Economics, 3rd Edition

BUBBLES AND SPECULATION

One of the areas of disagreement amongst economists was the extent to which the pre-crisis financial 

landscape was subject to a ‘bubble’. An 

economic bubble

 occurs when prices of assets and securities 

rise way above their true or fundamental value. Once a bubble bursts, asset and security prices collapse. 

37

THE FINANCIAL CRISIS 

AND SOVEREIGN DEBT

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CHAPTER 37  THE FINANCIAL CRISIS AND SOVEREIGN DEBT  783

The collapse in asset and security prices was a feature of the financial crisis but the origins of the bubble 

(and  some would argue the word is meaningless) lie in the way in which economies changed in the 

30 years prior to the crisis.

Deregulation

During the 1980s, the move towards supply-side policies led to a period of deregulation. In particular, rules 

and deregulation surrounding the activities of financial institutions were abolished or relaxed. In the UK 

and US in particular, successive governments gradually picked away at regulation during the 1980s and 

1990s allowing financial institutions to trade globally and with more freedom to innovate than ever before. 

Deregulation went hand-in-hand with developments in technology and led to further innovation.

Deregulation meant that the average person in the street had access to credit which was much easier 

than it had ever been. In the US and UK, this was further enhanced by the rise in house prices which gave 

many people positive equity in their homes which they could use as security to access credit. What these 

funds could be used for was also relaxed and so more homeowners were in a position to borrow money 

to buy cars, holidays, finance weddings and other luxuries as well as carry out home improvements and 

extensions.

In the US, shocks to the system in the form of the dot.com collapse and the terrorist attacks of 9/11 led 

to dips in economic activity. In each case the Fed responded by cutting interest rates and flooding the mar-

kets with cash. In addition, preparations for a predicted IT disaster at the turn of the millennium (the Y2K  

threat) had meant that many large financial organizations had invested heavily in technology which meant 

that they possessed advantages that enabled them to improve productivity – possibly ahead of time if 

that investment into the Y2K  threat had not occurred. Even in the face of concerns about the fragility of 

consumer spending, profitability in banks rose.

As the search for returns intensified, banks looked to widen the market segments that they were pre-

pared to do business with in the search for new markets and opportunities to improve returns. In addition, 

the prevalence of relatively low rates of interest meant the prospect of high yield returns became even more 

attractive, especially given the fact that such returns could be linked to bonuses for staff. Deregulation and 

global trading meant that capital movements across national boundaries were much easier. Funds could 

be borrowed from countries with low interest rates (particularly Japan which experienced negative interest 

rates at times in the early 2000s) and invested in assets in countries with higher yielding currencies.