The anatomy of a bubble: from displacement to panic

Prices do important work in a market economy. When the price of one asset rises relative to another, money, people and effort flow towards it. Rising prices for technology shares draw investment into technology; rising house prices encourage building. Most of the time, this is how resources find their way to where they are most valued.

But markets also seem, every so often, to lose their footing. Prices rise far beyond anything that sensible estimates of value could justify, then fall just as dramatically. These episodes are called bubbles, and the collapses that follow them are called busts. They have occurred in tulip bulbs, company shares, railways, land, houses and technology stocks, across centuries and continents.

What is striking is how similar they look. The assets differ, the countries differ and the technology differs, but the sequence of events repeats with remarkable consistency. This article sets out that sequence, stage by stage, using a widely used framework and well-documented historical examples. It is the first in GoCore’s series on bubbles, and the ideas here underpin the articles that follow.

Where the framework comes from

The stage model of bubbles is most closely associated with the economic historian Charles Kindleberger, whose book Manias, Panics, and Crashes (first published in 1978) studied financial crises over several centuries. Kindleberger built on the work of the economist Hyman Minsky, who argued that periods of stability encourage the risk-taking and borrowing that eventually make the financial system unstable.

The framework is not a law of nature, and not every bubble passes through every stage in the same way. But it describes the broad shape of most episodes well enough to be a useful map. Its stages are usually described as:

Displacement: an outside event creates a new opportunity.
Boom: investment and credit flow into the new area, and prices rise.
Euphoria: speculation overtakes genuine investment, and expectations become extreme.
Distress: the rise slows, and a trigger starts a decline.
Revulsion and panic: prices fall sharply, credit retreats and the wider economy suffers.

Stage 1: Displacement

Every bubble begins with something real. An event changes the investment landscape and appears to open up a new opportunity. Economists call this a displacement.

The displacement can take many forms:

A new technology, such as canals, railways, electricity, radio, the personal computer or the internet.
The end of a war or crisis, releasing pent-up demand and confidence.
A large fall in interest rates, which makes borrowing cheaper and raises the value of future income.
Financial deregulation, which allows lenders to lend more freely or to new kinds of borrowers.
A new market opening up, through trade, political change or discovery.

The nature of the displacement is the biggest source of variation between bubbles. It is also part of the problem. Because each bubble begins with something genuinely new, it is easy to believe that old lessons do not apply. Nobody expects a second internet bubble in exactly the same form; the danger lies in the next new thing that generates similar excitement.

Why displacements are usually genuine

It is worth stressing that the opportunity at the start of a bubble is usually real. Railways did transform transport and trade in the nineteenth century. The internet did change how people communicate, shop and work. The problem is rarely that the opportunity is imaginary. It is that the price paid for a share in it eventually runs far ahead of what it can deliver, and that many of the businesses formed to exploit it will not survive.

Stage 2: Boom

If the displacement is strong enough, it creates an economic boom as investment moves into the new area. Early investors earn high returns. Their success attracts others. New companies are formed, existing companies expand, and prices begin to rise.

Credit plays a central role at this stage. Banks often fuel the boom by expanding lending rapidly. Even when established banks are cautious, history suggests that other sources of finance step in: new banks, finance companies, foreign lenders, personal credit and novel financial products. Money floods into the booming sector, pushing prices higher and creating still more apparent profit opportunities.

The boom feeds on itself. Rising prices make the investments of early participants look brilliant, which encourages more lending against those investments, which funds more buying, which raises prices further. The article Credit: the fuel behind every bubble looks at this process in detail.

At this point, there is often still a reasonable case for higher prices. The opportunity is real, profits are rising and the economy may be strong. The boom has not yet become a bubble, but the foundations are being laid.

Stage 3: Euphoria

At some point the boom reaches a phase described as euphoria or mania. Speculation builds on top of genuine investment, and expectations of future returns reach extreme levels.

Several things tend to happen together:

Recent returns are extrapolated endlessly forward. If prices have risen 30% a year for three years, people come to expect the same indefinitely.
Valuation is swept aside. Traditional measures of value, such as price compared with earnings or rents, are dismissed as outdated.
New participants arrive. People with little experience of the market, and little interest in it until recently, are drawn in by the prospect of quick gains.
Popular interest soars. The market becomes a topic of everyday conversation, media coverage and social discussion.
Lending standards loosen. Lenders compete to finance the boom, and borrowers take on more debt.

There is a well-known saying that when taxi drivers start offering share tips, the market is near its peak. The point is not about taxi drivers; it is that when everyone, including people who have never shown interest in a market, wants to buy, there are few new buyers left to push prices higher.

Warnings during euphoria

During this phase there are usually plenty of people warning of a bubble: economists, central bankers, politicians, journalists and experienced investors. Their first warnings are almost always too early. Prices keep rising after the warnings, and the people who gave them are often discredited or ignored.

A famous example is the speech in December 1996 in which the then chair of the US Federal Reserve, Alan Greenspan, asked how anyone would know when “irrational exuberance” had unduly escalated asset values. US share prices continued to rise strongly for more than three years afterwards. The article Why bubble warnings come too early explores why this pattern is so common.

Stage 4: Distress and the trigger

Eventually the rise slows. Some participants take profits. Fewer new buyers are willing to come in at ever-higher prices. The market may move sideways for a while, sometimes in a period of eerie calm.

Then something precipitates a decline. The trigger can be:

an external shock, such as a war, political crisis or natural disaster
a rise in interest rates, which makes borrowing more expensive and raises the return available on safer assets
an economic slowdown, often because the new investments made during the boom have come on stream and created overcapacity
a failure or scandal at a prominent company or lender
nothing in particular: sometimes the trigger is simply the straw that breaks the camel’s back

The trigger does not need to be large. A market priced for perfection can be brought down by modest disappointment. What matters is that it reveals the gap between price and value, and that participants begin to doubt that prices will keep rising.

Overcapacity

One of the most common triggers deserves particular attention. During a boom, high prices encourage enormous investment in new capacity: new railways, new factories, new offices, new houses, new fibre-optic networks. When that capacity is completed, supply rises sharply. If demand does not keep pace, prices and profits fall. The very investment that the boom encouraged becomes the reason it ends.

Stage 5: Revulsion and panic

The next stage is often called revulsion. Prices fall, and the mood changes completely. Financial distress rises as borrowers who bought at high prices find themselves owing more than their assets are worth. Bankruptcies increase. Banks, having lent freely during the boom, pull back sharply.

The wider economy suffers. Investment falls as businesses abandon expansion plans. Uncertainty rises, and everyone wants to wait and see before committing to new hiring or investment. Consumers hold back on large purchases, such as cars and houses, worried about their jobs as well as their investments. Perfectly good projects now fail, simply because finance and customers have disappeared, adding to the distress.

Panic

Sometimes there is a panic phase, in which prices fall extremely rapidly as people try to sell before everyone else, and there are hardly any buyers. Liquidity, the ability to sell an asset quickly without a large price cut, dries up. Prices fall precipitously, in a kind of reverse speculation.

Panics end in one of a few ways:

Prices fall so far that buyers decide assets are now cheap.
Authorities close the market temporarily, hoping the panic will subside.
A lender of last resort, usually a central bank, provides emergency funding to restore confidence in the financial system.

Even with these responses, it is rare to escape a major bust without at least a serious economic slowdown, and often a recession. The article After the peak: what happens when a bubble bursts looks at the bust and its aftermath in more detail.

The stages in one table

Stage	What happens	Typical mood	Credit
Displacement	A genuine new opportunity appears	Interest, curiosity	Normal
Boom	Investment flows in; early investors profit	Optimism	Expanding
Euphoria	Speculation dominates; valuation ignored	Excitement, certainty	Loose, new lenders
Distress	Rise slows; trigger appears	Unease, denial	Tightening
Revulsion and panic	Prices collapse; failures mount	Fear, disgust	Withdrawn

A historical illustration: the British Railway Mania

The British Railway Mania of the 1840s follows the pattern closely.

Displacement. The success of early railways in the 1830s demonstrated that rail could transform the movement of goods and people. Early lines earned good returns.

Boom. Encouraged by those returns, and by a period of low interest rates, investors poured money into new railway companies. Parliament approved large numbers of new lines.

Euphoria. By the mid-1840s, railway shares had become a national obsession. New schemes were promoted with little regard for whether the routes would ever be profitable. Shares could often be bought by paying only a small deposit, with the remainder payable later when the company called for it, which drew in many people with limited means.

Distress. Interest rates rose, and the companies began calling for the unpaid portions of shares to fund construction. Investors who had bought on small deposits now needed large sums of cash.

Revulsion. Share prices collapsed, many schemes were abandoned, and many investors suffered heavy losses.

Yet much of the railway network that was built during the mania went on serving Britain for generations. The technology was real and transformative. Many of the investors who financed it lost heavily. That combination, a genuine innovation financed at prices that could never be justified, is typical of bubbles.

Why the pattern keeps repeating

If the pattern is so well known, why does it keep happening? Several reasons stand out.

Each bubble looks different. The displacement is new each time, which makes it easy to believe that this time really is different.

Memories fade. Bubbles tend to occur after many years of rising prices and economic growth, when the pain of the last bust in that market has faded. A new generation of investors, lenders and borrowers may never have experienced one.

Early participants are right. For a long time, those who buy are rewarded and those who warn look foolish. That experience shapes behaviour.

Incentives encourage participation. Fund managers who avoid a booming market may lose clients long before the bust proves them right. Lenders who refuse to lend lose business to competitors.

Timing is genuinely hard. Even someone who correctly identifies a bubble cannot know when it will end, and prices can stay irrational for a long time.

What the pattern means for business owners

Bubbles are not just a concern for investors. They affect the businesses that sell to booming sectors, the businesses that depend on credit, and every business whose customers feel richer or poorer as asset prices move.

A few practical lessons follow.

Know which stage your market is in. If your customers, suppliers or lenders are in a euphoric phase, the conditions you see are unlikely to last. Plan for what happens when they change.

Be cautious about extrapolating demand. Demand driven by a boom can disappear quickly. Expanding capacity on the assumption that boom-time sales will continue is a common way for businesses to get into trouble.

Watch credit conditions. When lenders are competing to lend, borrowing is easy. When the cycle turns, the same lenders may withdraw facilities just when you need them.

Keep reserves. Busts create opportunities for businesses with cash and low debt: assets, staff and customers become available at sensible prices.

The article Running a business through a boom and bust develops these lessons further.

Common misunderstandings

“Bubbles are about foolish people.” Many participants act sensibly given what they see and the incentives they face. The pattern emerges from the system as a whole.

“The opportunity at the centre of a bubble is fake.” Usually it is real. The problem is the price paid for it.

“A bubble is obvious at the time.” Some signs are visible, but deciding whether a boom is a bubble is a matter of judgement, and the end is very hard to time.

“Busts only hurt speculators.” They damage businesses, workers and households who never speculated, through job losses, tighter credit and weaker demand.

Questions to ask

Is there a genuine new opportunity behind the current rise, and how much of its future is already reflected in prices?
Are recent returns being extrapolated as if they will continue indefinitely?
Are new, inexperienced participants arriving in large numbers?
Is credit expanding rapidly, and are new lenders or lending practices appearing?
For your own business: how much of your current demand depends on a boom that could end?

The series

This article opens GoCore’s series on bubbles. The other articles, in a suggested reading order:

Bringing it together

Bubbles tend to follow a recognisable path: a genuine new opportunity, a boom fuelled by investment and credit, a euphoric phase in which speculation overwhelms valuation, a trigger that exposes the gap between price and value, and a painful phase of revulsion and sometimes panic. The details change every time; the shape does not.

Recognising the shape does not make bubbles easy to predict or time. But it helps investors, lenders and business owners ask better questions about where a market stands, and prepare for the stage that comes next rather than assuming the current one will last.

Sources: an introductory chapter on asset bubbles written in the mid-2000s, Charles Kindleberger’s Manias, Panics, and Crashes, and widely documented market history. This article is general information, not financial or investment advice.