonded to happen.

The discussion around origins, development and, consequences of bubbles is not as old as bubbles itself but as been around for quite some time. It emerged again at an IMF forum by Larry Summers, former Treasury secretary, that in his presentation defended the idea that, we may be in a permanent condition of slow economic growth, and bubbles have been the only thing keeping economy unemployment to fall even further. Moreover, Summers implied that any tougher financial regulation may depress lending and borrowing at a time when more spending of any kind is good for the economy.

Paul Krugman advocates that bubbles have been essential to economic growth:

We now know that the economic expansion of 2003-2007 was driven by a bubble.” (1)

The notorious economist argues that “fixating on debt and deficits deepens the depression” and therefore any kind of spending is positive for the economic, whether it is productive or unproductive. This argument follows the idea that investment, of any kind, will lead to higher employment rates and credit expansion.

“In other words, you can argue that our economy has been trying to get into liquidity trap for a number of years, and that it only avoided them, for a while, thanks to successive bubbles.”(2)

In fact, as mentioned by Krugman and Summers, bubbles can mitigate stagnation and stimulate growth but the length of this growth has still to be accessed. According to them, bubbles should be viewed as the way to avoid the liquidity trap. Thus allowing a continuous investment and, provide conditions for the economy to reach a higher levels that would be reach without them. Furthermore bubbles generate a redistribution of wealth, not only among the participant agents, but also among the agents that potentially receive the externalities and collateral impacts (2).

Saying we need bubbles to grow is not an endorsement to bubbles. Need means that has been evident that only with bubbles has been possible to generate enough aggregated demand and therefore creating adequate employment. Bottom point is that bubbles can work as a boost to the economy aggregate demand and thus employment.

It follows that the burst of these bubbles cannot be forgotten given it is the other side of the coin. In this context becomes very important to understand the consequences of a bubble crash. Another pertinent question that comes to mind is if the growth, achieved through continuous bubbles, suffices to offset the impact of their fall out.

In general terms, it is agreed that bursts have substantial costs in terms of macroeconomic stability, say the impact in real GDP growth or unemployment rate. It can slow down or harm job creation and output, since when there is a burst it is not feasible to support jobs and output as they inflate. Moreover, as stated previously, this phenomenon also causes misallocation of resource.

Until now bubbles have been the way to avoid low economic growth but it is also evident that we need a more sustainable way to prevent that slow down. Krugman advocates that a smaller trade deficit, stronger social safety net, in order to increase consumption, frequent fiscal stimulus, and higher inflation – correcting the zero lower bound -could help to accomplish growth and sustainability.

Taking into account this effects and the idea that we need bubbles to achieved some growth, avoiding secular stagnation – that can be explained by demographics, say low population growth, slow technological innovation and, or trade deficit – they become a major issue for monetary policies.

Thus, the question to ask is if monetary policy should respond to asset price bubbles. Furthermore, which attitude should be taken towards bubbles, prevent their formation, accept, or even promote, them as a necessary economic tool.

 Marta Caeiro 632 and Tiago Branco 664



(3) Álvaro Jiménez Jiménez – 2011 – Understanding Economic Bubbles.

Peter M. Garber – 2001 – Famous First Bubbles: The fundamentals of Early Manias

Scherbina, Anna – 2003 – Asset price bubbles: a selective survey 

William C. Hunter, George G. Kaufman and Michael Pomerleano – 2005 – Asset Price bubbles – The implications for monetary, regulatory and international Policies

 William H. Janeway – 2013 – The Next Economic Bubble The Coming Green Tech Mania – And Why It’s a Good Thing,




Author: studentnovasbe

Master student in Nova Sbe

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