A year after the collapse of home values triggered the financial crisis and Great Recession, another rapid and irrational rise in the price of assets _ whether stocks, home values, oil or something else _ would seem unlikely. After all, major bubbles through history have been spaced decades, if not centuries, apart.
Today, though, amid the wreckage of the last bubble, the ingredients for the next are still with us. The price of gold spiking to its highest level ever _ $1,060 an ounce on Thursday _ is one warning sign, as is the 66 percent surge since March in the Nasdaq Stock Market index.
One reason is that there's a sharp rise in the amount of capital sloshing around the world in search of the best returns. Investors are still fixated on short-term gains over long-term performance. And information now travels instantly, fueling a herd mentality and feeding the optimism wired into our brains.
Bubbles feel good when they're inflating, but even that upside isn't a replacement for slow-and-steady growth _ the type of economy the U.S. mostly had for decades. The problem comes when the music stops and the wreckage spreads far beyond the assets that were inflated.
After the housing bubble popped, we're lucky to still have a functioning financial system. And because millions of working Americans now depend on 401(k) plans instead of pensions for their retirement savings, they're more vulnerable when the stock market plunges as it did last fall.
"It's not a matter of could it happen again; it's a matter of when," says Kenneth Rogoff, an economics professor at Harvard University and co-author of a new book on bubbles called "This Time Is Different: Eight Centuries of Financial Folly."
Reckless day traders and unqualified home buyers got blamed for the Internet stock bubble at the beginning of this decade and the still-deflating housing bubble. But they're just bit players in the story. The surge of global capital seeking the quickest and most profitable investments played a larger role.
Over the last 30 years, the value of financial assets _ such as stocks, bonds and bank deposits _ grew to be four times larger than annual global gross domestic product. Key factors: personal savings rates rose in Asian economies, companies piled up profits year after year and Middle Eastern oil-exporting countries grew wealthier.
Mckinsey Global Institute estimates this measure of wealth peaked at $194 trillion in 2007. And while it fell back to $178 trillion at the end of last year, it is still dramatically larger than the $43 trillion in 1990 or the $94 trillion in 2000.
That money helped fuel the Internet boom. Billions of dollars in seed money enabled Silicon Valley startups to go public with only vague business plans _ and attract more investors.
After tech lost its luster in 2000, capital stampeded into another promising asset: the U.S. residential housing market.
That money made it easy for millions of Americans _ even those without good credit or money for a down payment _ to get mortgage loans because global institutional investors were eager to buy the high-yielding securities the mortgages were packaged into.
Before last year's financial crisis, China had amassed $376 billion in long-term U.S. agency debt, mostly in assets issued or backed by mortgage-finance giants Freddie Mac and Fannie Mae.
Today, record-low rates for short-term loans in the U.S. _ tied to the Federal Reserve cutting its target rate for overnight bank loans close to zero _ are also now playing a role. And there's more incentive for money managers around the globe to use dollar-denominated short-term loans to buy stocks, commodities and other investments that typically deliver higher returns. That's contributing to the dollar's 6.5 percent decline in value this year against a basket of six major currencies.
A the dollar has fallen, gold, copper and other commodities priced in dollars have become cheaper for overseas buyers. Gold, for example, has risen 21.7 percent in the last six months in dollar terms. But measured in terms of the euro, the currency used by Germany, France and 14 other European nations, gold is up only 7 percent over that period.
While buying gold is viewed as a way for investors to protect themselves against inflation, it can be a way for money managers to profit off other investors' inflation fears. This is called momentum trading.
And as money managers shift funds around the globe in search of the highest returns, they often end up piling into the same asset classes so they can show clients they're wise to the next hot investment. This is the kind of herd mentality that leads to asset prices inflating beyond their fundamental value.
Harvard professor Rogoff and others say that's why tougher rules on risk-taking, Wall Street compensation and borrowing are needed. "Good policy changes could put off the next (bubble) by 50 to 75 years, instead of five or 10," he says.
Asset bubbles date to the 1600s.
During Holland's "Tulip Mania" in the 17th century, the slender flower became a status symbol and sparked a brief but ruinous bubble that saw tulip bulbs sell for as much as the price of a house before the market crashed. In the late 1800s, shares of U.S. railroads soared and crumbled. And just a few decades later, after the birth of the U.S. auto industry helped pump up the economy _ and home prices _ the stock market made its historic ascent and 1929 crash, triggering the Great Depression.
From World War II up until the 1980s, large-scale asset bubbles in the U.S. were rare.
World economies were tightly regulated and the flow of international capital was restricted, making it much harder for bubbles to form, says Carmen Reinhart, an economics professor at the University of Maryland.
It's a vastly different picture today. International financial markets have become deeply enmeshed, and the cross-border flow of money has ballooned, making the U.S. economy "much more crisis prone," Reinhart says.
It's true that credit is harder to come by today and that could temper the threat. But until lending standards are further tightened, a "misalignment" between the risks and rewards of investing with borrowed money will persist, says Mark T. Williams, professor of finance and economics at Boston University.
The Obama administration is calling for tougher measures against subprime lending to ensure only qualified borrowers get loans. It also has proposed limiting executive pay to discourage excessive risk-taking and making banks keep more capital on their books to safeguard against risky borrowing, or leverage.
Harrison Hong, an economist at Princeton University who researches bubbles, says the same short-term mindset that prods investors to pile into the next boom also allows them to forget the previous bust.
After the bursting of the tech bubble in 2000, it only took a few years before the same investors who lost money on Internet stocks turned their attention to real estate as home prices rose rapidly. "Memories are fairly short," Hong says. "My sense is that we're going to be in for a repeat of this stuff somewhere down the line."