What role do asset bubbles play in financial crises?

Let's put it this way: you can imagine a financial crisis as a massive fire, and the "bubble" is like the firewood and waste paper piled up at the scene before the fire, drenched in gasoline.

The bubble itself isn't the fire, but it makes the outbreak of the fire almost inevitable, and once it ignites, the blaze becomes uncontrollable.

Specifically, the bubble plays several roles:

1. The "Amplifier" and "Accelerator" of Hype

Imagine something, like a house or a company's stock, suddenly becoming incredibly popular. Everyone is spreading the word, "Buy this and you'll get rich," and so prices start to skyrocket.

This price has far exceeded its intrinsic value (for example, a house with a pitifully low rental yield, but whose price has doubled in a year). This is a bubble.

At this point, many people, fearing they'll "miss the boat," rush in. To afford it, they start borrowing heavily. Banks, seeing that the price of this asset is constantly rising and deeming it safe collateral, are more than happy to lend money.

You see, bubble → more people borrow to buy → prices rise faster → bubble gets bigger. This forms a cycle, with the bubble becoming the "engine" of the entire market frenzy. Without a bubble, people wouldn't borrow so frantically to speculate; without frantic borrowing, the bubble couldn't inflate to such a size.

2. The Buried "Landmine"

This party always has to end. When prices become ridiculously high, early entrants start thinking, "That's enough, it's time to sell," or the government, deeming it too risky, begins to raise interest rates (making borrowing more expensive). This balloon can burst at any moment.

As soon as prices start to turn downwards, trouble begins.

Panic spreads rapidly, and everyone shifts from "rushing to buy" to "rushing to sell." Prices plummet like a waterfall.

At this point, the previous "amplifier" starts working in reverse: plummeting prices → people who borrowed to buy find their asset value is far below the loan amount (e.g., a house bought with a 3 million loan is now only worth 1.5 million) → they can't repay their loans and default → banks repossess houses but can't sell them for a good price, leading to massive bad debts.

This is the bursting of the bubble, detonating the "landmine" that was previously laid.

3. The Catalyst for a "Domino Effect"

One or two landmines exploding isn't terrifying; what's terrifying is when these landmines are linked in a chain.

With massive bad debts, banks themselves are on the verge of collapse. To protect themselves, they will do two things:

• Stop lending: Banks dare not lend money anymore, whether to individuals or other businesses. Society's "credit" suddenly freezes.
• Call in debts: They desperately demand repayment from individuals and businesses who can still pay.

This leads to a domino effect:

• Originally healthy businesses, unable to secure loans for working capital from banks, also go bankrupt.
• As businesses fail, employees lose their jobs and are even less able to repay mortgages and car loans.
• With more people unemployed, everyone becomes hesitant to spend, leading to more businesses being unable to sell their products, resulting in further bankruptcies and layoffs.
• Ultimately, even banks that provide funding to other banks run into trouble, and the entire financial system collapses like a row of dominoes, one after another.

To summarize:

In a financial crisis, the bubble plays the role of both the "culprit" and the "catalyst".

• It lures everyone in with false prosperity, encourages excessive borrowing, and inflates risk into a giant balloon.
• When the balloon bursts, it shatters everyone's illusion of wealth and exposes massive debt problems.
• Finally, by destroying the credit function of banks, it transforms an asset price collapse in one sector into a catastrophic financial crisis that sweeps across the entire economy.

Therefore, almost every financial crisis is preceded by a massive bubble. It's like an aperitif before a grand meal: it makes you happy while you drink it, but ultimately sets the stage for a huge bill and a painful hangover.