Financial Bubbles, Real Estate Bubbles, Derivative Bubbles, and the Financial and Economic Crisis


The financial crisis of 2008, which started with an initially well-defined epicenter focused on mortgage backed securities (MBS), has been cascading into a global economic recession, whose increasing severity and uncertain duration has led and is continuing to lead to massive losses and damage for billions of people. Heavy central bank interventions and government spending programs have been launched worldwide and especially in the USA and Europe, with the hope to unfreeze credit and bolster consumption. Here, we present evidence and articulate a general framework that allows one to diagnose the fundamental cause of the unfolding financial and economic crisis: the accumulation of several bubbles and their interplay and mutual reinforcement have led to an illusion of a “perpetual money machine” allowing financial institutions to extract wealth from an unsustainable artificial process. Taking stock of this diagnostic, we conclude that many of the interventions to address the so-called liquidity crisis and to encourage more consumption are ill-advised and even dangerous, given that precautionary reserves were not accumulated in the “good times” but that huge liabilities were. The most “interesting” present times constitute unique opportunities but also great challenges, for which we offer a few recommendations.


Stock Market Central Bank House Price Federal Reserve Housing Bubble 
These keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.


  1. 1.
    Gibbs L (trans) (2002) Aesop’s fables. Oxford University Press, OxfordGoogle Scholar
  2. 2.
    Andersen JV, Sornette D (2004) Fearless versus fearful speculative financial bubbles. Physica A 337(3–4):565–585MathSciNetADSCrossRefGoogle Scholar
  3. 3.
    Wikipedia (n.d.) Basel II accord.
  4. 4.
    Berns G, Capra CM, Moore S, Noussair C (2009) Neural mechanisms of social influence in consumer decisions. Working paperGoogle Scholar
  5. 5.
    Blanchard OJ (2008) The crisis: basic mechanisms, and appropriate policies.
  6. 6.
    Borgatti SP, Mehra A, Brass DJ, Labianca G (2009) Network analysis in the social sciences. Science 323:892–895ADSCrossRefGoogle Scholar
  7. 7.
    Boss M, Elsinger H, Summer M, Thurner S (2003) An empirical analysis of the network structure of the Austrian interbank market. Fin Stab Rep 7:77–87Google Scholar
  8. 8.
    Brock WA, Hommes CH, Wagener FOO (2008) More hedging instruments may destabilize markets. CeNDEF Working paper 08-04, University of AmsterdamGoogle Scholar
  9. 9.
    Broekstra G, Sornette D, Zhou W-X (2005) Bubble, critical zone and the crash of Royal Ahold. Physica A 346:529–560ADSCrossRefGoogle Scholar
  10. 10.
    Camerer CF (2003) Behavioral game theory: experiments in strategic interaction. Princeton University Press, PrincetonMATHGoogle Scholar
  11. 11.
    Campbell JY, Cocco JF (2005) How do house prices affect consumption? Evidence from micro data. NBER Working Paper No. 11534, August 2005Google Scholar
  12. 12.
    Cannata F, Quagliariello M (2009) The role of Basel II in the subprime financial crisis: guilty or not guilty? CAREFIN Research Paper No. 3/09.
  13. 13.
    Case KE, Shiller RJ (2003) Is there a bubble in the housing market. Brookings Pap Econ Act 2:299–362CrossRefGoogle Scholar
  14. 14.
    Corcos A, Eckmann J-P, Malaspinas A, Malevergne Y, Sornette D (2002) Imitation and contrarian behavior: hyperbolic bubbles, crashes and chaos. Quant Finan 2:264–281MathSciNetCrossRefGoogle Scholar
  15. 15.
    Damasio A (1994) Descartes’ error. Putman Adult, New YorkGoogle Scholar
  16. 16.
    Demyanyk YS (2009) Quick exits of subprime mortgages. Federal Reserve Bank of St. Louis Rev 91(2):79–93Google Scholar
  17. 17.
    Demyanyk Y, van Hemert O (2009) Understanding the subprime mortgage crisis. Rev Fin Stud 1305 (forthcoming).
  18. 18.
    Doms M, Furlong F, Krainer J (2007) Subprime mortgage delinquency rates. Working Paper Series 2007-33, Federal Reserve Bank of San Francisco.
  19. 19.
    Dunbar RIM (1998) The social brain hypothesis. Evol Anthropol 6:178–190CrossRefGoogle Scholar
  20. 20.
    Farmer JD (2002) Market force, ecology and evolution. Ind Corp Change 11(5):895–953CrossRefGoogle Scholar
  21. 21.
    Fogedby HC (2003) Damped finite-time-singularity driven by noise. Phys Rev E 68:051105MathSciNetADSCrossRefGoogle Scholar
  22. 22.
    Fogedby HC, Poukaradzez V (2002) Power laws and stretched exponentials in a noisy finite-time-singularity model. Phys Rev E 66:021103ADSCrossRefGoogle Scholar
  23. 23.
    Freixas X, Parigi BM, Rochet J-C (2000) Systemic risk, interbank relations, and liquidity provision by the central bank. J Money Credit Banking 32(3):611–638CrossRefGoogle Scholar
  24. 24.
    Garber PM (2000) Famous first bubbles: the fundamentals of early manias. MIT Press, Cambridge, MAGoogle Scholar
  25. 25.
    Gintis H, Bowles S, Boyd R, Fehr E (eds) (2005) Moral sentiments and material interests. MIT Press, Cambridge, MAGoogle Scholar
  26. 26.
    Gluzman S, Sornette D (2002) Classification of possible finite-time singularities by functional renormalization. Phys Rev E 66:016134MathSciNetADSCrossRefGoogle Scholar
  27. 27.
    Greenspan A (1997) Federal Reserve’s semiannual monetary policy report, before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, February 26, 1997Google Scholar
  28. 28.
    Greenspan A, Kennedy J (2008) Sources and uses of equity extracted from homes. Oxford Rev Econ Policy 24(1):120–144CrossRefGoogle Scholar
  29. 29.
    Helbing D (ed) (2008) Managing complexity: insights, concepts, applications. Understanding complex systems. Springer, HeidelbergGoogle Scholar
  30. 30.
    Ide K, Sornette D (2002) Oscillatory finite-time singularities in finance, population and rupture. Physica A 307(1–2):63–106MathSciNetADSCrossRefMATHGoogle Scholar
  31. 31.
    Johansen A (2003) Characterization of large price variations in financial markets. Physica A 324(1–2):157–166MathSciNetADSCrossRefMATHGoogle Scholar
  32. 32.
    Johansen A, Ledoit O, Sornette D (2000) Crashes as critical points. Int J Theor Appl Fin 3(2):219–255CrossRefMATHGoogle Scholar
  33. 33.
    Johansen A, Sornette D (1998) Stock market crashes are outliers. Eur Phys J B 1:141–143ADSCrossRefGoogle Scholar
  34. 34.
    Johansen A, Sornette D (2000) The Nasdaq crash of April 2000: yet another example of log-periodicity in a speculative bubble ending in a crash. Eur Phys J B 17:319–328ADSCrossRefGoogle Scholar
  35. 35.
    Johansen A, Sornette D (2001) Finite-time singularity in the dynamics of the world population and economic indices. Physica A 294(3–4):465–502ADSCrossRefMATHGoogle Scholar
  36. 36.
    Johansen A, Sornette D (2001) Large stock market price drawdowns are outliers. J Risk 4(2):69–110Google Scholar
  37. 37.
    Johansen A, Sornette D (2006) Shocks, crashes and bubbles in financial markets. Brussels Econ Rev (Cahiers economiques de Bruxelles) 49(3/4). Special issue on nonlinear analysis.
  38. 38.
    Johansen A, Sornette D, Ledoit O (1999) Predicting financial crashes using discrete scale invariance. J Risk 1(4):5–32Google Scholar
  39. 39.
    Kaizoji T, Sornette D (2010) Market bubbles and crashes. In: Encyclopedia of quantitative finance. Wiley, New York (in press). (long version of the paper at
  40. 40.
    Keys BJ, Mukherjee T, Seru A, Vig V (2008) Did securitization lead to lax screening? Evidence from subprime loans. Athens Meetings Paper, European Finance Association, December 2008.
  41. 41.
    Kindleberger CP (2005) Manias, panics, and crashes: a history of financial crises, 5th edn. Wiley, New YorkCrossRefGoogle Scholar
  42. 42.
    Krugman P (2008) The return of depression economics. W.W. Norton, New YorkGoogle Scholar
  43. 43.
    Krugman PR, Dominquez KM, Rogoff K (1998) It’s baaack: Japan’s slump and the return of the liquidity trap. Brookings Pap Econ Act 1998(2):137–205CrossRefGoogle Scholar
  44. 44.
    Laherrère J, Sornette D (1998) Stretched exponential distributions in nature and economy: “fat tails” with characteristic scales. Eur Phys J B 2:525–539ADSCrossRefGoogle Scholar
  45. 45.
    Lietaer B, Ulanowicz R, Goerner S (2008) White paper on the options for managing systemic bank crises (November 2008).
  46. 46.
    Lux T, Sornette D (2002) On rational bubbles and fat tails. J Money Credit Banking 34(3): 589–610CrossRefGoogle Scholar
  47. 47.
    Malkiel BG (2003) A random walk down Wall Street, 8th edn. W.W. Norton, New YorkGoogle Scholar
  48. 48.
    Marsili M (2008) Eroding market stability by proliferation of financial instruments. Working paper (November 21, 2008). Available at SSRN:
  49. 49.
    Marsili M, Raffaelli G, Ponsot B (2008) Dynamic instability in generic model of multi-assets markets. Working paper (November 21, 2008). Available at SSRN:
  50. 50.
    Mauboussin MJ, Hiler R (1999) Rational exuberance? Equity research report of Credit Suisse First Boston, January 26, 1999Google Scholar
  51. 51.
    Philippon T, Reshef A (2009) Wages and human capital in the U.S. financial industry: 1909–2006. Working Paper 14644, National Bureau of Economic Research.
  52. 52.
    Poser NS (2009) Why the SEC failed: regulators against regulation. Brooklyn J Corp Fin Comm Law 3(Spring). Brooklyn Law School, Legal Studies Paper No. 132.
  53. 53.
    Roehner BM, Sornette D (2000) “Thermometers” of speculative frenzy. Eur Phys J B 16: 729–739ADSCrossRefGoogle Scholar
  54. 54.
  55. 55.
    Serrano MA, Boguna M, Vespignani A (2007) Patterns of dominant flows in the world trade web. J Econ Interact Coord 2(2):111–124CrossRefGoogle Scholar
  56. 56.
    Sheffrin H (2005) A behavioral approach to asset pricing. Academic, New YorkGoogle Scholar
  57. 57.
    Shiller RJ (2000) Irrational exuberance. Princeton University Press, New YorkGoogle Scholar
  58. 58.
    Sornette D (1998) Discrete scale invariance and complex dimensions. Phys Rep 297(5): 239–270MathSciNetADSCrossRefGoogle Scholar
  59. 59.
    Sornette D (2003) Why stock markets crash (critical events in complex financial systems). Princeton University Press, New YorkMATHGoogle Scholar
  60. 60.
    Sornette D (2008) Nurturing breakthroughs: lessons from complexity theory. J Econ Interact Coord 3:165–181CrossRefGoogle Scholar
  61. 61.
    Sornette D, Andersen JV (2002) A nonlinear super-exponential rational model of speculative financial bubbles. Int J Mod Phys C 13(2):171–188ADSCrossRefMATHGoogle Scholar
  62. 62.
    Sornette D, Johansen A (2001) Significance of log-periodic precursors to financial crashes. Quant Fin 1(4):452–471CrossRefGoogle Scholar
  63. 63.
    Sornette D, Takayasu H, Zhou W-X (2003) Finite-time singularity signature of hyperinflation. Physica A 325:492–506MathSciNetADSCrossRefMATHGoogle Scholar
  64. 64.
    Sornette D, Woodard R, Zhou W-X (2009) The 2006–2008 oil bubble and beyond. Physica A 388:1571–1576ADSCrossRefGoogle Scholar
  65. 65.
    Sornette D, Zhou W-X (2004) Evidence of fueling of the 2000 new economy bubble by foreign capital inflow: implications for the future of the US economy and its stock market. Physica A 332:412–440ADSCrossRefGoogle Scholar
  66. 66.
    Stodder J (2000) Reciprocal exchange networks: implications for macroeconomic stability. Paper presented at the International Electronic and Electrical Engineering (IEEE) Engineering Management Society (EMS), August 2000, Albuquerque, New MexicoGoogle Scholar
  67. 67.
    Taylor JB (2009) How government created the financial crisis. Wall Street Journal, February 9, 2009Google Scholar
  68. 68.
    Taylor JB (2009) Getting off track: how government actions and interventions caused, prolonged, and worsened the financial crisis. Hoover Institution Press, StanfordGoogle Scholar
  69. 69.
    Vasiliki S, Veldkamp L (2009) Ratings shopping and asset complexity: a theory of ratings inflation. NBER working paper 14761.
  70. 70.
    Zhou W-X, Sornette D (2003) 2000–2003 Real estate bubble in the UK but not in the USA. Physica A 329:249–263ADSCrossRefMATHGoogle Scholar
  71. 71.
    Zhou W-X, Sornette D (2004) Causal slaving of the U.S. treasury bond yield antibubble by the stock market antibubble of August 2000. Physica A 337:586–608ADSCrossRefGoogle Scholar
  72. 72.
    Zhou W-X, Sornette D (2006) Is there a real-estate bubble in the US? Physica A 361:297–308MathSciNetADSCrossRefGoogle Scholar
  73. 73.
    Zhou W-X, Sornette D (2008) Analysis of the real estate market in Las Vegas: bubble, seasonal patterns, and prediction of the CSW indexes. Physica A 387:243–260ADSCrossRefGoogle Scholar
  74. 74.
    Zhou W-X, Sornette D, Hill RA, Dunbar RIM (2005) Discrete hierarchical organization of social group sizes. Proc R Soc London 272:439–444CrossRefGoogle Scholar

Copyright information

© Springer 2010

Authors and Affiliations

  1. 1.Department of ManagementTechnology and EconomicsZurichSwitzerland
  2. 2.Swiss Finance Institutec/o University of GenevaGeneva 4Switzerland

Personalised recommendations