Class,

"Bursting Bubbles"

One of the most dangerous phenomena (in an economic sense) is an asset price "bubble." Asset prices are bid up to unreasonable levels based largely on an optimistic view that the rise will continue. The world has seen the effects of stock market bubbles, real-estate bubbles, and commodity bubbles. The problem with asset price bubbles is that when they burst it can be devastating for an economy as we are now experiencing.

Consumers and businesses make financial decisions based on the position of their balance sheet (actual or implicit). An over-inflated asset side of the balance sheet can result in the taking on of an excessive level of debt. When the bubble bursts many households and businesses become technically insolvent. Those that do not must cease much purchasing activity until their balance sheets can be repaired. Consequently the effects of a bubble burst are most often devastating to the well-being of an economy. Indeed, the most recent asset bubble devastated the economy from which the recovery has been painful and slow.  I am referring to the burst of the housing market bubble that began here in 2009 and also caused another asset bubble-Stock Markets-to loose large amounts of value.

Carefully reread the first page of Chapter 10. Described is one of the best known bubble bursts in U.S. economic history: the stock market crash of 1929. Several interesting additional bits of trivia are excluded however. The first is that the participation rate in the stock market had peaked prior to the burst. I believe it was Joe Kennedy that removed his family's fortune from the market when he overheard shoe shiners discussing their investments. He believed that such high participation indicated an irrational valuation of the market. History has proven him correct and the Kennedy fortune survived. Another bit of historical trivia is that many analysts of the time were predicting that mass production has changed the fundamentals of the market. The old measures of proper market valuation were obsolete and the market had the potential to climb to even greater heights in this "new economy."

Whereas the current stock market drop is related to global issues, what I want you to consider is whether you believe that the U.S. experienced a stock market bubble that began to deflate in 2008 and how this might be a direct result of the housing bubble that began to burst in the fall of 2007. Certainly participation in the stock market was up and analysts indeed stated that the fundamentals had changed resulting in a new economy. Indeed the similarities to the "roaring 20's" are intriguing. But as with most anything of any consequence the experts are divided.  For example, many economists argue that Greenspan and the Federal Reserve Board should have deflated the stock market bubble that was developing and eventually led up to the 2000-2001 burst, Greenspan in a speech after the fact said, "The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble is almost surely an illusion." Dr. Greenspan and the Fed also seem to have missed the significance of the impending housing bubble back in 2005-06 or did not believe it would be as devastating as it became in 2009.

What do you think? Should the Fed and others in government have seen that a bubble was forming in the housing market? Is the Federal Reserve or any other agency of the federal government worried that another stock market or bond market bubble might be forming now?  After the dust settles in the current situation, will we be headed for more prosperous times with steady economic growth?