There is a chapter in the study of economics called the business cycle. The title is pretty self-explanatory but just to give an overview, the business cycle is pretty much about the different phases a business goes through, and it is illustrated in a horizontally facing S-shaped graph.

A bubble pretty much goes by the same description; it is the rapid increase of the price of a stock or asset which later pops because the price of that stock or asset has risen way beyond its true value. Remember when I mentioned the business cycle earlier? The cycle has five phases – expansion, peak, recession, trough and recovery. That also almost goes for a bubble, except that events leading up to an inevitable burst of a bubble aren’t recorded in textbook terms as phases, like the business cycle, even though the principle is the same. A bubble is caused by a surge of an economic activity in an industry where prices of stocks or assets, which metaphorically represent a bubble, inflate beyond measures to a point where that inflation has fully filled the bubble and the bubble bursts, and after that happens, those prices fall flat and lose value.

The first ever bubble recorded was in 1634, in Holland and what happened was, there became a bubble because of a type of flower. A phenomenon of tulip bulbs took off back then after one researcher had planted them and the neighbors stole those bulbs and began to sell them and then after that, the demand just grew insanely and that caused the price to surge as well.

A more recent and popular bubble was the housing bubble in 2007. In America in 2003, there was a boom in the housing market, so a lot of people took out mortgage loans. What happened after that was, the commercial banks who granted those mortgage loans repackaged them and sold them to investment banks, and investment banks sold them to pension and hedge funds. Now firstly, when you take out a loan, you must have collateral, in case you later default on that loan and the bank needs something to settle that default. Hedge funds and pension funds ended up owning the loans people took out, meaning that they then had claims to the collateral, and that collateral was the houses people bought, meaning repossession. When the commercial banks were pooling the loans sell off to other parties, they didn’t know that the boom was a bubble, and a bubble inadvertently bursts, so they didn’t think people would default on their loans. Needless to say, they were wrong

As the demand for houses grew, so did the price, and they grew beyond their value, so people couldn’t afford to pay their monthly installments on their home loans anymore, so they had to default. What the defaults caused was funds putting claims on the collateral that came with buying the loans people took out, and that collateral was the actual homes. People lost their homes and their jobs and that set the American financial system into a disarray that gave birth to the global financial crisis from 2007 through 2009.

In a nutshell, bubbles are the averse side of an unmitigated consumption of a product into the market. Their effects are detrimental to not only the economy from where they occur, but to other economies they have strong international trading ties with, hence the the much recent economic crisis.