When someone mentions the term “bubble”, in the middle of a conversation on economics, they are most likely not talking about the bubbles you would blow as a child. The term bubble in economics refers to a situation where the price of a good exceeds the actual value of the good. When a bubble is popped, the price of the good falls back down to the actual value or below it. There have been mentions of bubbles throughout history, and how they created crises, after popping. Bubbles can be very simple to create, but the effects can lead to situations such as the 2008 market crash, or the 2011 gold asset bubble.
One cause for creating a bubble is low interest rates. Low interest rates help people borrow money more cheaply since they don't have to pay back as much. At the same time it can lower the interest rates of investments, which leads to investors moving their money to higher-risk, higher-profit assets, increasing the asset prices.
Another cause for creating a bubble is demand-pull inflation. This is when the buyers’ demand for a product exceeds the actual supply of the product. This causes the price of the product to increase.
Asset shortage is also a cause for creating bubbles. This is when investors believe that there is not enough of a product to go around. These types of shortages make asset bubbles more likely to occur because the imbalance of supply and demand lead to the prices of a good to appreciate (opposite of depreciation, when the price of the good increases), beyond its actual value.
To better understand a topic, one needs to see an actual example. Many people have heard of the 2008 market crash, which caused millions of American citizens to be displaced from their homes. Even a movie was made about a few guys who saw the crisis coming. The actual story of this is too big, we might cover it some other time, now we can just cover the basic points. Banks in America were willing to give out loans to anyone, regardless of whether they could pay the loans back or not. This is because of the high demand for Mortgage-backed securities. However, when the demand was met, the house prices began to fall, causing the bubble to burst, and the start of the 2008 financial crisis.
Do we know whether we are in a bubble or not? Many believe that right now there is a bubble in the stock market. “Yes, we are in a huge—perhaps unprecedented—equity market bubble and it keeps getting bigger and bigger,” writes Rosenberg Research founder David Rosenberg.
So how can we avoid a bubble and make sure our piggy banks can be full of money? We can avoid bubbles if we observe the market carefully, and assess the situation before buying into something risky. With our observation of the market, we need to see if a product has too much hype. If you believe the hype for a product exceeds the actual value of it, try not to buy into it.
Please note: you do not have to assess the market for buying something like a Kex choklad. You probably won't fall into a bubble if you buy a Kex choklad.