What Caused the Dot Com Bubble: 1: Bubble, Credit and Monetary Policy

From this sector, we are going to talk about the main causes of the dot com bubble. In my bog, three factors are going to be talked about. First of all, the relationship between the bubble and the credit will be talked about.

 

There are a wide variety of reasons that can result in a bubble, both inevitable reasons and accidental reasons. Early researches have been focused on the irrationality of the investors and this will be mentioned later. But along with the development and the liberalization of the financial market, it became very important to analyse its role in the bubbles.  Monetary policy toward the asset bubbles has always been a controversy of the economist.  Some of the economist proposed that the reaction of the financial market should be taken into consideration when making the monetary policy. But some others cannot agree with the idea.  There is also controversy among the people who think it is necessary to take the financial market into consideration when making the monetary policy. Some of them think the policy should be an ex-ant action while the others think it should be an ex-post one.

 

“Standard theories of asset pricing assume that investors purchase asset with their own wealth. In most financial systems, this is not the whole story .Intermediation is important. Many of the agents buying real estate, stock and other assets do so with other people’s money (Allen and Gale).” This is really the case during the dot com bubble. During that time, investors borrowed large amount of money buying new shares. The dot com corporations borrowed money to expand. And they did these in an extreme way. This really led to the formation of the bubble.

 

Allen and Gale (1999) suggested that the relationship between credit and asset prices becomes even more complex in a dynamic context. And they suggested that the uncertainty about the level of credit can further aggravate the bubble “the more uncertainty that is with the future credit, the more uncertainty the future price will be. Because of the risk-shifting problem, uncertainty makes the asset price more attractive to the debt-financed investors.” The process of the formation of the dot com bubble is also the process of the increase of the uncertainty. This also implies that a signal of tighten the credit can be very likely to lead to the burst of the bubble.

 

But the story is not that easy. It’s not like that: ease credit and bubble form while tighten credit and bubble burst. In fact, bubble and prosperity is like the two sides of a coin. In the next bog, I’ll talk something about the Mississippi bubble and John Law. Compared with dot com bubble it is relatively innocent. Only then, it can help us to clearly observe the role which money played in the bubble, and more important, in the economy.

 

Allen, F. and Gale, D. (1999) “Bubbles, Crises, and Policy”, Oxford Review of Economic Policy, 15, 9-19.

Allen, F. and Gale, D. (2000) “Asset Price Bubbles and Stock Market Interlinkages”, mimeo.