We often hear about housing bubbles, financial market bubbles, economic bubbles. These bubbles have one thing in common that they all need liquidity. Without liquidity, bubbles can hardly be created. Bubbles occur when people miscalculate the values of goods or assets. However, sometimes people even know they are creating bubbles when they are creating bubbles. This is because they are dealing with assets with high liquidity, they believe creating bubbles will continue and the assets they buy at one period will be sold at higher prices in the next time period.
However, to build up such illusion of continuously increasing prices has to have liquidity. The madness of bubbles needs very narrow time gap between trades, liquidity can ensure that assets can be sold faster. Some people argue that real estate markets have bubbles as well, as we can see that the Financial Crisis was started by the collapse of the US real estate market. However, I think that the US real estate market is the real cause of the crisis, the problem was started in the bond market. Bond has much higher level of liquidity. However, bonds need borrowers to start the initial bond formation. The banks used the people who originally could not afford mortgages to expand their lending and create more mortgages. Then they securitized these mortgages to transfer them into assets with better liquidity. Because of the MBSs, the housing market started to be filled with bubbles. People traded MBSs and banks saw an opportunity to earn more profits by creating more such MBSs, they would look for more mortgage borrowers, then the real estate market expands as more buyers appeared as more people became able to borrow mortgages.
Therefore, bubbles always take place in markets with better liquidity.
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