An assumption of classical economics is that consumers and firms are rational. i.e. they take care to make the best choices given the information available.
In theory, people would seek to avoid situations where they buy overvalued assets. However, in the real world, we often have seen asset bubbles and behaviour which seems to be irrational. This is often termed irrational exuberance. It is studied in behavioural economics
Examples of Booms and Busts
Throughout history there have been many examples of speculative booms where investors jumped onto rising commodity prices, ignoring the economic fundamentals. Some examples of famous booms and busts include:
- The price of tulips 17th Century immortalized by the book "Extraordinary Popular Delusions and the Madness of Crowds, "
- The South Sea Company 1720
- Florida Real Estate craze of 1926
- The Wall Street boom of the 1920s and crash of 1929.
- Dot Com bubble 2000-2002
- House price boom in America 2001-2007
Why People ignore Risk
- The Madness of Crowds - This is the idea that the majority must be right. If other people are piling into a stock, it must be a good thing. Therefore, people feel safe because the so-called experts are recommending the stock. This is sometimes known as the herding effect.
- New Paradigm. This applied particularly to the dot-com bubble in 2000-02. People were aware share prices were worth much more than earnings suggested they should be. However, the argument was that internet stocks were different to old stocks. The internet offered a chance for speculative growth, therefore, we shouldn't use old pricing formula.
- People like the prospect of making a lot of Money. These asset bubbles generate stories of people making a lot of money. Maybe people think they can beat the market. i.e. they know there could be a crash, but, they believe they will be able to get out at the top.
In the post-2001 period, there was a period of easy and cheap credit. People felt that low-cost borrowing would continue for a long time. Therefore, many took out risky mortgages. Mortgage companies sold on their debt, thinking this acted as a kind of insurance. The problem was that the risk of lending was spread throughout the financial sector. People taking out mortgages felt secure because:
- The mortgage companies who were very keen to lend.
- Interest rates were very low (especially in the US)
- Mortgage companies were keen to lend because they saw house prices rising (and felt they would always keep rising)
- They sold on their loans in the form of CDOs to other finance companies.
However, the problem was that interest rates of 1.5% didn't last. They increased as consumer spending rose. Mortgage companies in the US were motivated to sell mortgages that were inappropriate.House prices didn't keep rising.
The effect was that mortgage defaults rose and house prices fell. This led to the credit crunch and shortage of funds causing interbank lending to become more difficult and expensive.
The problem here is that people were focused on a small aspect of the overall picture. There was certainly a strong sense of belief in rising house prices. Also, the last financial crisis led the Federal Reserve to aggressively cut rates to avoid problems.
However, it is of course, always easy to be wise after the event.