2 - The bubble bursts: what does history's experience tell us? (1)

The inflation and bursting of bubble economies is a recurring phenomenon in the world's economic history. Although the causes, timing and size of bubble economies and their impact on society vary, they all end tragically, and in some cases with great economic and financial disaster.

The literature on bubbles is extensive. However, there is no systematic response to how all previous bubbles burst. Today's markets, with their growing optimism, make it particularly important to discuss this topic in depth.

From the 17th to the 19th century, there were three famous bubbles: the Dutch Tulip Bubble of 1635 to 1637, the BritishSouth Sea Bubble of 1720 and the Great Railway Madness of 1844 to 1846. In the case of these bubble economies, interest rate volatility was a key catalyst for the asset market boom and subsequent collapse.

Source: Gareth Campbell: "The railway mania: Not so great expectations?"

Asset bubbles have emerged more frequently in recent decades, with important ones including the 'Pretty Five-0' of the 1950s and 1960s, gold in the 1970s, Japan in the 1980s, technology stocks in the 1990s and the property bubble of the 21st century. 

Source: Chen Zhao - Alpine Macro 2021

All of these post-war asset bubbles had several important features in common: firstly, all asset bubbles were built on sound and solid economic fundamentals. Bull markets only evolve into asset bubbles when market speculation begins to be overly optimistic about fundamental trends. Secondly, cheap and declining interest rates are a prerequisite for the formation of asset bubbles. Typically, asset bubbles are always born out of a sharp drop in interest rates triggered by an economic downturn. Thirdly, just as all bubbles start from low or falling interest rates, the bursting of financial manias or asset bubbles is caused by rising interest rates and monetary tightening. However, some bubbles burst as soon as interest rates start to move higher, while others last until the end of the rising interest rate cycle. Invariably, asset bubbles inevitably burst when short-term interest rates are higher than long-term bond yields, resulting in an inverted curve.