Asset pricing bubble:

An asset bubble is when the price of an asset, such as housing, stocks, or gold, become over-
inflated. Prices rise quickly over a short period. They are not supported by the underlying
demand for the product itself. It's a bubble when investors continue to bid-up the price beyond
any real, sustainable value. These price spikes often occur when investors all flock to a particular
asset class, such as the stock market, real estate, or commodities. Such a bubble is also called
asset inflation.

Three Causes of an Asset Bubble;

Low-interest rates are the most frequent cause of an asset bubble. They create an over-expansion
of the money supply. Hence, investors can borrow cheaply but cannot receive a good return on
their bonds. So they look for another asset class. 

The second biggest cause is demand-pull inflation. That's when an asset class suddenly becomes
popular. As asset prices rise, everyone wants to get in on the profits. But the consumer price
index does not always accurately capture this form of inflation. So policy-makers overlook it. 

Third, a supply shortage will aggravate an asset bubble. That's when investors think that there is
not enough of the asset to go around. They panic and start buying more before it runs out.

2005 - Housing Bubble Example:

An asset bubble occurred in real estate in 2005. Credit default swaps insured derivatives such

as mortgage-backed securities.  Hedge fund managers created a huge demand for these
supposedly risk-free securities that created demand for the mortgages that backed them.

To meet this demand for mortgages, banks and mortgage brokers offered home loans to just
about anyone. That drove up demand for housing, which homebuilders tried to meet. Many
people bought homes, not to live in them or even rent them, but just as investments to sell as
prices kept rising. When the homebuilders finally caught up with demand, housing prices started
to fall in 2006. That burst the asset bubble. It created the subprime mortgage crisis in 2006. That
led to the banking credit crisis in 2007 and the global financial crisis in 2008.

2013 - Stock Market Example:

The stock market took off in 2013. By July, it had gained more points than any year on
record. On March 11, the Dow Jones Industrial Average closed at 14,254.38, breaking its
previous record of 14,164.43 set on October 9, 2007. On May 7, it broke the 15,000 barriers,
closing at 15,056.20, and broke the 16,000 barriers on November 21, closing at 16,009.99. The
Dow set its high for the year at 16,576.55 on December 31, 2013.

Price gains rose faster than corporate earnings, which are the underlying driver of stock prices.
Companies achieved increases in earnings by cutting costs, not increasing revenue. Demand for
many consumer products was weak since unemployment was still high (around 7 percent)
and average income levels were low. Investors were more concerned about whether the Fed
would taper QE than they were about real economic growth.

How Do Asset Bubbles Cause Recessions?

Asset bubbles shoulder blame for some of the most devastating recessions ever faced by the

United States. The stock market bubble of the 1920s, the dot-com bubble of the 1990s, and the
real estate bubble of the 2000s were asset bubbles followed by sharp economic downturns. Asset
bubbles are especially devastating for individuals and businesses who invest too late, meaning
shortly before the bubble bursts. This unfortunate timing erodes net worth and causes businesses
to fail, touching off a cascade effect of higher unemployment, lower productivity and financial
panic.

The real trouble starts when the asset bubble picks up so much speed that everyday people, many
of whom have little-to-no investing experience, take notice and decide they can profit from rising
prices. The resulting flood of investment dollars into the asset pushes the price up to even more
inflated and unsustainable levels. Eventually, one of several triggers causes the asset bubble to
burst. This sends prices falling precipitously and wreaks havoc for latecomers to the game, most
of whom lose a large percentage of their investments. A common trigger is demand becomes
exhausted. The resulting downward shift puts downward pressure on prices. Another possible
trigger is a slowdown in another area of the economy. Without economic strength, fewer people
have the disposable income to invest in high-priced assets. This also shifts the demand curve
downward and sends prices plummeting.

Historical Examples of Asset Bubbles

The biggest asset bubbles in recent history have been followed by deep recessions. The inverse is
equally true. Since the early 20th century, the largest and most high-profile economic crises in
the U.S. have been preceded by asset bubbles. While the correlation between asset bubbles and
recessions is irrefutable, economists debate the strength of the cause-and-effect relationship.
Universal agreement exists, however, that the bursting of an asset bubble has played at least
some role in each of the following economic recessions.

Several main reason/causes of assets bubble pricing:

Liquidity: One possible cause of bubbles is excessive monetary liquidity in the financial system,
inducing lax or inappropriate lending standards by the banks, which makes markets vulnerable to
volatile asset price inflation caused by short-term, leveraged speculation. For example, Axel A.
Weber, the former president of the Deutsche Bundesbank, has argued that "The past has shown
that an overly generous provision of liquidity in global financial markets in connection with a
very low level of interest rates promotes the formation of asset-price bubbles."
Social psychology factors: Greater fool theory states that bubbles are driven by the behavior of
perennially optimistic market participants (the fools) who buy overvalued assets in anticipation
of selling it to other speculators (the greater fools) at a much higher price. According to this
explanation, the bubbles continue as long as the fools can find greater fools to pay up for the
overvalued asset. The bubbles will end only when the greater fool becomes the greatest fool who
pays the top price for the overvalued asset and can no longer find another buyer to pay for it at a
higher price. This theory is popular among laity but has not yet been fully confirmed by
empirical research.
Extrapolation: is projecting historical data into the future on the same basis; if prices have risen
at a certain rate in the past, they will continue to rise at that rate forever. The argument is that
investors tend to extrapolate past extraordinary returns on investment of certain assets into the
future, causing them to overbid those risky assets in order to attempt to continue to capture those
same rates of return.
Herding: Another related explanation used in behavioral finance lies in herd behavior, the fact
that investors tend to buy or sell in the direction of the market trend. This is sometimes helped
by technical analysis that tries precisely to detect those trends and follow them, which creates
a self-fulfilling prophecy.
Moral hazard: Moral hazard is the prospect that a party insulated from risk may behave
differently from the way it would behave if it were fully exposed to the risk. A person's belief
that they are responsible for the consequences of their own actions is an essential aspect of
rational behavior. An investor must balance the possibility of making a return on their
investment with the risk of making a loss the risk-return relationship. A moral hazard can occur
when this relationship is interfered with, often via government policy.
A recent example is the Troubled Asset Relief Program (TARP), signed into law by U.S.
President George W. Bush on 3 October 2008 to provide a Government bailout for many
financial and non-financial institutions who speculated in high-risk financial instruments during
the housing boom condemned by a 2005 story in The Economist titled "The worldwide rise in
house prices is the biggest bubble in history". A historical example was intervention by the
Dutch Parliament during the great Tulip Mania of 1637.
Other causes of perceived insulation from risk may derive from a given entity's predominance in
a market relative to other players, and not from state intervention or market regulation. A firm or
several large firms acting in concert (see cartel, oligopoly and collusion) with very large
holdings and capital reserves could instigate a market bubble by investing heavily in a given
asset, creating a relative scarcity which drives up that asset's price. Because of the signaling
power of the large firm or group of colluding firms, the firm's smaller competitors will follow
suit, similarly investing in the asset due to its price gains.
However, in relation to the party instigating the bubble, these smaller competitors are
insufficiently leveraged to withstand a similarly rapid decline in the asset’s price. When the large
firm, cartel or de facto collusive body perceives a maximal peak has been reached in the traded
asset's price, it can then proceed to rapidly sell or "dump" its holdings of this asset on the market,
precipitating a price decline that forces its competitors into insolvency, bankruptcy or
foreclosure.
The large firm or cartel – which has intentionally leveraged itself to withstand the price decline it
engineered – can then acquire the capital of its failing or devalued competitors at a low price as
well as capture a greater market share (e.g., via a merger or acquisition which expands the
dominant firm's distribution chain). If the bubble-instigating party is itself a lending institution, it
can combine its knowledge of its borrowers’ leveraging positions with publicly available
information on their stock holdings, and strategically shield or expose them to default.