Financial Bubbles

A 2001 Journal of Psychology and Financial Markets study called Financial Bubbles: Excess Cash, Momentum and Incomplete Information, by Gunduz Caginalp, David Porter and Vernon Smith (winner of the 2002 Nobel Prize for Economics), suggested that it is relatively easy to create a financial “bubble”, as long as there is available liquidity for purchasing power.

Multiple trading experiments performed under varied conditions with set amounts of capital showed that prices paid for assets mostly began trading for less than, and then sometimes far above its 'worth', before crashing from limited liquidity in the end.

The second time the same traders did the same experiment, it produced a bubble, but it wasn't as big.

In the third try, there was no bubble.

“From 1833 to 1837, the nation's money supply (specie plus bank notes and deposits) increased by 78 percent, or nearly 20 percent annually.  The new money sparked a cotton boom in the South, a canal boom in the Middle West, and a land and real estate boom everywhere.  By early 1837, interest rates began to rise as cotton planters and canal contractors sought to borrow more capital to sustain their struggling projects.  In the spring, a sudden contraction in British credit and a fall in the demand for cotton paralyzed the American economy.  Large mercantile houses in New Orleans and New York failed. Interest rates skyrocketed. Prices plummeted.  Thousands were thrown out of work. In May, the banks suspended specie payments.  The money supply fell by 17 percent. 

President Martin Van Buren blamed the crisis on "excessive issues of bank paper and an "undue expansion of credit.” 

The Bank of the United States, whose president, Nicholas Biddle, was determined to restart the boom by borrowing funds in Europe and using it to buy cotton.  The money supply increased by 8 percent in 1838 sparking a mini-boom. 

It did not last long. 

Panic again struck in the fall of 1839.  There was another run on the banks…  Cotton prices again fell, as did the price of stocks and real estate. Many banks failed entirely, including the powerful Bank of the United States.  States defaulted on their bonds, and canal companies and other firms went bankrupt." 

H.A. Scott Trask

The Federal Reserve saw a need for increased financial liquidity in response to the savings & loan and Asian currency crisis’s, the insolvency of Long Term Capital Management and the anticipation of the Year 2000 computer problems at the end of the twentieth century.

The 16.5% rise in the money supply supplied by the Federal Reserve from January 1998 to January 2000 may have contributed to a massive run up in financial assets in 1999 and early 2000 and the resulting downfall.

The results from the financial bubble study may correlate to the first popping of the financial asset bubble in 2000, the second popping of the real estate, mortgage bubble, leading to the 2008-9 finanical crisis, and the possible emergence of another Central Bank created induced low interest rate and liquidity induced smaller bubble in the present.

Federal Reserve liquidity injections from relatively lower price levels may produce negative economic effects after increased supplies are absorbed by financial markets, unless even larger supplies of money are created.